For the past few years, mutual funds have become a popular option for UK investors. This popularity can be attributed to their investment diversification, advantages of professional management these investment vehicles offer, liquidity, and the customizability of their products.
About one in every five Britons has invested in shares and stocks. With a growing interest in stocks and shares and the increasing popularity of mutual funds, investors need to understand how to leverage funds to invest in these assets. This article walks you through the nitty gritty of mutual funds.
A mutual fund is a company that pools money from stockholders and invests it in securities such as bonds, stocks, short-term debt, and other assets.
There are various types of mutual funds, like equity funds, index funds, global funds, and income funds.
Mutual funds offer benefits like diversification of investments, expert management, and low-cost investment.
Investors need to consider various factors, such as personal goals and the performance of mutual funds before committing to one.
How Do Mutual Funds Work?
Managed by professional fund managers, a mutual fund pools money from stockholders and invests it in securities such as bonds, stocks, short-term debts, and other assets. The combined investments of a mutual fund are called its portfolio.
A mutual fund's portfolio is shaped in accordance with its goals and objectives. Retail investors can invest in mutual funds by buying their shares. Each share represents a portion of ownership and the income it generates.
Types of mutual funds
With over 4,000 mutual funds in the UK, it can be confusing for investors to decide where to put their money. Though many mutual funds are unique and distinct in their own capacities, they all fall into one of the four categories discussed below.
Equity funds
Equity funds invest solely in stocks, portfolios of which can depend on a variety of categorisations. The size of the company is a common category, which is defined by the market capitalization of companies stretching from small-cap stocks to large-cap stocks.
It’s also common to see equity fund portfolios being structured around investment strategies, such as aggressive growth, which invests in high-growth companies, or income-oriented approach, which involves investing in dividend-yielding stocks.
- Potential high returns – Equity funds invest in company stocks, which has a very high upside potential.
- Liquidity – Investors can quickly redeem their investments in equity funds, which usually takes less than three days.
- Affordable – Investors can start investing as low as £100.
- Not ideal for short-term investment – stock markets are quite volatile. Short-term investments can be too risky as stock investments need time to iron out the ups and downs of the market.
- High risk – Stocks are difficult to predict accurately. High-performing stocks can suddenly collapse due to minor reasons such as reputational issues.
Fixed income funds
These are mutual funds that pay investors fixed interest or dividends until the maturity of their investments – which in turn passed to individual investors of the fund. Typically, fixed-income funds invest in assets that pay a fixed rate of return, such as corporate bonds, government bonds, and other debt instruments.
- Predictable income – Investors receive the same income periodically.
- Less risk – Debt instruments such as government bonds and corporate bonds are less risky.
- Lower returns – These funds offer lower returns than other funds, such as equity funds.
- Interest rate risk – If the interest rates rise, the value of these investments falls.
Index funds
Index funds aim to match the performance of a specific financial market index. Most index funds in the UK are designed to match the FTSE 100, for example, and aim to deliver the same or similar returns. This implies that if the accorded market index increases, the value of shares in the fund rises, and vice versa.
- Sustainable returns – They offer better returns in the long run than conventional funds.
- More affordable – Have lower trading costs because the portfolio rarely changes.
- Transparency – They are transparent because they track a specific known index.
- Rigid – They lack flexibility because they are anchored to a specific index portfolio.
- Can’t beat the market – They cannot outperform the tracked index.
Income Funds
As the name suggests, the primary purpose of income funds is to provide a steady income to investors. They mainly invest in government bonds and low-risk corporate debts, allowing investors to earn regular interest streams.
While the holding income funds may appreciate over time, the primary objective of income funds is to give investors a steady cash flow. They are ideal for retirees and conservative investors.
- Regular income stream – They offer a steady source of income.
- Lower risk exposure – They are low-risk investments because they primarily invest in government and corporate bonds.
- Low upside potential – Low returns since their primary goal is not to offer high profits.
Benefits of investing in mutual funds
There is a good reason behind the growing popularity of mutual funds, not just in the UK but across Europe. These investment avenues provide investors withinvestors with many benefits that are not easily accessible via other investment approaches. These benefits include:
Diversification
Diversification is the practice of creating a portfolio that comprises a wide range of assets to reduce risk. Mutual funds diversify their portfolio by investing in multiple assets. Investors who buy shares in mutual funds instantly tap the benefits of diversification.
Economies of scale
Buying and selling securities in small denominations usually attract high transaction costs. Mutual funds pool resources allowing investors to buy securities in bulk hence lower transaction costs. Similarly, the costs accrued by the selling of securities are not reflected to the individual investors.
Expert management
Securities markets are complex, especially for ordinary investors. Not well-thought-out investments can easily end up in losses. Market professionals manage mutual funds. These experts have in-depth knowledge of different markets and are less likely to make uninformed investments. Mutual funds provide an avenue for ordinary investors to leverage the expertise of market professionals.
Actively vs passively managed funds
UK investors have thousands of options when investing in funds. Though the large number of funds gives investors a wide range of variety, it also makes it difficult for them to decide which fund type is appropriate for them. All funds fall into two major categories, and knowing which fund category is ideal for you is an important aspect of the investment process.
A fund manager is a person or a team of experts responsible for implementing a fund's investing strategy, managing portfolios, and overseeing market analysts.
Fund managers are paid a fee, usually a percentage of the fund's average assets under management (AUM). The top three fund managers in the UK right now include James Thomson, Carlos Moreno, and Terry Smith.
Actively managed funds
These are funds actively managed by a fund manager, who develops the portfolio. The primary objective of actively managed funds is to beat the market by employing strategies that take advantage of short-term market fluctuations.
- Higher upside potential – Actively managed funds can beat the market.
- Flexibility – They can invest in a wide range of assets.
- Ability to limit losses – Fund managers employ mechanisms to lessen losses.
- Higher operating costs – Fund managers and market analysts are paid a fee for their work.
- Less tax efficient – They are prone to short-term capital gains, which are taxed at a higher rate than long-term capital gains.
Passively managed funds
Passively managed funds employ a buy-and-hold strategy that tracks specific market indexes. Though the goal of passively managed funds is to match the indexed markets, there are always minor variations since it is impossible to perfectly track an index.
- Transparent – Investors are always aware of what the fund has invested in.
- Lower fee – This is because of low operation costs.
- Better tax efficiency – Passive funds enjoy the benefits of long-term capital gains.
- Performance issues – It barely, if ever, beats the market.
- Less flexibility – tracked market index already predetermines the portfolio.
Exchange-traded funds (EFTs) are quite similar to mutual funds. Like mutual funds, EFTs pool stakeholders’ funds and invest them into securities. Much like index funds, ETFs also usually invest in various stocks and aim to track the performance of a selected index.
However, there are distinct differences. Unlike mutual funds, units of which can only be bought from a fund house, EFTs can be traded on exchanges just like shares. Besides, EFTs don’t have any minimum lock-in periods and can be traded at any time.
Benefits of mutual funds over EFTs
Wide variety: Mutual funds invest in a wide variety of assets than EFTs, which means further diversification.
Service quality: EFTs have lower expenses because they offer minimal shareholder services. In contrast, mutual funds are costlier, but they hire fund managers who serve stakeholders.
No commission fee: Mutual funds don’t charge commission fees, especially if the investment plan includes incremental investment over time. EFTs investors have to pay broker commissions every time they trade shares.
Charges when investing in mutual funds
Like all businesses, running a mutual fund incurs costs. Funds pass these costs to investors as fees. Though charges vary from fund to fund, most are universal. Common ones include;
Shareholder fees: Its charged for responding to investor inquiries and providing investors with information about their investments. They include sales load charges, sales charges on purchases, and deferred sales charges.
Account fees: Fee charged for the maintenance of investor accounts.
Redemption fees: Fee charged when investors redeem their shares.
Annual fund operating expenses: Its charged to facilitate the management and operation of the mutual fund.
Exchange fee: Fee charged when an investor transfers from one fund to another within the same fund group.
Purchase fee: Fee charged when investors purchase the fund's shares.
How to Invest in Mutual Funds in the UK
Step 1: Choose a Trading Platform
Step 2: Choose Which Mutual Fund You Want to Invest In
Step 3: Deposit Funds
Step 4: Place Your Trade
How Do Investors Earn from Mutual Funds?
Mutual funds enable investors to earn through various strategies – the most common mechanisms include dividend payments, capital gains distributions, and increased NAV.
Dividend payments: Funds that invest in stocks and bonds earn dividends and interest from the investments. The fund deducts expenses from the interest and dividends and distributes the income to shareholders.
To illustrate, say that Fund X has invested in stocks and government bonds. When dividends and interest from the assets are paid, Fund X uses a percentage of the earnings to pay fund managers and other operational expenses.
The balance is then distributed to shareholders as their income. Different funds offer varying redemption procedures to their members. The UK mutual funds fetch a yield of between 3% and 4.5% – note that not all funds pay dividends; some are focused on capital growth.
Capital gains distributions: Prices of securities held by a fund may increase. When a fund sells securities that have increased in price, it earns a security gain. At the end of the year or agreed term, the fund distributes these capital gains to investors less capital losses.
For example, if a fund sells stocks of a certain company from its portfolio at a profit, the proceeds may be shared with stakeholders. Capital gains distributions reduce a fund’s net asset value (assets minus liabilities) since they decrease a fund’s portfolio.
Increased NAV: When the value of a fund’s portfolio increases, the value of the fund and its assets also increases. This implies the value of investors’ investments also increases. If an investor sells their shares at an appreciated rate, they earn more from the sale than they invested.
How to Choose a Mutual Fund?
Choosing the right mutual fund to invest in is key to maximising one’s returns. While many mutual funds share features and their operations are based on similar principles, most have one or two selling points that distinguish them from the rest.
When choosing a mutual fund, investors must assess these differences and settle for those that align with their needs. Some of the key factors to consider include;
Your goals and risk tolerance: Mutual funds have varying goals. While some aim to earn from long-term capital gains, others prefer interest from bonds. For conservative investors or those interested in regular income, for example, funds that invest in bonds may be ideal.
Fees and loads: Fund charges impact how much investors earn, so it’s vital for investors to consider charges before committing to one. A small difference in fee charges can mean large differences in returns over time. The average initial fee is 5.5%, and an ongoing fee is about 1%.
Fund Performance: It is important to measure the performance of a mutual fund before investing. Some key metrics to consider include alpha, beta, r-squared, standard deviation, and the Sharpe ratio.
The Bottom Line
Mutual funds can provide a lucrative investment opportunity. These organisations not only offer affordable investment vehicles, but also provide easy and secure investment alternatives.
However, for investors to maximise the benefits, they must ensure they commit to funds that match their needs and expectations.
