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Investment funds give investors the opportunity to group together to invest in a much broader spread of investments than they could manage on their own. They also require less maintenance than a portfolio of directly held shares. But with so many types of fund available, how do you choose which type is best? The main distinction is between "open-ended" funds and "closed-ended" funds. Open-ended funds include unit trusts and open-ended investment companies (OEICs), while closed-ended funds are generally referred to as investment trusts. Recently a third type has cropped up, exchange-traded funds (ETFs), which are essentially a hybrid of the two types. Which type of investment fund is best for you will depend on what you want it to achieve. While we look at the different types, though, bear in mind that, other things being equal, lower costs should translate into better long-term performance. Unit trusts and OEICs are known as open-ended, because their size changes as investors put money in and take it out. (OEICs, by the way, are essentially just a European form of unit trust. In recent years, unit trusts in the UK have been turning themselves into OEICs so that they can also be marketed in Europe.) So, if there is net money flowing into a fund, then it will have more money to invest, while if there is net money flowing out of the fund, then it will have to sell some of its investments in order to provide the money for the investors that are pulling out. Pros Since you put money directly into the fund, and take it directly out, there are no 'discounts' (as there are with investment trusts, see below). In other words, you can be confident that if you put £100 in, you'll get an interest in £100 worth of underlying assets (subject to charges of course). Open-ended funds are also organised to deal with regular savings efficiently. So, if you're saving £100 per month, then a unit trust is probably the most efficient means of doing it. Most unit trusts can also be bought with an ISA wrapper for no extra cost. Cons Unit trusts and OEICs tend to have higher management charges than other types of fund, partly because of the admin costs involved in all the money flowing into and out of the fund, but also because the annual charges have to support the advertising budgets of the fund management companies. Index-tracking unit trusts, however, don't get advertised so heavily and tend to have much lower charges. This means that they tend to perform better than their higher-charging, 'actively-managed', brethren over the long term. As unit trusts get bigger, there is also no requirement for them to pass 'economies of scale' in the management expenses onto investors (as there is for investment trusts, see below). So there might be a 1.5% management fee on a £1 billion fund, just as there is a 1.5% fee on a £10m fund. Find out more about Unit Trusts and OEICs here.
The easiest way to understand closed-ended funds, or investment trusts, is to think of them as being like a company, because that's exactly what they are. Just like any other company, they issue shares to raise money from shareholders and then they invest that money. The only real difference between investment trusts and normal "trading" companies is that they invest their money in the shares of other companies rather than in physical assets such as factories, grocery stores or mobile phone networks. There are a couple of important knock-on effects from investment trusts being companies. First of all, they have to act in the interests of their shareholders (i.e. the investors). That means no advertising and generally lower costs. It also means that as the investment trusts get bigger, they have to pass on the benefits of economies of scale to their shareholders. This means that the largest investment trusts, with around £1 billion of assets or maybe more, tend to have seriously low charges. The second point is that investment trust shares are traded just like they are for any company. So, if you want to sell your shares, you will only get what someone else is prepared to pay for them, which may be less than their actual underlying value (which is what you'd get from a unit trust, see above). In fact, investment trusts tend to trade at a 'discount' to their net asset value. That's fine if you get a discount when you buy and it's the same or smaller when you sell, but if the discount gets bigger, then you'll lose out. Pros Investment trusts tend to have lower charges than unit trusts. The very big ones can have seriously low charges – sometimes even lower than index-tracking unit trusts. Over the long-term, this tends to mean better performance. Whilst the discount is problematic, it does have its advantages from an income point of view, because the dividends are paid out without the discount. If you had underlying assets worth 100p, then they might 'yield' 3p each year in dividends. If you bought those assets for only 90p by buying an investment trust on a discount of 10%, then your yield will be little higher – 3.33% -- giving you 3.33p per year in dividends. This extra yield will be eroded by the investment trusts costs (which is probably why the discount, and extra yield, are there), but it does at least mitigate against the costs to an extent. Cons Because you buy shares in investment trusts like any other shares, the charges are the same too. That means it tends to be more efficient, in terms of costs, to buy them in fairly large chunks. If you want to put them in an ISA, you may have to get a self-select ISA separately. Some investment trusts offer schemes for regular saving, but there may be additional costs. So the structure of investment trusts isn't ideal for regular monthly investments into an ISA. The 'discount' makes investment trusts a little more risky because not only can the value of the underlying investments go up and down, but so can the discount. Investment trusts are given more leeway about how they invest your money. That might be fine if you want that particular balance of investments, but it also makes them higher maintenance. You should always have an idea where your money is invested and be happy with the balance. Find out more about investment trusts here. ETFs are a sort of cross between open-ended and closed-ended funds. As far as you or I are concerned, they appear "closed-ended" like an investment trust. You buy and sell them through a stockbroker just as you would any company or investment trust. However, for the big financial institutions, ETFs suddenly become open-ended, like unit trusts. This means that the ETF managers are prepared to issue new 'shares' and redeem (that is, take back and cancel) existing ones as long as you're prepared to do it in very large chunks (way beyond the means of private investors). The ETFs that are currently available in the UK are sold under the 'iShares' banner and managed by Barclays Global Investors. The principal product is the iFTSE100 which, as the name suggests, is designed to track the FTSE 100, but there are others covering different markets and sectors, like the iFTSE Euro 100, the iBloomberg European Pharmaceuticals, the iBloomberg European Telecoms and iBloomberg European Financials. Pros By being open-ended to institutions, the 'discount' to net asset value tends to be very small. By being closed-ended to you and me, the charges are very low. They therefore offer an efficient means, particularly for lump sums, of getting accurate exposure to an index, whether it's the FTSE 100 or a specialist sector index. Cons Because they're closed-ended to you and me, like investment trusts, they're not ideally structured for regular savings. However, some brokers, Comdirect for example, have set up cheap schemes for investing small regular amounts into iShares via an ISA. Find our more about Exchange Traded Funds here. More: Find out more about investing in funds in the Fool's ISA centre | Choosing An Investment Fund. Problems With Past Performance.
