We share important lessons and tips for experienced and novice investors investing in funds and trusts.
Over a decade ago, I left university and stumbled into writing about fund management. It was an industry I had no prior knowledge of, resulting in a steep learning curve.
Over the years, having written for a consumer audience at Telegraph Media Group and Money Observer, and for financial advisers and wealth managers at trade title Investment Week, I have regularly covered the basic principles on improving your odds of success as a fund investor.
Below, I have rounded up seven key lessons and tips for both experienced and novice investors to use to their advantage.
Active fund outperformance is far from guaranteed
When it comes to actively managed funds, investors buy on the hope that a fund manager will outperform rival funds and a relevant stock market index, but outperformance cannot be guaranteed. Complicating matters further is the enormous amount of choice investors have, with thousands of funds to choose from.
The reality is that most of the funds available to investors do not consistently add value above the returns of a stock market index over multiple time periods, so investors need to do their homework and due diligence. Then, it is a case of taking a view on whether the fund manager and the strategy of the fund looks well placed to deliver in the years to come, with five years widely viewed as the minimum holding period for fund investors.
One useful tool in the research process that helps narrow down your options is our Super 60 and ACE 30 lists, which highlight superior fund options handpicked by interactive investor’s investment committee.
Broadly speaking, fund investors have three options: to put their faith in active funds in an attempt to beat the market return, accept the return of the market minus fees by selecting a passively managed index fund or exchange-traded fund (ETF), or mix and match between the two styles.
Take advantage of the investment trust structure
Investment trusts have certain structural quirks, but rather than being put off on the grounds of their complexity, private investors should use the structure to their advantage.
Our beginner's guide to investment trusts details everything that private investors need to know.
But at the time of writing, at the start of August 2020, the attractions of investment trusts for income-seeking investors have become even more important.
Investment trusts do not have to distribute all the income generated by their underlying assets every year. Up to 15% can be held back each year, which means they can build up a “rainy day” reserve to bolster dividend payouts in leaner years. In contrast, open-ended funds have to return to investors all of the income generated each year.
As a result of this structural advantage, the vast majority of dividend-paying investment trusts have so far not moved to cut dividends, despite the dividend drought that has emerged as businesses have cut, suspended or cancelled income payments in response to the coronavirus pandemic.
In the months ahead, the sustainability of investment trust dividends will continue to be tested, and while there are no guarantees that boards will dip into the reserve pot to maintain or increase dividends if they face the prospect of insufficient income from the portfolio’s underlying holdings, it is a good thing as far as investors are concerned that boards have the option of doing so.
Fund charges matter: one thing an investor can control
When it comes to buying a fund, investment trust, tracker fund or ETF, the reality is that the only thing investors can control from the outset is charges.
In the case of passive funds, investors should look for two things: the annual fee and the index fund or ETF’s tracking error, which indicates how closely it mirrors the stock market index it is aiming to replicate - in other words, how good a job it is doing. Some passive funds for developed markets cost less than 0.1% a year (£10 on a £10,0000 investment).
For active funds, assessing whether you receive value for money is more subjective. As a rule of thumb, active funds have an ongoing charge figure of 0.85% to 1% a year. There is nothing wrong in paying a premium price if it is backed up by stellar performance.
The danger of owning too many similar funds
The pitfall of over-diversification with active funds is, in my opinion, an understated risk that can prove detrimental to long-term returns.
“Diworsification” occurs if you buy too many funds that are similar, for example, several UK equity income funds. While the fund managers will have their own investment philosophies, and some funds, for example, will target shares with high dividend yields while others focus more on dividend growth, the risk is that an investor can end up owning most, or even all, of the companies in an index. This runs the risk of replicating the market, something that can be done much more cheaply through a passive fund – an index tracker or ETF.
Avoid complacency across your portfolio
Financial planners advocate that investors should review their portfolio at least once a year, and preferably twice. Doing so prevents portfolios going off the boil, enabling you to sell those funds that are persistently underperforming and take profits from funds enjoying a purple patch of form that may prove to be unsustainable.
As part of a portfolio review, it is a good idea to take a step back and remind yourself of your investment goals and attitude to risk. If they have changed, then so should your portfolio. Also, consider whether the funds are still achieving their objective, such as promising to deliver “enhanced income”.
Fund share classes: buy the cheapest one available
When buying a fund, investors are faced with a sometimes-confusing choice of fund share classes. Depending on the fund, investors are likely to have to choose between various letters, such as A, C, I, Z. Instead of being bogged down by them, focus on the annual charge and select the cheapest available on interactive investor.
The big decision investors need to make is deciding whether to select the accumulation or income share class. The accumulation share class (acc) reinvests the income generated by a fund manager back into the fund, while the income share (inc) class pays income to the investor in cash.
Invest in what you know
Finally, as Warren Buffett puts it: “Risk comes from not knowing what you are doing.”
Understanding how a fund invests and what it is aiming to achieve stands investors in better stead to act if performance is not up to scratch.
When I opened my first stocks and shares Isa seven years ago, I made a mistake that may be familiar to other self-directed investors. I bought an absolute return fund without fully understanding the risks involved, such as the fund’s ability to “short” in order to profit when share prices decline. Over a short period, the fund’s value sank like a stone, but I couldn’t put my finger on why performance had plummeted. As a result, I cut my losses.
Since then, I have only invested in conventional funds and investment trusts: those that buy shares in the hope that share prices increase over time, and those that don’t rely on shorting as part of their approach.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.