by Mark Dampier
There are some disadvantages, which I shall come to, but it is important to start with the advantages, as the worst thing you can do in investment is be talked out of a good thing for the wrong reason. Let me therefore quickly expand on the fundamental strengths of funds as I see them. For the purpose of this exercise the funds I am referring to are usually unit trusts and OEICs, which are broadly similar (see the separate box for how they differ). I discuss later why I generally – but by no means exclusively – prefer these kinds of funds to investment trusts, exchange-traded funds (known as ETFs) and other variants. I also explain why I do, however, make use of one kind of investment trust, known as a venture capital trust (or VCT), for my own portfolio.
Fund types
Unit trusts and OEICs (open-ended investment companies) are two variants of what are called open-ended funds. When investors buy units, or shares, in a fund like this they become entitled to their share of any gains or income the fund generates. The size of the fund rises and falls in response to investor demand. When demand exceeds supply, the fund management company issues new units, and when sellers outnumber buyers, it cancels (‘redeems’) them instead.
While their legal and corporate governance structure is somewhat different, for practical purposes the only real difference between the two types of open-ended fund is that with an OEIC, the buying and selling price is the same, while for unit trusts there is a ‘spread’ between the two (made up of the bid and offer price respectively.) The price of open-ended funds is determined by the value of the investments that the fund makes, after the management charges have been deducted.
Investment trusts, also known as closed-ended funds, differ from unit trusts and OEICs in having a fixed capital structure rather than one which ebbs and flows with supply and demand. Investors own shares in the trust and unlike open-ended funds, these can be bought and sold on the stock market. There is, however, no guarantee that the share price will always be the same as the value of the investments which the trust owns – another difference from unit trusts and OEICs. (See chapter 8 for more of my thoughts about investment trusts.) Exchange-traded funds amalgamate some features of both open-ended and closed-ended funds. It is easiest to think of them as unit trusts that can be traded on the stock market like any other share. As such they are more likely to be used for short-term trading than for long-term investment.
Convenience
The first fundamental reason for investing in funds is they take most of the hassle out of what can otherwise be a time-consuming and frustrating exercise. By investing in funds you are effectively delegating most of the heavy lifting to someone else. A fund in that respect is quite a lot like a syndicate, where you pool your money with others to buy a racehorse or do the lottery. As part owner of a racehorse, you get to go to the course on race days, pose for photos and (very occasionally) collect some winnings, but you are not the one who has to get up at 5 o’clock in the morning to gallop your horse in the freezing cold and call in the vet when it catches a chill.
So it is with a fund: the professional fund manager makes the buy and sell decisions for all the investors in the fund and you get to enjoy the fruits of any success without having to do any of the hard work. (Before you get the wrong idea, I should emphasise that the rewards from investing are much greater and a whole lot more reliable than those you get from owning a racehorse or doing the lottery.) With the advent of sophisticated IT systems, these days you don’t even have to fill out and sign a form to buy or sell units in an investment fund. You can do it all with a couple of clicks of the mouse. Someone else takes care of all the paperwork and admin too.
Scale and diversification
A second crucial benefit of investing in a fund is that pooling your money with others has a number of practical advantages when it comes to making investment decisions. For a start it greatly widens the choice of investments you can make, allowing you to make investments all over the world, not just in the UK. This is true whether your main area of interest is buying shares in a company (equity investment) or investing in bonds (fixed-income investing). Professional fund managers also have access to much more information and research than any individual investor can obtain.5
The largest fund management firms have specialists in almost every kind of investment you may wish to make. They also have years of experience in making investment decisions. These days they even have to be qualified to do so – not something that was always the case in the past! Once upon a time they were also able to trade stocks and shares more cheaply than you, although this advantage has diminished with the advent of low-cost dealing services for private investors. (These days, by shopping around, you can buy and sell shares through a platform for as little as £7.50 a trade.)
Investing in a fund is also the simplest way to obtain the benefits of diversification, which is every investor’s best protection against the risk of loss and personal stupidity. In order to be able to take money from investors, funds are required to spread their investments across a minimum number of instruments. By pooling investors’ money, and then spreading that pool of money across a wide range of individual stocks and shares, a typical fund provides an important degree of diversification that individual investors could not achieve without doing a lot more work themselves. Fund investors only have to make one decision, to buy and sell a fund. All the other decisions are delegated.
Tax benefits
A third key feature of funds stems directly from the fact that they are managed by professional investment managers, acting on your behalf. As investing money for others is their sole business, HM Revenue & Customs gives funds an exemption from paying tax on the investments they buy and sell, so long as that money remains within the fund. It means that any money you keep invested in a fund can go on compounding in value without the taxman dipping in every year to take a chunk of it away. Because of the wonders of compounding, this can have a material effect on how big your investment pot will grow to become over time.
The advantage of funds in this respect has diminished somewhat in recent years thanks to the generous tax concessions that successive governments have introduced for individual investors, which I described in the last chapter. Because only a small number of people earn enough to be able to invest more than their £15,240 a year ISA allowance, in practice this means that investing tax-free has become a feasible option for the majority of investors. Investment funds also make excellent building blocks for a pension, as you can take advantage of the generous tax relief on contributions, even if the amount you can invest each year without paying tax has been much reduced in recent years.6 Most company schemes now offer you the option to pick your own funds from a menu of alternatives. The convenience and diversification benefits of funds are just as valuable in this context as they are for more general investment. Despite what you might read in the press, the costs of investing through a pension fund have fallen quite sharply in recent years.
Problems with fund investing
If these are the primary advantages of investing in funds, what are the drawbacks or challenges of using funds? I would single out three in particular.
The first is a result of how successful the fund industry has become. Because funds are so simple and convenient to invest in, they have become very big business. Annual sales of unit trusts and OEICs have averaged around £15 billion a year over the last ten years. The amount invested in them at the end of 2014 reached £800 billion. Selling and managing funds is a profitable and competitive business and as a result the number of funds on offer to investors has grown like Topsy.
Today there are more than 3,000 authorised unit trusts and OEICs to choose from and at least 100 companies that sell them. The range and type of things they invest in also covers a wide spectrum. The choice, in other words, has become overwhelming. While the best funds are very good, the majority – 90% of them, to be brutally honest – are poor value. Picking the right fund is therefore absolutely cr
ucial.
The second issue reflects the fact that, like most good things, funds don’t come free. By using your ISA allowance, and claiming tax relief on pension contributions, it is relatively easy to minimise your current tax bill. But funds themselves come with costs attached. The manager of any fund you invest in will charge each investor in the fund an annual fee for doing all that heavy lifting I referred to earlier. In addition, the investor often has to pay a number of additional costs that the fund manager incurs in running the fund. If you invest through a platform, the platform will also charge you a fee for looking after your money.
All these costs add up and come straight out of any return that you might make. The issue of whether funds cost and charge too much has become a big area of concern for both the industry regulator and the media in the last few years. In 2013, after years of dithering, the regulators finally banned advisors from being paid commission on fund sales. The hope was that this would increase competition and benefit consumers by making fund costs and charges more transparent and therefore help to nudge those costs lower. It hasn’t quite worked out like that, although I do think that costs are set to come down (see chapter 8 for further thoughts on this important topic).
The third problem is one that applies to unit trusts and OEICs, but not to investment trusts. It has to do with the way that open-ended funds work. Being open-ended, the size of the fund fluctuates in response to supply and demand. When demand exceeds supply, funds issue more units to accommodate the new demand. Similarly, if there are more sellers than buyers, the fund cancels or redeems surplus units in the fund. That all sounds fine, and works well most of the time. It means that funds can grow quite rapidly. From time to time, however, these flows of money can have a detrimental effect on how well the fund performs.
How so? Consider the case of a fund that has done particularly well for a number of years. As more investors become aware of how well it has done, more money is pushed in its direction. But suppose by the time the money arrives in the fund, the manager has come to the conclusion that the type of investments he or she is paid to make are no longer as attractively valued as they were. The money still has to be invested that way, because that is what the fund has promised to do, but the potential returns are now much lower. Demand has turned the fund manager into a forced buyer – never a comfortable place to be.
In this case, being successful has the paradoxical effect of damaging the interests of the investors in the fund. Something similar can happen when a fund has done poorly for reasons that may also be outside the manager’s control. The outflows from disgruntled investors can force the manager to sell holdings just as they are about to go up. This kind of experience is far from uncommon.7 It underlines the need to exercise care when deciding when and how much you want to invest in funds.
A body of recent academic research tells us that the human brain, wonderfully powerful as it is, is not particularly well-attuned to making good investment decisions. Most of us suffer from unconscious and conscious biases that can work against us doing the right thing. One such bias is chasing past performance – picking funds purely on the basis that they have done well recently. Such mistakes can be costly and unfortunately there are a number of traps and pitfalls that lie in wait for the unwary fund investor which the open-ended structure tends to exacerbate.
These three issues – choice, costs and traps for the unwary – are the ones where I think most self-directed investors need to direct their efforts. I hope to be able to provide you with help on all three. The point is that while funds are a wonderfully easy and convenient instrument through which to invest, they do not absolve you from the need to take an active interest in how and what you buy. The important thing is to devote such time as you can give to your portfolio to the things that are really going to make a difference. These are not always the ones that might at first appear to be the most important.
The case for platforms
The arrival of platforms has been a great breakthrough for the DIY investor. In the same way that the motor car helped to give millions of people the ability to go where they wanted when they wanted, so investment platforms liberate everyone to access nearly all the investment opportunities which they are likely to need at their own convenience.
What is a platform? Essentially it is a one-stop website which enables you to research, buy and sell, and then manage investments, all in your own time. General Omar Bradley, of US Army fame, said about military leadership: “…amateurs talk tactics, professionals talk logistics”. A platform is the logistical tool that puts you in charge of your own money in a way that was not possible before.
Most people already know how valuable the internet can be for finding out information. An investment platform gives you access to bundles of it. It is no exaggeration to say that the average individual investor can get more detailed information from websites today than any leading professional investor had at his or her fingertips 20 years ago. To have so much choice at your fingertips – and then to act on things so easily once you have decided on a course of action – is hugely valuable.
Take a look round one of the leading platforms and you will quickly see how much useful material there is to be found there. It is a very competitive field and the range and calibre of content is improving all the time. At minimum you can expect to find details of hundreds of shares and factsheets about nearly every type of investment fund (unit trusts and OEICs, investment trusts, tracker funds and venture capital trusts). Charting functions allow you to monitor the performance of any or all of these over a period of days, months or years. By becoming a client of the host firm, you can set up an ISA, a SIPP and buy and sell both shares and funds with a few simple strokes on your computer keyboard. Dealing charges vary from platform to platform, but this is also a competitive area which helps to keep trading and other costs down. Most funds also offer commentary on recent developments in the markets.
But there is another benefit of using a good platform which is not mentioned so often, and you could argue is even more important. That is the cost-effectiveness of having someone else to do all the boring paperwork and admin for you. What you are getting with a platform is in effect your own personal ‘back office’. Twenty years ago, if you bought a fund you had to do all the paperwork yourself. You would have to rely on the fund company sending you at least two valuations a year through the post. You might think, “Oh well, that’s no big deal”. But then, if you had 20 funds, you would have got 40 pieces of paper through the post, none of it standardised, with each one showing the key information in a different and possibly confusing way.
That made it difficult to see exactly where all your money was being invested, let alone how well you were doing overall. In practice what you really want to know is: how much did I invest? How much income did I get? And what is it worth now? You used to have a lot of trouble trying to find that out. Now with a good platform, someone else is doing all those calculations for you, and saving the results in your personal online account. They will send you a six-monthly statement summarising everything that you have bought or sold, plus the income paid out and the current values of your holdings.
You can also, if you wish, log in every hour of the day to check how well your money is doing (not that I recommend you do any such thing). That tedious chore is partly what you are paying for. If you are only investing small amounts, like £25 a month, it may still be slightly cheaper to buy your funds directly from a fund provider. But as you progress, and the amount you have invested grows, you will quickly find that it becomes more messy and time-consuming to go on operating in the old-fashioned way.
In addition to the logistics, while it is fairly easy to do nothing if your investments are going well, as and when the markets start to do badly, or you have an admin problem, the ability to have someone to ring up for help in sorting out the problem is really important. With the best platforms, you should be able to get through to someone w
ho knows that they are talking about within at most a minute. Filling in your tax return can be a nightmare at the best of times, but a good platform will also help fix that problem for you too, sending you a single consolidated tax certificate every year that includes all the information you need to give the taxman in one single document.
The same goes with sorting out probate after someone dies. It is so much easier for the executors and the beneficiaries to sort out all the details if you can get a single probate paper from the platform. If the person who has died has 40 different investments, as many people do, each one of them will otherwise require a separate death certificate and a probate form to process. With a platform, you only have to produce a death certificate once. There is no need to spend hours going through drawers full of paper looking for the bits of paper which you need and chucking out the ones that you don’t.
Now that the new ‘pension freedom’ regime is in force, if you are in or approaching retirement it is worth thinking through how best to keep track of your pension savings. If you can access money directly from your SIPP as and when you want it, which is what the new regime means for many retired people, it will be more important than ever to keep track of how much you have drawn out and the tax liability that may go with that. I expect it won’t be long before your platform will give you all the information you need to monitor your pensions and track the cash flow and tax information on a monthly basis.
Finally, on the investment side, it is worth recalling how much more convenient it is to have personal access to your portfolio at all times via your computer. In the old days one reason investors paid hefty fees to discretionary fund managers was the knowledge that someone would be ‘looking after’ their investments while they were away on business or on holiday. Now, as long as you have a mobile phone or access to a computer, you can monitor your portfolio and buy and sell investments wherever you are at any time of night or day.