Should you choose investment funds or shares?

Investment / Savings
Rosie Murray-West looks at the pros and cons of investment funds and shares.

When you are deciding how to invest your money, you will need to decide whether to buy shares in companies directly,
or whether to put your money into one of the many funds that are targeted at retail investors.

Both solutions have their pros and cons, so making the choice is a matter of personal investment style as well as experience. Here are some of the things that you should consider before making your choice.

Funds

Many experts will advise newcomers to stocks and shares to invest using a fund. One of the reasons for this is that your money is pooled with other investors and spread over a wider range of companies’ shares or bonds. This means that if one of the companies in which you invest hits problems, you are likely to lose a smaller proportion of your money.
Even if the fund you choose invests in just one geographical area, or one sector of industry, it is unlikely that all the companies in which the fund is invested will hit problems at the same time – although of course this is not impossible, as we all saw with the global credit crisis.

If the fund you invest in covers lots of geographical areas or lots of industries, the risk of them all experiencing difficulties at once is even smaller.
When we refer to funds we are usually talking about unit trusts, or open ended investment companies, which are known as OEICS for short. These are the commonest type of fund, To invest in these you buy ‘units’ either directly from the provider of the fund (which is usually the more expensive option) or from a broker or discount fund supermarket. You can use an Independent Financial Adviser to help you buy a fund, or you can decide to buy and hold them yourself, known as the DIY or ‘execution-only’ route.

OEICS will pool your money with other investors, and the price that you pay for the units will change depending on the value of the companies that are held in the fund. OEICS and unit trusts usually hold shares, bonds or portfolios of other funds. One alternative to OEICS and unit trusts is to buy investment trusts, which are sold on the stock market. These are often cheaper and invest in similar portfolios, but are slightly more complicated to understand and may be more volatile.

Funds can concentrate on one particular area of the stock market, for example just smaller companies, or just technology companies, or they can concentrate on one geographical area, such as India, Japan or the UK. Other popular types of fund concentrate on companies that pay a high dividend to their shareholders. These are known as equity income funds. According to the Investment Management Association (IMA), which is the trade body for fund providers, the current most popular types of funds are equity income and property funds.

Another main distinction between funds is whether they are active or passive. Passive funds simply track an index, such as the FTSE 100, or India’s Sensex index. They buy the shares that make up the index and then replicate its performance exactly.

Active funds, by contrast, have a manager who decides how the cash will be distributed. Both types of funds have charges, but actively managed funds tend to be more expensive. The argument for this is that an expert manager may pick stocks that outperform the index as a whole. You should be able to see the past performance of a fund before you buy it, as well as a fund factsheet that details the main fund holdings and management.

It is important to understand the charges that you are paying for buying a fund, and the effect that they will have upon performance. As well as an annual charge, the cost of a fund is affected by the cost of dealing within it. The best measure for comparing these charges is the total expense ratio (TER) or a measure called Ongoing Charges, which is replacing the TER. This will show you how much of your cash will be eaten up by charges. If you invest through an online platform or fund supermarket, as is usually the case if you buy the funds yourself, you will also pay charges to the platform. Passive funds tend to be cheaper than active funds, as you are not paying for management expertise. However, these are guaranteed not to outperform the market, as they will merely replicate its performance. Some trackers do this by buying shares in all the companies that make up the index. However, synthetic trackers use complex financial instruments to track what the index does by buying shares in a cross-section of companies. Some tracker funds are unit trusts or OEICS, while others are Exchange Traded Funds (ETFs), which are traded on the stock market and tend to be very low cost.

Shares

If buying a fund requires you to do your homework in the form of researching management performance and holdings, investing in single shares requires you to do even more.

Buying shares means that you become a part owner of a company. The value of your share of that company goes up and down depending on how many people want to buy the shares, based on their perception of how well that company is doing.
The advantage of this is that you know exactly where your money is going and can target it precisely. You may find hidden gems by doing your own research, and may also get dividend income, which is paid to shareholders in some companies either annually or bi-annually. You can get dividend income by investing in a fund, as well.

Researching a company requires you to look at its performance. Listed companies give financial figures at least twice a year. These should show you how much debt the company has, how much it is growing and whether it can continue to pay out dividends. Key measures that many investors use when looking at shares are the price/earnings ratio, which is calculated by dividing the latest share price by the earnings per share – a measure that is given on the accounts. Dividend cover, showing how much cash the company has to pay its dividends, can also help to predict whether the dividend is likely to be cut.

You will pay a dealing charge to buy and sell shares. You can do this online or through a telephone stockbroker, which may be more expensive.If you buy individual shares it is important not to put all of your eggs in one basket. A properly diversified portfolio should include a variety of stocks in different sectors. Defensive sectors, such as tobacco and pharmaceuticals, perform well when the economy is weaker, while ‘cyclical’ stocks such as technology companies tend to perform better in a stronger market. A mixture of the two should help mitigate risk.

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