An investment fund is an investment vehicle which pools the funds of many individual investors. These funds are actively managed by a professional fund manager, or passively managed in the case of exchange traded funds (‘ETFs’).
Regardless of structure, funds typically focus on one singular asset class. However, some funds are multi-asset and hold a combination of asset classes. The most common asset classes include equities, debt (gilts, investment grade bonds, high yield or junk bonds) and alternative investments (property, commodities).
This article will explain how various types of investment funds differ, including:
- Types of investment fund
- Public open-ended funds
- Public closed-ended funds
- ETFs
- Hedge funds
- Private equity funds
- Types of public open-ended funds
- Unit trusts / OEICs
- Offshore funds
- Types of public closed-ended funds
- Investment trusts
- Split capital investment trusts
- Real estate investment trusts
- Venture capital trusts
- Types of ETF
- Types of fund management
- How to invest in investment funds
Types of investment fund
Publicly available investment funds are either open-ended, closed-ended or ETFs. Closed-ended and ETFs both trade on the stock exchange, but closed-ended funds are actively managed whereas ETFs are passive investments.
In addition, there are hedge funds and private equity funds which tend to only be available to sophisticated investors / high net worth individuals.
Public open-ended funds
An open-ended fund can issue or redeem units or shares as required, with no limits to the number in circulation. For this reason, investors generally acquire units/shares from the fund directly. Open-ended funds are traded once a day and remain priced at their net asset value.
As the capital structure can be unstable (due to the buying or selling activity of investors), open-ended funds are less able to utilise leverage in an attempt to increase gains. In addition, open-ended funds are not well-suited to holding illiquid investments. There are imposed limits on the level of unquoted investments fund managers can hold. However, large drawdowns or delisted shares may inadvertently result in limits being breached.
The majority of open-ended funds are actively managed, though index tracker funds are growing in popularity.
Public closed-ended funds
In a closed-ended fund, capital is initially raised via an Initial Public Offering, akin to an individual listed companies. In order to invest in a closed-ended fund, investors must purchase shares via a stock exchange. There are a fixed number of shares in the fund until such point as a secondary share offering is made.
Unlike open-ended funds where capital regularly flows in/out of the fund, capital only increases or decreases for a small number of reasons. This is the key difference between open-ended and closed-ended funds are distinguished.
| Increase in capital | Decrease in capital |
|---|---|
| Making strong investment decisions. Net asset value of the fund increases when underlying assets appreciate in value. | Making poor investment decisions. Net asset value of the fund decreases when underlying assets depreciate in value. |
| Taking on debt capital, leveraging the fund. | Dividend distributions to shareholders. |
| Issuing preferred shares, leveraging the fund. | The repurchase of shares via tender offer. May be employed where shares are trading at a discount to net asset value. |
| Conducting a rights offering (i.e. offering all existing shareholders the opportunity to invest more funds in proportion to their existing ownership). | Liquidation of the funds assets. |
| Conducting a secondary share offering (i.e. offering new shares to new investors). | For leveraged funds, forced sales to remain compliant with leverage limits. |
The relatively stable capital base of closed-ended funds make them a good structure for investing in illiquid securities such as property. Further, this structure enables closed-ended funds to borrow capital to make investments. The ability to leverage capital has the potential to increase investment gains, but also increases investor risk.
As closed-ended funds are traded on a stock exchange and feature a fixed number of shares, prices fluctuate according to supply and demand. Where prices exceed the underlying net asset value (‘NAV’), the fund is said to be trading at a premium. Where the share price is lower than the NAV, the fund is said to be trading at a discount.
ETFs
Exchange traded funds (or ETFs) are passive investment vehicles which seek to track the performance of an underlying indices or benchmark.
Investments in ETFs are becoming increasingly popular as they combine the ability to acquire shares at (very close to) NAV akin to open-ended funds with the ability to trade at any time during trading hours akin to closed-ended funds. In addition, ETFs also typically benefit from low ongoing holding costs.
Hedge funds
A hedge funds is an open-ended fund, only available to high net worth investors. Unlike public open-ended funds, a hedge fund does not give investors the right to redeem their investment on a daily basis at net asset value. Instead, there are normally predetermined ‘redemption days’ on which you can sell your holding.
In addition, there is generally a minimum holding period (commonly one year) or an early redemption fee if you sell your holding within a stated initial period. A ‘gates’ policy is also common which means that the amount of investment which can be sold on a particular redemption day is limited (usually as a proportion of the NAV of the fund).
Hedge fund managers are less limited than public fund managers and will invest in a range of assets including shares, bonds, futures, options, land, currency, and other alternative assets.
Private equity funds
Private equity (‘PE’) funds are closed-ended funds, typically only available to high net worth investors. Typically an investor will sign a binding agreement to invest a fixed amount of capital for a period of time typically ranging between 3-5 years. The private equity fund will draw down on this commitment as investment opportunities are found and will ultimately redistribute capital as those underlying investments are sold.
The PE model typically involves acquiring businesses or supporting management buy-outs/buy-ins via highly leveraged transactions. The fund managers will then aim to get their hands dirty to manage the business for a number of years, delivering profitable growth. Once the business is deemed ready for sale, the fund will typically seek to exit its investment via a trade sale or leveraged buy-out by another PE firm.
Types of public open-ended funds
Unit trusts / OEICs
Unit trusts and OEICs are the most common type of public open-ended investment company. The two are similar in many regards, with some subtle differences.
Unit trusts are governed by trust law, whereas an OEIC is established as a company. This means that you acquire units when you invest in a unit trust, whereas you purchase shares when you invest in an OEIC.
The key difference between the two is how they are priced.
Unit trust pricing
Many unit trusts quote a bid price and offer price. If you are buying a unit, you will pay the higher offer price whereas if you are selling a unit, you will receive the lower bid price. The difference between the bid and offer price is commonly referred to as the bid-offer spread.
The purpose of this spread is to ensure that new or redeeming investors do not dilute the value of the current/remaining shareholders units through the occurrence of transaction costs. However, fund managers can commonly avoid transaction costs by matching buy/sell orders made on the same day which drives profitability for the investment firm.
OEIC pricing
Shares in OEICs are bought and sold at the same singular price on a daily basis. However, a ‘swing pricing’ mechanism exists to protect existing investors when there is a imbalance between buyers and sellers.
The logic of the swing pricing mechanism is that whilst normal amounts of shareholder buying and selling activity will not incur material transaction costs (particularly as buy/sell orders made on the same day can commonly be matched), material activity would. Therefore, when shareholder activity passes a certain level of net activity in either direction (buying or selling), the singular price will be swung upwards or downwards to ensure that the transaction costs created are borne by the new or exiting investor rather than the current/remaining shareholders in the fund.
Offshore funds
Offshore funds are generally open-ended investments in unit trusts or OEICs located in low taxation territories. Investing in offshore funds can often provide tax advantages, particularly to wealthy individuals who have fully utilised available onshore tax-free allowances.
Types of public closed-ended funds
Investment trusts
Investment trusts are the most common type of closed-ended fund. An investment trust is a listed company which acquires a wide range of shares and other assets. Investment trusts will each feature different investment strategies and thus risk levels will vary.
Split capital investment trusts
A split capital investment trust has multiple classes of share, with the different classes featuring different levels of risk and potential reward. Unlike traditional investment trusts which do not have an investment end date, split capital investment trusts typically run for a specified period of time (usually 5-10 years). At the end of this time period, the different classes of share are paid out in accordance with the rules set out when the company was formed.
Real estate investment trusts
Real estate investment trusts (‘REITs’) is a listed closed-ended fund which owns, operates or finances income-producing real estate assets.
REITs typically specialise in a specific type of real estate assets. For example, a REIT may focus on retail locations, office blocks, residential property or commercial premises.
In the UK, the London Stock Exchange dictates that in order to quality as a UK REIT, the fund must generate at least 75% of its profit from property rental and 75% of its assets must be involved in the property rental business. All UK REITs are therefore equity REITs (which means they own the underlying physical properties). In the US, REITs can also be mortgage REITs (which means they finance the underlying properties) or hybrid REITs (which means they both own and finance the underlying properties).
Venture capital trusts
A venture capital trusts (‘VCT’) is a type of listed investment fund that invests solely in small companies, subject to strict eligibility rules. A VCT will commonly be invested in between 20-70 companies and will either be generalist (investing in unquoted companies across a range of sectors) or AIM focused (investing in companies listed on AIM).
As investing in small companies can be high risk, the Government offers significant tax incentives to support those who make private investments in VCTs.
Types of ETF
Whilst the majority of ETF investments are equity ETFs which aim to track the performance of an underlying stock market index like the FTSE 100 or FTSE 250, there are multiple other types of ETF investments:
- Bond ETFs – Offer exposure to a wide range of fixed income investments.
- Commodity-based ETFs – Track the price of a commodity such as gold or oil.
- Sector and industry ETFs – Track equities in a particular industry.
- Alternative ETFs – Offer exposure to the alternatives asset class, investing in strategies such as real estate, private equity and hedge funds.
- Style ETFs – Designed to track a particular investment style (e.g. value or growth stocks) or asset class (e.g. small-cap, mid-cap or large-cap stocks).
- Actively Managed ETFs – Track the performance of a portfolio of securities chosen by a fund manager rather than following an index.
Types of fund management
Actively managed funds
The majority of funds are actively managed. This simply means that a fund manager or managers, along with a wider team of helpers, actively makes portfolio decisions based on analytical research, forecasts and their own judgement/experience.
Passively managed funds
A passively managed fund seeks to replicate the performance of a specific benchmark or index. In order to accomplish this, automated trading is employed to make regular portfolio adjustments.
Passive funds can either be traditional funds (unit trusts or OEICs) or exchange traded funds (ETFs). The key difference between the two forms is that ETFs are traded on a stock exchange and can be bought/sold at any time during trading hours, whilst traditional funds are typically traded once daily. Learn more about investing in tracker funds and ETFs.
Fund of funds
Fund of funds (also known as ‘multi-manager funds’) are funds which themselves hold underlying fund investments. In this type of fund, investors effectively pay for the convenience of not having to manage their fund own investment allocations. When you invest in a fund of funds, you will typically pay both an ongoing charge to invest in the fund of funds and ongoing charges to invest in the underlying fund holdings.
How to invest in investment funds
To invest in investment funds, you will need an account with an online fund platform. If you do not already possess an account, make sure you read our comparison of fund platform charges as there can be dramatic differences in the costs of investing with different providers.