We understand that the fund management industry has an array of jargon that can confuse both the novice and well-seasoned investors. Here we aim to demystify some of the key concepts.
Funds exist to enable many investors to pool their money and invest together. This allows them to achieve economies of scale when buying stocks and diversify their exposure to a variety of stocks, rather than buying each one individually.
Funds are often known as ‘collective investment schemes’. These come in a number of guises, but largely fall into two key categories: ‘open-ended’ or ‘closed-ended’. In the UK, the most common types of open-ended funds are unit trusts and investment companies with variable capital (ICVCs), also known as open-ended investment companies (OEICs). Unit trusts and OEICs have different legal structures: one operates under trust law and issues ‘units’; the other operates under company law and issues ‘shares’.
However, they share a common characteristic: the number of units (or shares) is not fixed, but expands and contracts depending on the level of investor demand – hence the name ‘open-ended’.
Another name for this kind of investment scheme is ‘mutual fund’, a term which is commonly used in the US. Because these funds are open-ended, the price at which they can be bought and sold relates directly to the underlying value per share of the entire portfolio.
Investment trusts are an example of a ‘closed-ended’ investment scheme. The defining characteristic of these is that the number of shares on offer does not change according to investor supply or demand, but is limited to the amount in issue. These investments are bought and sold on the stock market and can trade at a premium or discount to the underlying value per share of the portfolio depending on the level of supply and demand for the shares.
‘Long only’ is one of the most common investment styles in fund management. It refers to buying a basket of stocks and/or bonds with the aim of generating returns through an increase in the price of the underlying holdings and from any income generated by these holdings.
‘Absolute return’ is a style of investment which aims to produce a positive return in all market conditions. It involves quite sophisticated strategies, including the use of derivatives to create short positions where the manager seeks to profit from a fall in the price of an underlying security.
Investments can usually be made in a number of different asset classes, such as stocks, bonds, currencies and cash.
Multi-asset funds may adopt ‘long only’ or ‘absolute return’ strategies. Typically they invest across a number of different asset classes, especially those that do not move in correlation, and thereby attempt to reduce the volatility of returns.
Active management involves trying to select a range of investments with the aim of outperforming a particular benchmark index. The ultimate aim of active managers is to generate positive ‘alpha’, i.e. invest in stocks that outperform the market and return more than is expected given the perceived level of risk the shares carry.
Passive management involves trying to replicate the performance of a particular index, such as the FTSE All-Share. Tracker funds are a form of passively managed fund.
Not putting all your eggs in one basket
Diversification is the technical term for ‘not putting all your eggs in one basket’. In theory, stock-level risk can be reduced by holding about 20 to 30 different stocks, so that a downturn in the fortunes of one holding may be mitigated by the performance of other holdings in the fund.
Additional diversification across countries, sectors and asset classes is needed to reduce macroeconomic and political risk.
Asset allocation involves channelling investments across asset classes, geographic regions and/or market sectors. A weighting toward bonds might be increased to boost a portfolio’s income, for example, or greater investment might be made in emerging markets for those seeking growth who are prepared to accept a higher level of risk.
Company share prices
A ‘bottom up’ approach focuses on the prospects and valuations of individual shares while a ‘top down’ approach focuses on broad economic issues or market themes that have the potential to influence company share prices. Many managers may incorporate both into their investment processes, but usually have an emphasis on one or the other.
Growth and value describe certain investment biases adopted by funds and fund managers. A growth manager will look for stocks with good earnings momentum, but be careful not to buy when expectations are too optimistic (i.e. stocks are highly priced). Small and mid-sized companies from flourishing industries tend to be good growth candidates. A value manager ideally looks for attractively priced businesses that have fallen out of favour with the market and have been neglected, but whose fortunes are expected to change. ν
Past performance is not necessarily a guide to the future. The value of investments and the income from them can fall as well as rise as a result of market and currency fluctuations and you may not get back the amount originally invested. Tax assumptions are subject to statutory change and the value of tax relief (if any) will depend upon your individual circumstances.