But with more than 1,600 funds available to choose from investing in a variety of markets and industries, how do you pick one that suits you?
Your first step should be to decide what type of investor you are: cautious, balanced or adventurous and how long you are planning to invest for. Finding out the answers to these questions will help determine what type of funds you should be buying. Read more about how to build a portfolio.
Once you have worked out the type of investor you are, it’s time to start working out which funds to buy.
The first, and most important, thing to remember about funds is that no two are the same. They might invest in the same part of the world but have very different approaches to investing. You must look very carefully too at what funds invest in, not just the returns they have produced, before you buy.
Low or high risk?
Performance
Checking the fund manager’s credentials
If you think of yourself as a cautious investor, the type of funds you should buy are very different to those an adventurous investor should consider. As a general rule, cautious investors should try to seek out funds that don’t take big risks to produce the highest possible returns but that take a steady approach instead.
Adventurous investors should look for exactly the opposite, although mixing in a few lower risk funds is a good idea. Balanced investors sit somewhere in the middle, probably with a core holding of low risk funds and then ‘satellite’ holdings in more risky funds.
Working out which funds are low risk and high risk is not easy and something even the experts argue about. One individual’s attitude to risk is, after all, very different to another person’s.
Most experts tend to put equity income funds, global funds and corporate bond funds in the lower risk categories with overseas funds and those focusing on a single industry, such as technology funds, in the higher risk category. But you must look more carefully at funds in each sector as some take a riskier approach than others. Funds that, for example, invest in smaller companies are regarded as more risky than those that invest in larger firms. Similarly, funds that invest in a small number of companies, generally fewer than 50, are higher risk than funds investing in a larger number.
If you can only afford to invest in one fund at first, it is sensible to focus on lower risk funds and then diversify into higher risk funds as your portfolio grows. Diversification makes as much sense with funds as with individual shares as you can benefit from a variety of different approaches and invest in a number of different areas. If one fund doesn’t perform well for a period, another fund may.
Once you have decided what type of funds you want to invest in you can start to select the best ones to suit your aims. To do this you need to compare their performance and find out how they invest.
Every investor wants to make money but choosing a fund by simply looking at its past track record is a sure-fire way to lose money. Funds can produce stunning returns over short periods for all sorts of reasons. The manager may have ‘got lucky’ with a few choice investments or perhaps the country or sector they have invested in has done particularly well.
Technology funds, for example, produced stunning returns during the late 1990s. Thousands of investors ploughed money into these funds during 1999 and 2000 in the hope these returns would be repeated. But in March 2000 the bubble burst and savers suffered very heavy losses. So, if something looks too good to be true, it usually is.
This does not mean you should ignore good performance but you do need to look at it more closely. You should look at the returns made each year relative to its peers and its benchmark rather than simply the cumulative performance. A fund that steadily outperforms its rivals in four out of five years may have a better chance of reproducing these returns again than one that produces stunning gains in one year but underperforms its peers the for the remaining four years.
So ignore the marketing literature sent out from fund firms showing a fund’s total returns over five years and look in specialist magazines or websites that show returns over individual years.
Once you have narrowed down your search, look at how the fund is managed. Get an up to date information booklet from the fund manager directly or from their website, and look at the type of shares the fund buys and how many it tends to have in its portfolio.
What investment process do they use? Are they, for example, top down or bottom up investors? These terms may sound complicated but are quite simple. If a fund manager is a top down investor, their investment decisions will be driven by what happens in the economy. Bottom up investors look for stocks they believe will do well regardless of what is going on in the wider economy. Read more about strategies for investment.
How long has the manager been running the fund? You might discover that a fund’s good performance has been down to a previous manager, not the one that is currently managing it. This might not be a reason to avoid it but you should find out what the track record of the new manager is.
Read the manager’s report too. This gives you information on what has affected the market the manager has invested in, what shares owned by the fund have boosted or detracted from performance, and what the outlook is.
Above all, make sure you are not persuaded by slick marketing literature. Remember, it is designed to persuade you to invest in a fund and is not independent. So, read the views of independent professionals in magazines, newspapers and on websites to help you make the best decisions. Make sure too that you monitor your investment regularly to ensure they continue to perform well.