Perhaps you have £500 saved and you want to get started with your investment portfolio. Perhaps it’s the first of many similar amounts of money you will go on to invest in your lifetime. But what should you do with your £500 now?
I would not invest directly in individual shares just yet, because I reckon the execution costs will eat too great a proportion of the investment. Those costs include the broker’s fee for buying the shares, the spread between the buying and selling prices on offer (the bid-offer spread), and stamp duty (tax), which is usually set at 0.5% of the transaction value.
Overcoming the diversification problem
Buying shares in just one company would leave you exposed to single-company risk. If something goes wrong with that one stock you’ve invested in, you stand to suffer badly with your concentrated investment. The way most investors get around the problem is by investing in several different companies at the same time, which is known as diversification. But you can’t do that with £500.
What you can do is invest in a share fund. Share funds are great because they offer instant and comprehensive diversification. In the fund, your money is spread across many underlying shareholdings. But should you go for a managed fund or a passive fund?
Managed funds are usually run by an experienced professional fund manager or a team of professionals who choose the shares that the fund buys and sells. The idea is that by picking shares according to their strategy, the fund will go on to out-perform its benchmark, which could be a share index such as the FTSE 100 or the FTSE All-Share.
Because the fund is actively managed the ongoing fees are often quite high. But there’s a catch. Not that many managed funds go on to beat their benchmark, so you will likely end up paying higher fees for nothing.
Sometimes, when you look at the shares an active fund is holding, they will remind you of all the shares you normally see in, say, the FTSE 100 index. Such situations indicate to me that the fund is more interested in playing it safe, rather than seriously aiming to outperform the market. But will happily go on collecting the fees. Some people call those kinds of funds ‘closet trackers’.
It can get worse than that too. Sometimes, managed funds underperform their benchmarks like the Woodford funds did over the past few years. In cases like that you’d be paying high fees only for your investment to perform below that of a low-cost, passive index tracker fund.
Overcoming the mismanagement problem
Tracker funds are where I’d put my £500 investment. They are passively managed rather than actively managed, which means they aim to mimic an index or a sector of the market in a mechanical manner. Because of that, the ongoing fees are much lower. I’d even consider spreading my £500 between as many as three tracker funds for even greater diversification. And I’d be sure to add to those investments as often as I could.
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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.