Investing Basics: Investing in Funds

Many of those new to DIY investing start by assembling a portfolio of funds and investment trusts achieving instantly diversified investments at a reasonable and transparent cost – writes Christian Leeming

Some prefer to let the experts take the strain and buy an actively managed fund while others will seek to track a certain index – some follow popular markets such as the FTSE100 whereas others will look for more esoteric global opportunities.

Investing in a tax-efficient ISA wrapper is rarely a bad idea as it is one of the few opportunities the DIY investor has to make money whilst paying very little tax, and those advantages are explored elsewhere on this site.

A Self-invested Personal Pension (SIPP) comes with many tax advantages and may be an attractive option for the DIY investor looking to take control of their retirement planning.

‘Investing in a tax-efficient ISA wrapper is rarely a bad idea’

It is possible to buy funds directly from a fund manager but with a fee equivalent to 5% of the initial investment, this is the most expensive way to do.

Much cheaper is purchasing funds from an execution only (XO) broking platform or ‘fund supermarket’ which will usually negotiate away the initial fee and charge a dealing commission and annual account fees which may be fixed or a percentage of the value of the assets you hold.

Percentage based fees are often either capped or reduce beyond a certain threshold so that they do not penalise successful and diligent investors.

For those with modest investments, a platform charging a percentage is usually the cheaper option, whereas those with a larger pot are usually better off with a platform charging a flat fee.

DIY investing platforms charge modest fees and allow you to hold all your funds in one place; they typically have copious amounts of historical data and product information to inform your choice and often also include selector tools to screen products and help you choose the most appropriate funds.

Some platforms have model portfolios which allow the investor to choose according to their financial objectives and risk tolerance and others will allow you to mimic portfolios of other investors.

In addition to lump sum investments, many platforms will allow regular monthly investments into a fund or range of funds with dealing commission as low as £1 per trade.

‘Much cheaper is purchasing funds from an execution only (XO) broking platform or ‘fund supermarket’’

Platforms often charge lower dealing commission for buying funds than equities and then charge a custody fee (normally quarterly)based upon the value of the funds that are held.

Following the 2012 Retail Distribution Review (RDR), brokers and platforms can no longer retain ‘trail’ commission from issuers as a reward for introducing business and fees are consequently lower and more transparent.

If you choose to engage a financial adviser to assist in your choice of funds you will be charged a fee (sometimes flat, sometimes percentage based) whereas in the past the adviser would have taken commission from the issuer.

In order to ‘buy in’ to a fund, investors have to make a minimum investment, usually £500 to £1,000, and then choose the version of the fund they want; funds typically have two versions, an ‘accumulation’ class (acc) which reinvests dividend income into the fund to boost growth, or an ‘income class’ (inc) which pays out dividends to those who want income.

Funds typically levy two sets of charges – an initial fee, and annual management charges, which pays to run the fund and pay its staff; it is generally recognised that the value-add in active fund management comes with a manager that can consistently beat the market – not a common occurrence – and the additional benefit is that the larger a fund becomes, the lower fees it can levy as a proportion of an investment.

In the past annual management charges were typically around 1.5% with half of that being paid as an incentive to financial advisers and platforms to sell the fund; now these payments have been stopped on new investments and ‘clean’ funds have been introduced, which charge 0.75% – 1% and pay nothing back to advisers or platforms.

‘regular monthly investments into a fund or range of funds with dealing commission as low as £1 per trade’

With the advent of clean funds there can now be a large number of variants of the same fund which are often identified by a letter after its title, although the lack of consistency has not helped those looking for a fund that behaves in a certain fashion; clean funds are sometimes ‘unbundled’ whereas those with higher annual management fees are ‘inclusive’.

Annual management charges are deducted from your investment each year and act as a drag on its performance; the true cost of investing in a fund is usually higher than the annual management fee and is known as a fund’s ‘ongoing charges’ which replaces the old total expense ratio or TER.

Investment trusts tend to be a lower cost option than funds, with no initial charge and lower annual fees and have in many cases delivered better performance than funds over time; they can however be inherently riskier than their unit trust counterparts on the basis that they can trade at a premium, or discount, to the combined value of the assets they hold.

Those opting for a passive investment strategy often do so on the basis that exchange traded funds (ETFs) do not have to pay out for active (expensive) fund management, but products tracking more exotic indices will charge considerably more than those tracking the FTSE which may have charges in single digit basis points (bps – hundredths of 1%).