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Investing in Funds: First Principles

So far we have been talking about direct investments in financial assets - stocks, bonds, money markets, foreign exchange, commodities and so on - whether undertaken by yourself as an individual or in consultation with a professional investment manager who builds and manages a portfolio on your behalf. Now we need to consider another type of investment - the investment fund.

Funds are pooled investment vehicles, whereby a professional fund manager invests the monies paid into the fund on the investors behalf. They are pooled in the sense that the combined monies of a group of investors are invested in one investment vehicle - the fund - and the investor's returns (or losses) are proportionate to the amount they put into the fund.

Some of these funds are straightforward investment vehicles; others are designed specifically with tax efficiency in mind; and then you have funds linked to specific goals like pension plans, mortgage linked endowments and with-profits life insurance policies.

The ins and outs of choosing what vehicle you want to invest in can be a complicated business but the basic principle is pretty simple.

Whatever the aim, and whatever the structure, what these managed vehicles boil down to is someone else investing on your behalf … and whatever money you put in a fund or investment plan, it is going to end up as a direct investment in (usually) stocks, bonds or money markets just as if you had invested it yourself.

There is another thing you need to think about too. No one is going to invest your money for free. Every layer of management between your cash and the assets the fund is buying on your behalf will cost you money – up-front in the form of acquisition costs, and ongoing, in the form of administration fees.

So why pay for someone to invest on your behalf when you could either do it yourself or work with a personal advisor?

Diversification

A commonly advanced argument is that investment funds offer a lower cost way to get a diversified investment portfolio. A fund investing in, say, the US market, may have investments in hundreds of different US companies; and you, as an individual, are unlikely to have the time or the inclination to do the same.

Economies of scale

Another advantage of pooled investments is simply that investment funds have market clout. Professional investment funds are big and like any big business they enjoy economies of scale: namely, the ability to dedicate teams of analysts to market sectors (particularly important when it comes to investing in international markets) and, sometimes, the clout to get better information and better prices.

Investment expertise

Finally, investment funds provide access to investment expertise at a relatively low cost. As we have already said, the moment someone else is investing on your behalf, they are going to be charging you for doing so. But funds, because they are pooled investments - because, that is, the cost of the investment expertise is spread between a large number of investors - are a relatively cheaper route to that expertise.


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