If you want to build up a pot of money for the future, be it retirement or paying for some of life’s expenses including children’s university fees or a loft conversion, investment funds can be a great way to grow your savings.

They enable you to quickly build a portfolio which could save you a lot of time and money.

You don’t have to spend hours researching the market for which stocks to buy, and you won’t incur anywhere near the level of dealing fees that come with building a portfolio of 20 or more stocks from scratch.

Finding the right fund for you is easier than you might think. This article is a step-by-step guide to navigating the world of funds so you can go straight to the type of product that fits your needs.

Don’t be put off by the fact there are thousands of funds on the market. It’s easy to sift through the list as they will be split into different categories including investment styles, sectors, themes and geographies. It’s just a case of following a simple path to find the best ones for you.

Just remember that as part of your fund selection journey, you need to make sure that each fund’s target market, style and goals fit with your own investment strategy, time horizon and risk tolerance.

STEP ONE: ACTIVE OR PASSIVE?

There are two main types of fund – active and passive. Active funds are run by a fund manager who selects which assets go into the portfolio and they are paid a fee by investors with the aim of beating the fund’s benchmark index.

ACTIVE FUNDS: WHAT’S THE DIFFERENCE?

Active funds involve a fund manager deciding what should go in and out of a portfolio. They fall into two categories – ‘funds’ which is the generic term to describe unit trusts and oeics, also known as open-ended funds; and ‘investment trusts’ which are closed-ended funds.

It may sound confusing but isn’t once you understand how they work.

Open-ended means funds create or cancel new shares depending on demand from investors. They only issue one price per day, and to deal you would usually have to place your investment instruction the day before, so you don’t know precisely what price you’re going to get.

Some investors prefer investment trusts because there is a live price throughout the day, and you know exactly the price at which you’re buying or selling.

That’s because investment trusts are closed-ended, which means the fund manager is investing a fixed pool of money. Investment trusts trade on the stock market like ordinary shares and their share prices can sometimes deviate from the value of the underlying portfolio or net asset value (NAV) depending on investor demand.

The existence of discounts and premiums to NAV makes investment trusts more complex than open-ended funds. It also makes them more volatile, because as well as variation in the price of the underlying portfolio, there is movement in the discount or premium to NAV.

Investment trusts can also borrow money to invest, which is known as taking on ‘gearing’ and can boost returns in the bull markets but exacerbate losses in bear markets.

Funds are suited more to liquid investments such as listed shares and bonds, while investment trusts are better for investing in illiquid assets like commercial property, infrastructure or unquoted private companies.

That’s because open-ended funds might have to suspend trading if lots of investors want their money back at the same time. It’s hard to sell illiquid assets fast.

An advantage of the investment trust structure is it allows these companies to use their ‘revenue reserves’ of cash squirrelled away in good times to at least maintain dividends in bad times. Investment trusts tend to have lower annual charges than their open-ended peers, but a significant number also levy performance fees, which are rarer in the fund universe. [JC]

Passive funds aim to mirror the performance of a key benchmark or index such as the FTSE 100. You’ll find these are also called tracker funds or exchange-traded funds (ETFs). The fees associated with these products are typically much lower than active funds.

Annoyingly, the funds industry isn’t very good at labelling which products are active or passive. You’ll need to read the description for each fund to find out. Yet as a short-cut, most products from Vanguard are passive funds in the UK, you can spot which one of Legal & General’s products are tracker funds as they tend to have the word ‘index’ in the name, and products from iShares and SPDR are all passive funds.

Another way to find out is to use fund screening tools that offer you the ability to select ‘active’ or ‘passive (or tracker)’, such as this one from AJ Bell.

STEP TWO: GROWTH OR INCOME?

The next decision you’ll need to make is whether to invest in a ‘growth’ fund or an ‘income’ fund, or one that offers both. This could be influenced by your investment goals, risk tolerance and   your age.

Growth funds hold shares in companies that are expected to increase in value over time, so the value of your capital should also rise. Some growth funds might pay dividends, but the income stream is likely to be small.

Fundsmith Equity Fund (B41YBW7) is one of the most popular growth funds with UK investors and nearly all investor returns come from growth in the value of its portfolio.

Income funds prioritise investing in companies that pay good dividends or bonds with attractive coupons. Some income funds will offer an element of capital growth alongside the income stream but with others the only way you’ll make money is through dividends as capital gains could be minimal. That’s fine if you understand what to expect from an investment.

For example, Round Hill Music Royalty Fund (RHM) owns the rights to various hit songs and receives a royalty when they’re played on the radio or on stage, feature in films or adverts, or are streamed online. It passes on some of these royalties in the form of dividends to investors. While it pays an income yield in the region of 4.5%, its share price has barely moved since launch in November 2020.

In contrast, BlackRock Income & Growth Investment Trust (BRIG) has a 3.7% dividend yield and its share price also increased by 6.6% over the past 12 months. So, you’re getting a blend of income and capital growth.

STEP THREE: GEOGRAPHY OR SECTOR?

This is the point at which you can go down many different paths. One route is to consider if you want exposure to a broad range of geographies. The other is to think about choosing a specific sector such as technology or a certain asset class such as property.

The technology sector isn’t typically known for generous dividends so going down this path may be of more interest to someone who just wants capital growth rather than income.

A key attraction of investing in property is to collect a regular income, but you may also see the value of your capital go up in time as well. The Association of Investment Companies, also known as the AIC, says the average yield on investment trusts that invest in UK commercial property is 4.6%.

For example, Custodian REIT (CREI) yields approximately 5% and has seen its share price rise by 7.5% over the past 12 months, giving investors a blend of returns from income and capital growth.

Other sector-specific funds on offer include ones targeting renewable energy, infrastructure, biotechnology and healthcare, financials and natural resources.

Some investors prefer to focus on geography than sector as they want exposure to a broad range of industries. In this case, many funds are global portfolios that put money to work in companies listed on the main international markets, whereas others focus on the UK or other developed markets such as the US, Europe and Japan.

Emerging markets funds invest in some of the world’s fast-developing economies including China, India and Brazil, while there are also country specialist funds and trusts tapping into opportunities in these vast emerging markets as well as frontier markets such as Vietnam.

GOOD SOURCE OF INFORMATION ON FUNDS, INVESTMENT TRUSTS AND ETFS

There are fantastic online sources of information on funds and investment trusts to help with the selection process.

The Investment Association is a good place to find details on fund sectors and statistics, while the AIC does the same for investment trust data.

AJ Bell’s website enables you to filter funds, investment trusts and exchange-traded funds and examine their performance. The AJ Bell and Shares Money & Markets podcast regularly features interviews with fund managers.

Shares’ website is flush with fund-related articles and fund manager interviews and videos.

Trustnet is a good resource for factsheets, fund performance data and topical articles, while investment trust fans should visit Kepler Trust Intelligence and QuotedData websites for in-depth research notes.

JustETF is a useful resource for people seeking passive funds as it contains information and screening tools for ETFs.

STEP FOUR: REFINING THE SELECTION FURTHER

At this point, you may wish to think about the size of the company to whom you want exposure, or the sector they operate in as you may only want to invest in a specific theme.

Some funds focus on smaller companies, medium-sized companies or large companies, known in the industry parlance as small caps, mid-caps and large caps respectively.

If you’ve got to this point in the fund search process and have come to conclusion that you’d simply like a bit of everything, the answer might be to look at multi-asset funds.

These products own a mixture of shares, bonds, currencies and alternative assets such as property and infrastructure. An all-in-one solution, they take the guesswork out of spreading your money across different asset classes in the quest for performance.

For example, Momentum Multi-Asset Value Trust (MAVT) can invest in stocks, loans, bonds, property, infrastructure and gold. It varies the allocations depending on what’s happening in the world and where it sees opportunities.

PUTTING THE SEARCH INTO PRACTICE

Let’s run you through an example of how to use AJ Bell’s fund screener tool. 

We want to find a passive fund that invests in companies globally and where any dividends are automatically reinvested. We’re happy to look globally for opportunities.

● Fund Company – the default setting is ‘All Companies’ and we’ll leave this untouched. If you wanted to find funds for a specific asset manager, you would select their name at this point.

● Morningstar Category – Morningstar is the research company that powers the fund data on AJ Bell’s website. We’ll also leave this one untouched as one of the subsequent filters (IMA Sector) does something similar and we don’t need to use both.

● Currency – here we select ‘GBP’ so we’re using the UK currency.

● IMA Sector – We select ‘Global’ to find companies listed on stock markets around the world.

● Distribution Status – there is a choice of ‘All’, ‘Inc’ and ‘Acc’. We select ‘Acc’ as this stands for ‘Accumulation’, meaning any dividends will be automatically reinvested. If you want to collect the dividends as cash, select ‘Inc’.

● Morningstar Rating – The research company has a ratings system, so we select four and five stars to find the top scoring funds.

● Total Net Assets – This shows the size of a fund. We select £1 billion as the minimum.

● Max Total Expense Ratio – This is where you can look for funds based on their fees. For our exercise, we select ‘1.00’ as the maximum, meaning we don’t want to pay more than 1% annual fee. This tool is very useful if you’re looking for the absolute cheapest fund for a particular area of the market.

● For the purposes of this search, we leave the Morningstar Analyst Rating, Morningstar Risk, 3 Year Standard Deviation, Return %, Minimum Initial Purchase and Max Initial Sales Charge fields untouched. However, feel free to include these in your searches as they can be useful ways to further narrow the pack.

Our screen results in a list of 10 funds, covering both passive and active products. If we narrow it down to the highest Morningstar rating of five stars, there are two funds on the list: 

Janus Henderson Global Sustainable Fund (B71DPP6) and 

Vanguard FTSE Developed World ex-UK Equity Index Fund (B59G4Q7). 

The former is an active fund, and the latter is a passive fund.

As our original goal was to find a passive fund, the Vanguard product is therefore a good starting point for further research to ensure it meets our investment needs and goals.

It’s worth noting that the AJ Bell fund screening tool doesn’t include investment trusts. For those types of fund you’ll need to use this screening tool. The approach is essentially the same.

DISCLAIMER: AJ Bell referenced in this article is the owner and publisher of Shares magazine. The author (James Crux) and editor (Daniel Coatsworth) own shares in AJ Bell. Daniel Coatsworth also owns units in Fundsmith Equity

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