Anyone new to investing faces a bewildering choice of thousands of funds, all served up with a side helping of jargon. Here we look at how to choose a fund.
You may even have decided how to divvy up your money, between different parts of the world and types of investment, whether the shares in companies that drive growth (‘equities’), steadier loans to companies and governments (‘bonds’ and ‘gilts’), property and commodities. This is known as ‘asset allocation’. But how to choose a fund?
Here’s how to nail down the right funds for you.
How to choose a fund: start with the sector
Funds are handily grouped into ‘sectors’, which tell you where they invest.
This might be based on the investment approach, aiming for income or capital growth, and then geographically (eg global, UK, emerging markets), by asset type (eg equities, bonds, a mix of assets), by size of company (large cap, smaller companies) or by specific industry (eg healthcare, technology, property).
Selecting a combination of funds, rather than sticking with a single sector, can help keep your overall balance on an even keel.
Active vs passive
Within sectors, your choice depends on whether you want an actively-managed fund, which tries to beat a benchmark. Or a passive fund, which typically charges lower fees to mirror or ‘track’ a benchmark. You’ll also see passive funds called index funds or trackers.
Fees can dip below 0.1% a year for passive funds, heading up to well over 1% a year for active funds.
If you fancy passive funds
Choosing a straightforward tracker fund is relatively easy, once you have selected the index you’d like to follow. For example the FTSE100 index of Britain’s biggest companies or the global reach of the MSCI World Index.
The main areas to compare when thinking about how to choose a fund are the costs, and the ‘tracking error’, which shows how far the fund’s performance differs from the index it is trying to track. Basically, the lower the tracking error, the better, although there will always be some difference due to the fees charged.
If you fancy active funds
The whole point of an active fund is to beat the market, by picking the best investments and avoiding the worst, so the manager generates enough returns to beat both its benchmark and fees charged.
Sounds great – but beating the market consistently, year after year, is notoriously hard to do.
What to consider when choosing an active fund
Once you’ve settled on a sector, here are some key issues to consider:
As the caveat always says, ‘past performance is no guarantee of future returns’. However, you can at least see which funds have done well previously, and which have been dead as a dodo.
Focus on longer term performance, over five or 10 years, rather than any lucky breaks over the last few months. Look at how the fund has performed compared to its ‘benchmark’, which is the index it’s trying to beat, and compared to other funds in the same sector.
Alpha measures the extra performance, above and beyond the fund’s benchmark. Let’s face it, if you just want a fund that follows a benchmark, you could pay less for a tracker fund. In contrast, a high alpha number indicates a fund has done better than its benchmark.
Meanwhile the Sharpe ratio compares the returns a fund has generated to the risks it has taken. The higher a fund’s Sharpe ratio, the better its returns have been, relative to the investment risk taken.
2. Fund manager
Who manages the fund and how long for? A manager with a long track record has had the chance to survive and thrive during different market conditions. If the manager changed recently, performance in future might change too.
Lower fees will eat up a smaller portion of your returns, so when comparing funds, look out for cheaper options. Compare the ‘ongoing charge figure’ (OCF). This includes both the annual management charge (AMC), and additional costs for running the fund.
4. Size of fund
A large, established fund from a well-known asset management company can bring the peace of mind that it’s not about to disappear.
5. Investment approach
Funds vary in the ways they try to make money. Some focus on future growth, looking for value in unloved companies. Others on generating income, backing high tech bets or sticking with the safety of well-established big brands.
6. Type of fund
Often, the type of fund used doesn’t make a major difference, whether a unit trust, open-ended investment company (OEIC), investment trust or exchange-traded fund (ETF). However, some fund types can be better suited to particular situations.
For example, the structure of investment trusts helps when seeking reliable income or when investing in assets that are harder to sell, such as property and companies that aren’t listed on a stock market.
Similarly, fans of passive funds may find ongoing charges are cheaper when using ETFs instead of unit trusts. Just weigh up dealing fees before diving in, which can make buying investment trusts and ETFs more expensive than buying unit trusts and will be more of an issue when investing smaller amounts.
Click for our video on funds and investment trusts.
Remember, you don’t have to choose your own funds if you don’t want to.
You could pay an independent financial adviser to do it for you, or opt for a ‘robo adviser’.
These online wealth managers suggest portfolios based on your answers to a few questions, and then manage your money for you. Examples include Nutmeg, Wealthify and evestor.
Alternatively, if you don’t want to choose a combination of funds for different assets, you could go for a ‘multi asset’ fund, which bundles shares, bonds and potentially other assets such as properties and commodities into a single investment. Check out the percentage of equities – the higher the percentage, the higher the potential returns, but also the higher chance that your balance will bounce around all over the place. For a less heart-stopping approach, or a shorter time frame, opt for a lower percentage.
Whatever fund you choose
However you choose your funds, don’t get too hung up on your selection.
There is no such thing as the ‘perfect’ fund choice. Instead, there will be multiple combinations that suit your goals, time frame and attitude to risk.
Ultimately when thinking about how to choose a fund, it’s better to start with some sensible choices, benefit from time in the market and learn more, than let analysis paralysis stop you from investing at all!