FOOL SCHOOL
Choosing A Fund For Your ISA

March 30, 2005

Choosing a fund to put in your ISA can be daunting. There are around 3,000 unit trusts, open-ended investment companies (OEICs) and investment trusts and to choose from. But don't panic. Here are some guidelines to help you weed out the undesirables and make the choice more manageable.

Tracker or Managed?

As we explain in the Tracker Centre, index trackers beat around three out of four managed funds over the long term (say, five years or more). This is primarily due to the fact that their charges are lower. So, although some managed funds will perform better than the market, the odds of successfully picking such a fund are not in your favour.

The Importance of Charges

All else being equal, and it usually is, a low cost fund will tend to perform better than a high cost one. Some funds charge up to 6% in initial fees and 1.5% or more in annual fees. As a group, investment trusts tend to have lower charges than unit trusts, although their performance tends to be more volatile.

It's easy to assume that the odd 1% here and there doesn't make much difference. But this is definitely not the case. A fund that grows at 10% a year for twenty years will give you 24% more as a final sum than a fund that grows at just 8.5%. Initial charges can quickly take their toll, especially if you tend to switch funds every few years.

Whenever you buy a fund make sure you look at the Key Features document that accompanies your application. This has to list the charges in all their gory detail. Quite often you'll find that there are additional charges on top of the main annual management charge. Make sure you do not get caught out. In addition, the Financial Services Authority (FSA) has begun to publish Comparative Tables that show the effect of charges for some of the most popular funds on the market.

Beware of Past Performance

Plenty of research has been carried out on whether past performance is a good indicator of future performance. In English this means: should you buy a fund because it has done well in the past? The answer turns out to be no. Which is ironic, really, because evidence shows that most of us do choose our funds on this basis, not least because of the flashy performance statistics that are the main feature of fund adverts. If that wasn't bad enough, the adverts are often rather selective about how they present the data, flattering the true performance of the funds in question. In reality, periods of good performance are often only temporary and will often be followed by periods of poorer performance.

Funds to avoid

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.

Find out more in our ISA centre.