FOOL SCHOOL
How To Choose A Fund (Part II)

March 28, 2003

It's often easier to say what not to buy rather than what to buy. Three particular types of funds stand out as particularly poor value.

• Funds of Funds: these are funds that invest in other funds. They are intended to smooth out returns but in practice they just add a second layer of charges and lead to poorer performance.
• Closet trackers: many funds' holdings closely resemble an index like the FTSE 100, but they still charge high initial and annual charges. You're better off out of the closet and in an actual tracker itself. To unearth closet trackers compare their top ten holdings to the ten largest companies in the FTSE 100, or ask someone to do it for you. There's more about why many funds are closet trackers here.
• Hot sectors: many new funds are launched on the back of a spurt in performance, such as Far East funds in the mid-1990s and technology funds in 2000. Usually this is a classic sign that the spurt is about to turn into a slump. Stick with established funds wherever possible. The same applies to last year's top performing funds. In most cases the top performer will be a small, specialist fund that falls back to earth with a nasty bump, taking your hard-earned money with it in the process.

Investing Abroad

Should you invest outside the UK? It's often said that you ought to diversify your investments geographically. But, as it happens, investing in the UK companies gives you a reasonable amount of geographical exposure anyway. This is because a significant percentage of profits made by UK companies come from abroad.

While there's nothing wrong with investing abroad, there is little evidence that it is worth paying additional charges for the privilege. Until you have more experience of the stock market it is also better to avoid the smaller markets and to stick more developed markets like the US and Europe.

Your Risk Level

Many funds are graded as low, medium or high risk. If you ask for a fund to be recommended to you, you will be asked for your risk preference and any funds highlighted will be taken from one of the risk groupings. But how can you tell what risk is appropriate for you?

The longer you can afford to invest for (or the younger you are), the higher risk you can afford to take. Higher risk means higher volatility. The range of returns from these funds will be very large. But in the long-term, the theory is that your expected return should be higher. Most funds that invest in less developed economies, in one particular sector (such as health or technology) or in smaller companies, are labelled as high-risk.

Trackers and funds investing in the UK, Europe or the US are usually medium-risk. Their returns are expected to be lower than high-risk funds but more consistent from year to year.

Low-risk funds provide the lowest returns of all, but also minimise the risk that you will lose money. Usually they have a substantial proportion of their money in bonds or property. Others invest in the money markets, which means they are effectively high-interest bank accounts.

> Part I

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