Most investing by private individuals is done through collective investments (funds.) Why do people choose this route to the investment markets? What are the benefits? What are the costs? This week’s post is a brief description of the main aspects of this popular investment choice.
Economies of Scale
The primary advantage that attracted investors when funds were first marketed to retail investors about 80 years ago was the economies of scale they offered. No longer were the investment markets the preserve of the very wealthy. By grouping together those of more modest means could invest benefiting from the same investments as the better off. They could buy commercial property like hotels, factories and office buildings; they could have exposure to many different companies shares which spread their risk and they could benefit from professional investment management and research.
The ownership of a share in a company entitles you to a share in the profits made by the company. Ownership of funds is usually determined by a number of ‘units’ although shares are also used.
When capital is limited, choices need to be made, an investor needs to limit the number of investments in equities, bonds and property according to the amount of capital available and the cost of investing in these assets. To take an extreme example, it is unlikely to be of any benefit investing in one share costing $1 if the cost of purchasing that share is $10, an investor would need to achieve a 1,000% return before he had even recovered his cost of investing.
Funds enable individual investors to spread their investment over a wide variety of equities, bonds and property assets within just one unit. So if the unit price is $1 within that unit an investor has exposure to all of the investments of the fund, which may be tens or even hundreds of different assets. So as well as being cost effective, funds help reduce risk by providing diversification. The charges of most funds are also a percentage of the transaction amount rather than a fixed fee, this is particularly beneficial to smaller or regular investors where relatively small but regular sums are invested.
Funds provide investors with safe custody of the title documents of the fund’s assets such as title deeds to property and shares certificates where the are still issued. They will also be involved in the collection of dividends and receipt of interest from the assets held by the fund. Usually the custodian of the fund is a large international bank.
Funds also use lawyers when transacting deals such as property purchase or buying some other off market asset, ensuring proof of title and other important aspects of the purchase or sale.
Of course, many funds undertake a great deal of research to investigate investment opportunities for the fund manager to select, if he or she feels it is appropriate for the fund. This research will often involve visiting companies around the world and discussing the prospects of the company with senior managers and the firms directors.
Funds also offer convenience as they offer access to many investment opportunities in one place. The fund manages the collection of dividends and interest from the investment as well as the safe custody of documents. This saves the investor time.
Cost of Investing
For funds regulated in the EU, there is a new document called a Key Investor Information Document (KIID.) This is a 2 page document in a format prescribed by the fund’s regulator with basic information about the fund, including information on risk, the fund’s past performance and charges.
The cost of investing via a fund depends on many factors but typically there are 2 main charges an investor will consider. Firstly, the cost of investment, how much it costs to buy into the fund. This is often called the initial charge. As mentioned above, funds usually charge a percentage of the amount invested. Whilst 5% remains the industry norm for retail investments, I have seen this charge as high as 8% and as low as 1%.
The Ongoing Charges Figure (OCF) shows the drag on performance caused by most operational expenses associated with a fund. Expenses which are represented by this figure include payments to the manager, trustee, custodian and their representatives. The figure also includes registration, regulatory, audit and legal fees, and the costs of distribution. For actively managed funds a charge or between 1.5% and 2.0% is normal and for a passive fund like an ETF 0.5% is typical.
However the OCF does not included other costs such as Performance fees, transaction costs, interest on borrowing, costs associated with derivatives, entry and exit fees and soft commissions these should be factored in separately by the investor and for these figures the audited accounts, prospectus or scheme particulars should be consulted.Entry, Exit and Performance fees are stated separately in the KIID.
Next week I will begin a series of posts on the products available to expatriates living in U.A.E. The product reviews will be generic empowering you with the information you need to make an informed investment decision.