Undoubtedly the easiest way to invest in the stock market is via a pooled investment fund such as a unit trust or an OEIC (open-ended investment company).

With investment funds, your money is combined with that of other investors to form one fund. This fund is allocated to a fund manager who buys a range of stocks and shares or corporate bonds.

The returns made are dependent on the performance of this range of stocks but the risks and the costs are greatly reduced in comparison to investing in these companies individually.

It is aim of the investment fund managers to maximise returns for their investors, and meet the investment fund’s overall objectives.

These type of investments are usually regarded as long-term and it’s important to remember that values will fluctuate, so instant gains are unlikely.

Advantages of Investment Funds

Diversity and risk

One of the main advantages of collective investment is the reduction in investment risk (capital risk) by diversification. An investment in a single equity may do well, but it may collapse for investment or other reasons (e.g., Marconi, Enron). If your money is invested in such a failed holding you could lose your capital. By investing in a range of equities (or other securities) the capital risk is reduced.

The more diversified your capital, the lower the capital risk.

This investment principle is often referred to as spreading risk.

Collective investments by their nature tend to invest in a range of individual securities. However, if the securities are all in a similar type of asset class or market sector then there is a systematic risk that all the shares could be affected by adverse market changes. To avoid this systematic risk investment managers may diversify into different non-perfectly-correlated asset classes. For example, investors might hold their assets in equal parts in equities and fixed income securities.

Reduced dealing costs

If one investor were to buy a large number of direct investments, the amount they would be able to invest in each holding is likely to be small. Dealing costs are normally based on the number and size of each transaction, therefore the overall dealing costs would take a large chunk out of the capital (affecting future profits). Pooling money with that of other investors gives the advantage of buying in bulk, making dealing costs an insignificant part of the investment.

Disadvantages of Investment Funds

Costs

The fund manager managing the investment decisions on behalf of the investors will of course expect remuneration. This is often taken directly from the fund assets as a fixed percentage each year or sometimes a variable (performance based) fee. If the investor managed their own investments, this cost would be avoided.

Often the cost of advice given by a stock broker or financial adviser is built into the scheme. Often referred to as commission or load (in the U.S.) this charge may be applied at the start of the plan or as an ongoing percentage of the fund value each year. While this cost will diminish your returns it could be argued that it reflects a separate payment for an advice service rather than a detrimental feature of collective investment schemes. Indeed it is often possible to purchase units or shares directly from the providers without bearing this cost.

Lack of choice

Although the investor can choose the type of fund to invest in, they have no control over the choice of individual holdings that make up the fund.

Loss of owner's rights

If the investor holds shares directly, they may be entitled to shareholders' perks (for example, discounts on the company's products) and the right to attend the company's annual general meeting and vote on important matters. Investors in a collective investment scheme often have none of the rights connected with individual investments within the fund.

Style

 Investment aims and benchmarking

Each investment fund has a defined investment goal to describe the remit of the investment manager and to help investors decide if the fund is right for them. The investment aims will typically fall into the broad categories of Income (value) investment or Growth investment. Income or value based investment tends to select stocks with strong income streams, often more established businesses. Growth investment selects stocks that tend to reinvest their income to generate growth. Each strategy has its critics and proponents; some prefer a blend approach using aspects of each.

Funds are often distinguished by asset-based categories such as equity, bonds, property, etc.

Also, perhaps most commonly funds are divided by their geographic markets or themes.

Examples

In most instances whatever the investment aim the fund manager will select an appropriate index or combination of indices to measure its performance against; e.g. FTSE 100. This becomes the benchmark to measure success or failure against.

Active or passive management

The aim of most investment funds is to make money by investing in assets to obtain a real return (i.e. better than inflation).

The methods used to make your investment vary and two opposing views exist.

Active management - Active managers believe that by selectively buying within a Financial market that it is possible to outperform the market as a whole. Therefore they employ dynamic portfolio strategies buying and selling investments with changing market conditions.

Passive management - Passive managers believe that it is impossible to predict which individual holdings or section of the market will perform better than another therefore their portfolio strategy is determined at outset of the fund and not varied thereafter. Many passive funds are index funds where the fund tries to mirror the market as a whole. Another example of passive management is the "buy and hold" method used by many traditional Unit Investment Trusts where the portfolio is fixed from outset.

An example of active management success

Pricing models

Open-ended schemes are either dual priced or single priced.

Dual priced schemes have a buying (offer) price and selling or (bid) price. The buying price is higher than the selling price, this difference is known as the spread or bid-offer spread. The difference is typically 5% and may be varied by the scheme manager to reflect changes in the market; the amount of variation may be limited by the schemes rules or regulatory rules. The difference between the buying and selling price includes initial charge for entering the fund.

The internal workings of an investment fund are more complicated than this description suggests. The manager sets a price for creation of units/shares and for cancellation. There is a differential between the cancellation and bid prices, and the creation and offer prices. The additional units are created are place in the managers box for future purchasers. When heavy selling occurs units are liquidated from the managers box to protect the existing investors from the increased dealing costs. Adjusting the bid/offer prices closer to the cancellation/creation prices allows the manager to protect the interest of the existing investors in changing market conditions.

Most unit trusts are dual priced.

Single priced schemes notionally have a single price for units/shares and this price is the same if buying or selling. As single prices scheme can't adjust the difference between the buying and selling price to allow for market conditions another mechanism the dilution levy exists. SICAVs, OEICs and U.S. mutual funds are single priced.

A dilution levy can be charged at the discretion of the fund manager, to offset the cost of market transactions resulting from large un-matched buy or sell orders. For example if the volume of purchases outweigh the volume of sales in a particular trading period the fund manager will have to go to the market to buy more of the assets underlying the fund, incurring a brokerage fee in the process and having an adverse affect on the fund as a whole ("diluting" the fund). The same is the case with large sell orders. A dilution levy is therefore applied where appropriate and paid for by the investor in order that large single transactions do not reduce the value of the investment fund as a whole.

Easy Insurance Quote

Get a free insurance quote on Insurance Rate

 Cheap Auto Insurance Quote

Get auto insurance quickly with Auto Insurance Remedy