Investing Basics: How to select a fund

Selecting a fund or funds can seem overwhelming from the thousands to choose from, so here are some pointers to bear in mind.

Georgette Harrison says there is definitely some thinking to do before you get to the point of selecting the funds.

First ask yourself three key questions:

What are my investment goals? Are you planning to use dividends to provide an income, or are you looking to grow your capital? These decisions will often depend on which life stage you are at. Perhaps you want to supplement other retirement income or you are saving for a rainy day.

What is your attitude to risk? There is a trade-off between risk and reward; it is generally assumed that the more risk you are prepared to take, the higher the potential returns, whereas if you are very cautious with your investments, you can anticipate lower returns.

In other words, this is the ‘can you sleep easy’ test.

‘this is the ‘can you sleep easy’ test’

Are you prepared to be more adventurous with your investments and are you happy to take a risk with the investment choices that you make, in the hope that you will make gains. If you feel uncomfortable with that thought, you probably sit at the cautious end of the spectrum. One sage piece of advice is don’t risk what you can’t afford to lose.

Click here to learn more about risk.

What is your time frame? Received wisdom is that the longer the time frame you have to hold your investments, the more risk you might be able to take on, as there is potentially opportunity to ride out some of the inevitable peaks and troughs of stock market performance.

The next step is to consider these points:

Diversification

 
The old adage ‘Don’t put all your eggs in one basket’ holds true here. As you are selecting a fund, you will already have a level of diversification (as the fund will hold multiple individual company shares or different types of investment vehicle), however, it is important that you consider increasing this. Greater diversification should help reduce risk.

If you are invested in one particular sector which is impacted by events and the value of company shares in that sector falls, you are overly exposed to that risk. Whereas, if you have spread your investments across different sectors, you will have also spread your risk and reduced the impact of a sector underperforming.

Asset allocation

Add up all the assets you have across equities, fixed interest, property and cash and work out what the percentage split is to give you your ‘asset allocation’.

Think again about what your investment goals are and to what degree these are currently being met by your existing asset allocation. If there is scope for change to meet your objectives, the next step is to look at the different fund categories.
 

There’s an old rule of thumb which suggests you should subtract your age from 100 and the difference should be the percentage of your portfolio that you hold in equities. For example, if you are 55, around 45% of your assets should be held in stocks and shares. Now that people are living longer and need a greater accumulation of capital, it might be wiser to subtract from 110 or even 120. There is then longer to take advantage of the potentially higher returns that shares offer.

Fund categories

The Investment Association, the trade body that represents UK investment managers, splits funds into different sectors and most fund names will reflect the area or type of investment.

Click here to see the IA Sectors Matrix

Reflecting what your investment goals might be, funds fall broadly into two categories; those that aim to produce income and those that aim for capital growth.

The next level of classification is the type of asset (e.g. shares, fixed income), geographic region or industry sector in which the fund invests.

‘you might choose to have a mix of passive and active funds in your portfolio’

Some funds sit in sectors focused on capital protection, such as money market funds, or are in the specialist category, and some choose to remain unclassified.

The targeted absolute return sector contains funds that aim to produce positive returns in all market conditions.

If you are starting out, you might want to consider a global fund, the ultimate in diversification, as this will give you broad exposure to different markets and you don’t have to make choices as to how to split your investments.

You may take the view that you want to stick closer to home, in which case one of the funds investing in the UK would be your first choice.

Generally speaking, the narrower the fund’s investment objective, the more specialist it is and therefore the less diversified.

Passive or active management

Another aspect which it is worth considering is whether you would prefer to select a passive fund, like a tracker or Exchange Traded Fund (ETF), which follow an index or an actively managed fund, where the fund manager is making the decisions about which companies or investment vehicles to invest in. This is not necessarily an either-or choice. Following the diversification argument, you might choose to have a mix of passive and active funds in your portfolio.

Fund performance

Finally, the thorny issue of fund performance; you have an idea of which sectors you want to invest in, but there are usually many funds belonging to the same sector. Websites like FE Trustnet and Morningstar provide a wealth of information, including fact sheets on each of the funds, ratings and risk/return analysis.

If you are using an investment platform, this will also provide research and information on the different funds available. Some platforms also set up model portfolios, which can offer some good ideas on how to combine fund selections to achieve your investment goals.