Simple Pound

Thanks for visiting! If you like what you're reading, you may want to subscribe to my RSS feed.

And finally, let’s solve the last remaining secret of investment choices - open ended investment companies. One of the reasons I wrote about investment trusts yesterday, is that OEICs are a hybrid form of units and investment trusts.

They are companies issuing shares on the London Stock Exchange and subsequently use the money from their shareholders for other investments - essentially what investment trusts do. The difference to investment trusts is (and here’s where the similarity to unit trusts comes into play - which makes the OEIC a hybrid form) that OEICs are open-ended.

As I’ve already explained in the post about unit trusts, an open-ended investment means that the fund manager can keep issuing shares so that the price reflects the true underlying value of the fund (rather than some inflated number that merely represents a stock market hype for example).

But there is one difference between OEICs and unit trusts: OEICs don’t have the bid-offer spread that you’ll find with unit trusts. Therefore, you will always be able to buy and sell your shares for the same price, rather than having to sell for less than what you originally paid.

I think we’ve now covered a wide range of investment choices in this series and it’s about time to wrap it up. Yes, I could go into lots and lots of detail about options, futures, exotic derivatives, currencies, commodities, real estate and so on and so forth (the list is endless), but that would be missing the point, because I don’t intend to buy any of these (yet?). So why bother?

If you really feel like you want to know more about any of the above, leave a comment and I might re-consider…

Bookmark It

Hide Sites

Anyone up for more UK stockmarket jargon? Yes? Well, here’s what the English understand by an investment trust:

“A company quoted on the London Stock Exchange which invests its shareholders’ funds in the shares of other companies.” (www.finance-glossary.com)

Therefore an investment trust is essentially a company that exists solely to invest your money in other companies’ shares. Unlike unit trusts, investment trusts are closed-end funds in that they have a fixed number of shares whose prices are determined by market supply (fixed in this case…) and demand. This means that they often trade at either a discount or premium to the value of their underlying assets.

In short - I couldn’t find a difference between investment trusts and what American’s broadly classify as mutual funds. So unless someone tells me what the difference is, I will assume they are the same securities that simply go under different names in different countries. Just like people in the US refer to funds that mirror a stock index as index funds (which seems reasonable…), British people prefer to call them tracker funds.

So no real mysteries with investment trusts. Feel free to re-read the post on mutual funds and substitute “investment trust” every time you come across the words “mutual fund”.

Read part 10 of “Investment Choices” on OEICs >>

Bookmark It

Hide Sites

Whenever I read about the UK stock market and investments in the UK, two names/acronyms always seemed to be in the picture - unit trusts and OEICs. I had absolutely no idea what these are, even after I had done all my reading on investment choices. Today I finally had a minute to find out what these are all about. So here we go…

Unit trusts are essentially a special class of mutual funds. Many investors put together their money and have a fund manager to buy shares for them and thus diversify their risk without a huge financial involvement (Financial Advisers say that you need about £50,000 - £100,000 to put together a fully diversified portfolio on your own…).

The distinguishing feature of unit trusts is that they are open-ended, which means that as demand for a particular trust increases, the fund manager can just issue new shares. Therefore, the price of a unit trust is not determined by the secret pet theory of all economists (i.e. demand and supply) but actually reflects the underlying value of the fund.

Similar to mutual funds, unit trusts have various objectives to suit your needs and risk attitude: growth or income (i.e. high dividends), small companies or large, domestic or foreign investment and any combination of these (and more). And since it’s an actively managed investment you will have to pay some fees to your trust / fund manager.

One further difference to mutual funds is that unit trusts use different prices for bid and offer, i.e. buying and selling. This means that you will usually pay a higher price when buying shares than what you get if you are looking to sell. The difference is kept by the unit trust to finance their business. My first thought was that this should keep the annual charges and management fees down, because the fund managers earn through this spread as well. I’ll have a look to see whether this is indeed the case or not.

More on investment trusts and finally OEICs soon…

Read part 9 of “Investment Choices” on investment trusts >>

Bookmark It

Hide Sites

A bond fund works very similar to a share fund (i.e. mutual funds), in that someone else will buy and manage bonds for you. This means you won’t have to worry about inflation, interest rates, credit ratings of firms, etc. because the fund manager is there to take that responsibility from you. Obviously to be able to lean back and enjoy all the benefits, you will have to do some initial research on the different funds available in order to make sure your chosen fund manager shares your investment objective, and obviously does so well. Bear in mind that past performance is at best an indicator of quality - not a guarantee!

So why should you rather buy a bond fund as opposed to just simple buying the individual bonds yourself? There are a variety of advantages, some of which include:

• Diversification: Bond funds usually cover a number of different bonds, with different coupon rates and maturity dates so the performance of one bond (i.e. should the issuer not be able to pay the coupon rate or (upon maturity) the par value) does not impact the overall performance too heavily. Moreover, you’ll often find bond funds that are also diversified across different bond types, i.e. funds that cover both government and corporate bonds. Therefore you can achieve a great deal of diversification with only a fraction of the investment you’d have to sacrifice in order to re-build this diversity yourself.
• Professional management: I went on and on about how mutual fund managers earn their living by picking shares for you and spend hours and hours researching each and every company represented in their fund. Bond funds and their professional managers are no exception to this, which also means that you will have to pay some fees in order to support your fund manager’s salary. So make sure you pick a good one, to justify the extra expense.
• Liquidity: The great thing about investing in bond funds is that you are not tied down by a maturity date. If you want your money tomorrow, you can sell your fund shares and get your cash out at any time. Your shares will either be bought by someone else wishing to invest in this particular bond fund, or will simply by the company that is managing the fund.
• Regular income stream: Buzzword passive income. Passive income is income generated without requiring any action from you. In the case of bond funds this will be your fraction of the coupon rate that is paid monthly. But since the bond fund covers a number of bonds which all potentially pay out on different days of the month, you might generate income every single day of the week (even though it might still only be paid out monthly). If you don’t want the additional monthly income (because you’d spent it anyway…), you will have the option of automatically re-investing those payments. Therefore the amount you’ve originally invested will grow steadily - thus earning you bigger portions of the coupon rates, which in turn will give you higher income… The power of compounding at its finest!

To analyse the performance of a bond fund, you should look at three important values: its share price, its yield and its total return.

The bond’s share price represents the bond’s net asset value, which is based on the value of all securities in the bond - i.e. the share price reflects how well the bonds are rated and whether most of them are priced above or below their par value.

The yield tells you how much additional monthly income you would have had in the past 30 days if you’d have owned shares in the fund.

And finally, the total return is almost a mixture of the above values in that it shows the fund’s overall gain (or losses) based on the income generated and the price gains (or losses) of the bonds in the portfolio. Fidelity suggests you should concentrate on the last value when making decisions about which bond funds to invest in.

Alright, I hope this wasn’t too dense. I just sat my Finance exam this morning, so all this jargon sounds fairly familiar to me - admittedly only after six weeks of solid revision. As always, let me know whether you have any questions by leaving a comment and I will do my best to find an answer…

Read part 8 of “Investment Choices” on unit trusts >>

Bookmark It

Hide Sites

After I diverged a little bit from my original investigation into investment choices, let’s return and have a closer look at mutual funds this time.

I have already discussed index (tracker) funds in great detail, and while mutual funds and index funds do share some features, in most ways they differ significantly. You’ll hopefully soon see why.

Just as index funds, a mutual fund is essentially a collection of shares bought and administered by a fund manager. Mutual funds can be either bought with the fund company directly or through a normal broker and thus simply like you would buy any other share. While the shares of exchange traded funds (ETFs) are priced throughout the day (which is why they are often compared to ordinary shares) and can thus vary in value throughout the day, mutual funds are only priced once - at the end of the market day.

So why invest in mutual funds? The answer is simply - and you probably would have guessed - diversification. If many people invest in the same fund, large sums of money are made available to spread the investment over a variety of sectors, shares, countries and markets - something you clearly couldn’t achieve on your own, at least not if you don’t belong to Britain’s richest 5. Moreover, mutual funds are actively managed (remember that index funds where what is called “passively managed”), which means that some people devote their entire careers to picking stocks for you. That means they spent their entire days researching companies to find the next winner, the one company that is going to outperform the market in the long run (if it exists).

The advantage that should come with a dedicated fund manager is generally a better performance than e.g. an index like the FTSE 100. Since these people should be able to eliminate the companies whose shares are going to go down, right? Well… sort of. But even those fund managers are human after all, so in the end they are probably bound to make a mistake at some point. The truth is, that only about 15% of available mutual funds outperform the market in the long run. Therefore you will need to do your homework for funds just as you would for company shares.

The downside of actively managed investments is that you will need to pay the person who is doing all the work for you - after all, they want to pay off their mortgage too. This implies that the expense ratio of mutual funds will generally be higher than that for index (tracker) funds, and commonly accompanied by advertising expenses and a high turnover through a more frequent buying and selling of shares than mirroring an index would require. Since every buy- or sell-transaction incurs additional costs the most amazing gains could be eaten away by these additional expenses - a fairly good reason to do your homework properly.

Read part 5 of “Investment Choices” on bonds >>

Bookmark It

Hide Sites

After I have covered shares and ETFs, the next topic on my list of investment choices is the index fund - or tracker fund as it is more commonly referred to in the UK. The objective of these funds is to track the performance of an index or a specific sector by mirroring their composition. However, just because a fund is tracking a particular index, doesn’t necessarily mean the performance among different funds will be the same, nor does it imply that the fund’s performance will exactly match the index’s growth.

The main reason for these differences is that there are various ways to replicate an index (or sector). With full replication the fund manager buys every stock in the index in proportion to its weight in the index. This works just fine if the underlying stocks are easily available (to buy and sell) and the number of stocks in the index is not too large, since every buying and selling transaction involves fees, which in turn will be charged back to the individual investors, thus driving annual fees up and profits down.

Another method of replication is sampling where the fund manager only buys the largest shares in the index and mimics transactions only on bellwether shares, i.e. leading shares that can be assumed to reflect the performance of a particular sector.

Any replication method will result in tracking errors which reflect the difference between the performance of the index and the fund’s performance. High initial and annual charges widen the gap between the index and the fund, since fees will have to be taken into account when computing the (annual) performance of the fund.

The three most important points to bear in mind when choosing an index fund are:

• Charges: Some funds have annual charges as low as 0.3% which means that most of the fund’s returns will go back into your own pocket (that includes dividend payments for income shares represented in the fund)
• Index: This is a major consideration since the fund’s performance will be very similar to whatever index you choose. Stable economies promise a more reliable long-term growth than emerging market economies. Moreover, the more common an index is the lower are usually the associated charges while more “obscure” benchmarks usually incur higher fees.
• Tracking error: This can only be based on the historical performance of the fund and thus it is generally advisable to stick to funds that have been around for a few years. Firstly, you have historical data available that you can actually base your research on and secondly, they will have had the chance to learn from their experience and thus minimise the possible deviation.

Now that we have covered ETFs and index funds, there’s one large group of funds left: mutual funds. More on this soon…

Read part 4 of “Investment choices” on mutual funds >>

Bookmark It

Hide Sites