Investment Funds Explained: What They are and How They Can Benefit your Portfolio

Active funds

With active funds, there are people working to handpick stocks and track the performance of the fund in an attempt to beat the market. The fund managers are experienced investors and they decide when and what to trade. When choosing an actively managed fund, you don’t have to spend time choosing stocks and decide when to sell - instead you will pay the fund manager to do this. This has one glaring disadvantage: high fees. 

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Passive funds

With passively managed funds, there is no one working to handpick the stocks. Instead these funds follow a certain index or market sector. This has one big advantage: low administration costs. This way, the passively managed funds don't try to beat the average market return but rather match it. The passively managed funds are often referred to as index funds. 

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ETFs

An ETF is a type of passively managed fund. An ETF, which is short for Exchange-Traded Fund, meaning it is a fund traded directly on the exchange throughout the day. Like other funds, it is made up of stocks, commodities, bonds or other securities. An example of this is the S&P 500, which includes the 500 largest public companies in the US, or the FTSE 100 which comprises the top 100 companies in the UK. You can invest in ETFs through various trading platforms and they generally incur lower fees as there is no one actively managing the fund on your behalf. That’s why these funds are often designed with cost-sensitive investors in mind.

How does an ETF make money?

Like most passively managed funds, ETFs also follow an index or a specific sector. Here is how they work: ETFs, like other funds, pool together money from various investors into a common basket. This basket is likely to hold different types of investments including stocks, bonds, commodities and other securities.

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By spreading the fund’s money into different securities, and by investing in a wide range of companies, ETFs have in general proved to be a good way to provide investors with diversification and thereby help balance out risk.

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Are active funds or passive funds better?

That really depends on what your financial goals are. If you’re looking to make significant returns (more than 10%) then an active fund might be a better option for your portfolio. That being said, once you factor in all the administrative costs, most actively managed funds fail to “outperform the market” the way they intend to. There exist a few successful funds, but they’re hard to come by.

Research shows that passive investments outperform active investments in the long-term, as they’re not subject to high fees, timing errors and inaccuracies. The market has historically increased 7 to 10% every year so by choosing a passive fund with low administration costs, you’re actually likely to make better returns. 

If we look at data, we can see that investors are increasingly prioritising passive ETFs over active funds. In 2013, actively managed equity funds attracted $298.3 billion, while passive index equity funds saw net inflows of $277.4 billion, according to Thomson Reuters Lipper. But, in 2019, investors withdrew a net $204.1 billion from actively managed U.S. stock funds, while their passively managed counterparts had net inflows of $162.7 billion, according to Morningstar.

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The pros of investment funds

1. Fund managers choose and manage underlying investments

If you decide to buy into an active fund, you benefit from the expertise, knowledge and time spent by the fund manager and their team researching and picking the best opportunities in a chosen sector. This also means you don’t have to be the mastermind behind your investments, meaning you can pay someone to do the work for you.

2. Diversification

Investing in funds means your money is spread across multiple assets. As some investments will perform better and some worse over time, diversifying will, in theory, help spread the risk and smooth returns over time.

We always recommend investing for at least 5 years - you have a better chance of riding out short-term volatility and benefitting from greater returns.

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3. Liquidity

Because investment funds can be easily bought and sold on stock exchanges, they are a highly liquid investments.

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4. Broader range of assets

Also, when it comes to certain types of assets, like foreign equities or exotic commodities, mutual funds are often the only way for individual investors to access a broader range of asset types.

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5. Transparency

Thankfully, mutual funds are subject to industry regulation which means that they’re a completely fair and transparent investment. 

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The cons of investment funds

1. High fees

The main downside of active investment funds is that professional management, and thereby fees, can eat away at your returns. It’s crucial to be clued up on what fees different funds are charging so you can make a calculated decision on whether you think you’ll come up on top, rather than bottom. 

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2. No guarantee on returns

As with most investments, there is always the possibility that the fund won’t perform well and could result in losses for you as an investor.

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3. Choosing the right fund

There are thousands of funds available to you, so navigating through the choice of funds can feel like a mammoth task, and researching and comparing funds difficult and time consuming – particularly given that different funds focus on different types of assets of industries. Only index funds tracking the same markets tend to be genuinely comparable.

Are investment funds a safe investment?

Investment funds are generally seen as a safe investment. This is because they’re managed by experts hand picking the investments on behalf of the pool of investors. This is unlike buying individual stocks, where the burden of risk rests heavily on the individual investor themselves. 

That being said, investment funds are not shy of risk and there might be certain funds that have a high degree of uncertainty surrounding them. For example, you might have a fund that focussed on start-ups across Europe. But it’s not clear which way it will go, so it could be open to massive gains or massive losses. There’s unfortunately no crystal ball to predict that.

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Which investment fund should I choose?

The first step in deciding which investment fund to choose, is to figure out what your investing goals and risk appetite are. If you have a longer time horizon and a low risk appetite, then an index fund or an ETF provides and cheap and diversified way to venture into the world of investing.

On the other hand, an active fund works better for those who don’t want the burden of stress that comes with having to research and choose their own investments. However, it’s always important to remember that active funds incur higher fees and it can therefore be difficult to find an active fund that performs better than passive funds.

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How do I buy and sell investment funds?

In order to buy and sell investment funds, you’ll need to sign up to an investment platform. Different platforms will give you access to different types of funds, and they provide quick and easy ways to buy into them.