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3 things to know about investment funds

I reckon a good place to start when it comes to investing in the stock market is with investment funds.

Instant diversification

The great thing about funds is that you can build a diversified portfolio with low costs. The alternative to funds is to buy the shares of individual companies, but each purchase involves transaction costs such as broker fees, tax and the spread between the buying and selling prices of the shares, known as the bid-offer spread.

If you believe in the sound principle of diversifying your investments, such transaction costs can add up to a substantial sum when you buy the shares of several different companies. But if you invest in a fund, your investment will be automatically spread over many underlying companies, which gives you instant diversification for low transaction costs.

And there are many funds to choose between, each targeting a different geographic market, or a particular investment strategy or individual sectors. You can even diversify between funds by investing in more than one, thus layering diversification upon diversification.

Active versus passive

The first decision you’ll need to make about funds is whether to go active or passive.

As the name suggests, active funds are run by professional fund managers and they choose which investments go into the fund’s portfolio, as well as when to sell an investment. You might pick an active fund if you think the manager can make the fund outperform its benchmark, which could be an index such as the FTSE 100 or the FTSE 250.

But there are risks. Active funds charge you more in running costs than passive funds and often, active funds fail to outperform their benchmarks. Sometimes, they chronically underperform like the Woodford funds did recently. However, whatever the performance, the fees keep on coming.

On the other hand, passive funds, which are often known as tracker funds, aim to track the performance of a key benchmark or index. For example, they could follow the FTSE 100, FTSE All Share, S&P 500 or any other index. Because the buying and selling of underlying stocks is mechanical in nature the ongoing fees can be low – often well below 0.5%.

Accumulation versus income

When choosing funds you’ll need to decide whether to select the accumulation version or the income version. You may see ‘Acc’ or ‘Inc’ after the funds name, which reveals which type you are looking at.

An accumulation fund automatically ploughs the dividends back into the fund for you, which increases the value of each unit you hold in the fund. In other words, you’ll be compounding your gains and that’s key to building wealth. If you’re investing for retirement or on a long-term basis, I reckon accumulation is the way to go.

However, when you do need income from your investments, perhaps because you have retired, I reckon a good option is to switch to an income version of the fund. The income version of a fund will pay out dividends into your dealing account, ISA or SIPP and you can take the cash from there. Or, if you wish, you can invest the cash elsewhere.

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Kevin Godbold has no position in any share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.