How to invest in funds: our guide for beginners and experts

We give tips aimed at both beginners and experts on how to buy funds 

Whether you are new to investing or a seasoned saver, there are always things you can learn to improve how you pick your investments. In this new series, Telegraph Money will give advice aimed at both beginners and experts who want to buy a range of different assets. 

First up is funds – one of the most common ways investors can dip their toes into the stock market. The below is by no means an exhaustive list of everything you need to know but it will give some food for thought.

Beginners

Picking a fund shop

The first thing to decide, as someone who has not invested before, is which company to entrust your savings with. If you are investing a large lump sum of more than £50,000 for example, a fund shop with a flat monthly fee will be cheapest.

For someone investing monthly, avoiding fund shops that have high transaction costs will be important, as some will charge you for each new purchase every month.

Should you invest in active or passive?

Once you have decided who to invest with, the next step is to decide what to buy. There are two types of funds.

Passive funds, also known as trackers, aim to replicate the performance of a stock market index such as Britain's FTSE 100 or the American S&P 500.

There are also active funds are run by a fund manager who selects stocks on your behalf and aims to beat the market average. This is more expensive as you are paying for someone’s time and expertise. Investors should spend time on researching which active fund is best for them, so a passive fund is an easier starting point.

Do you want income or growth?

If you decide to buy an active fund, how much risk you are willing to take will determine which type of fund is best. There are two main different types for investors. Some invest for income – paying you a regular dividend – while others focus solely on growing your money. 

For those interested in stock funds, there are also many different strategies.

“Value” funds look to buy the cheapest stocks in the market that the manager thinks can rebound, while “growth” funds own the companies that are growing their earnings the quickest.

“Quality” fund managers look to own good companies that can make a solid return each year but that will never shoot the lights out, while “momentum” funds buy the stocks that have gone up the most recently.

Regional or thematic investing: which to choose?

After choosing whether be active or passive, you need to decide where to invest. Global funds will buy companies from all around the world but are most heavily skewed to the largest stock markets such as America.

You may instead wish to invest in multiple funds that cover specific regions, such as Britain, Japan or Europe, which will help you to balance your portfolio.

Regional investing is the main way many choose but others look to invest in themes rather than countries. Popular “thematic” funds range from healthcare, to technology, to banks and anywhere in between.

For the experts

Risk: volatility is a poor indicator

Most fund groups and analysts use “risk” to mean volatility – the amount share prices rise and fall. However, this is an inadequate way to determine the actual risk of a fund.

A portfolio could be “high-risk” because it has risen a lot very quickly, while a portfolio that has consistently lost small amounts over time could be deemed “low risk”.

For many, the real risk is losing money over time. One metric to help gauge this is maximum drawdown, which measures a fund’s largest fall from peak to trough. This will help investors figure out how much a fund can lose over a short space of time.

Another useful tool is the Sharpe ratio, which measures the returns of a fund relative to the risk it is taking. 

For example, a highly volatile fund that has made strong returns would have a good Sharpe ratio, as would a fund that does not move around as much but has made reasonable returns. However, high-risk funds that have not made top returns will be punished, as will lower-risk funds that make a loss.

Working out your hidden transaction costs

Expert investors are probably aware of the costs they pay to own the fund, such as the “platform” fee from their fund shop and the ongoing charges figure, or OCF, that is paid to the fund group.

While these cover much of the cost of owning a fund, transaction costs – how much it costs the fund to buy and sell stocks – are extra and can add up.

Funds that trade more often will have higher transaction charges. These costs can sometimes be found on investor documents such as the fund’s final accounts for the year, although this depends on the company.

If unavailable, investors should look at “portfolio turnover” which will give an indication of how often the fund trades.

Should you compare the fund with its peer group or benchmark?

Some managers will point to how they “outperform” their peers but if they have failed to beat an tracker fund that invests in the same region, then they are still failing.

Similarly, beating an index is great, but if most rivals funds did the same then the manager was a poor investment as investors should only pay for above-average returns.

You should look at both, but focusing on one over the other can help. In America, where active funds fail to beat the index more often than not, compare against the market benchmark, likely the S&P 500, or a tracker fund.

If investing in a “multi-asset” fund, the “benchmark” will differ and some may set low goals such as to beat inflation. In this instance, it would be best to compare against the peer group to check that you are getting value for money.

How to spot manager changes and style drift

Monthly factsheets produced by funds can help follow trends and changes that could help to avoid disaster in the future. 

If a value fund has Tesla, for example, or a growth fund owns cheap banks, it would be fair to question whether the manager is doing what is expected, and what investors pay for.

Although it will likely only have the top 10 holdings, sector weightings can also give a good indication of how the fund is investing. Check also to see if co-managers appear on the fund, as this can be an early sign of succession planning

Finally, always keep one eye on the fund size. If a smaller companies fund is growing quickly, it may not be able to own the smallest stocks any more.

Large withdrawals from investors in a fund can signal something is wrong or could lead to a change in approach from the manager.

Do you have any questions you would like answered or any useful hints and tips of your own? Let us know in the comments section below.