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You've read up about the share market and are chomping at the bit to get started on your investing journey. But you have no idea what stocks you should buy.
You know the best way to build long-term wealth is through a well-diversified investment portfolio. But you can't afford the transaction costs of buying a bunch of different individual shares. And, besides, you don't have the spare hours it takes to research hundreds of different companies anyway!
If you've had any of these thoughts, don't despair – you're not alone. Stock picking can be a difficult task for even the most seasoned investors.
But that's where investment funds come in. They take much of the guesswork out of investing and can provide your portfolio with low-risk exposures to different markets, asset classes, and investment strategies.
In this article, we'll explain what fund investing is and the different sorts of funds that exist out there, from exchange-traded funds (ETFs) to listed investment companies (LICs) and managed funds.
Let's dive in!
What is fund investing?
A fund is a pooled investment vehicle. This means it takes money raised from multiple investors and uses it to make investments. All investors in the fund then share in whatever returns the fund earns.
Funds provide individual investors with exposures to assets they might otherwise not be able to afford (like property, gold, or wholesale bonds). It combines their capital with that raised from other like-minded investors, giving them more buying power.
Many – if not most – funds use the money they raise from investors to buy a portfolio of shares. The fund's mandate defines the size and strategy of the portfolio. For example, it may only invest in growth shares, dividend shares, or the stocks that make up the S&P/ASX 200 Index (ASX: XJO).
This means investing in a fund can give you exposure to hundreds of different shares. In just one trade, you get a whole portfolio, saving you hours of research – not to mention potentially hundreds of dollars in brokerage fees.
Fund investing is an excellent choice for time-poor investors or those who don't yet have the financial knowledge to start stock-picking on their own. A fund manager makes the investments on behalf of the fund, meaning you can rely on their industry expertise.
And because the fund's strategy is defined by its mandate, you can combine different funds to tailor a portfolio that meets your investment needs and objectives. Check out our article on top investing strategies for some ideas.
Investing in ETFs
Exchange-traded funds (ETFs) are one of the most popular funds for everyday investors. They trade on the share market just like regular shares, making them highly liquid and easy for investors to access. Investing in an ETF is as simple as placing an order with your broker.
ETFs are well-regulated, transparent, and usually low-cost. Most ASX ETFs are index funds, meaning they track the performance of a particular share market index, like the ASX 200.
A big advantage of an index ETF is its fees — usually among the lowest you will pay for an investment vehicle. The lowest fee index ETF on the ASX charges just 0.03% annually. That represents roughly $3 a year for every $10,000 invested.
An ETF also 'rebalances' itself over time to ensure it continues to reflect its benchmark index accurately. This reduces the need for an investor to manage their investments. An ETF is a great 'set and forget' investment for those unable to dedicate significant time to managing their portfolio.
Not all ETFs track share market indices, though. The ASX hosts ETFs that track oil futures, platinum prices, gold, real estate and much more. These ETFs can provide easy access points to asset classes that can be difficult for individual investors to invest in.
For example, despite its benefits as a safe-haven asset, physical gold can be challenging to buy and expensive to store and transport. But if you want to add some gold exposure to your portfolio, you can invest in Global X Metal Securities Australia Limited (ASX: GOLD).
Global X Metal Securities is a commodity ETF backed by physical gold. It uses the money it raises from investors to buy actual gold bullion, which is stored in a vault in London. This makes it just as good as investing in the real thing. Better, even, considering the fund only charges 0.40% per annum in management fees to buy and store your gold for you.
Investing in index funds
As we just discussed, index funds aim to replicate the returns of a particular benchmark index. In finance-speak, an 'index' is a collection of shares or assets representing a specific market sector.
This means you can make an index out of just about anything — the ASX 200, an industry group (like healthcare), similarly sized companies (like small caps or blue chips), or even strategies (like growth or income shares).
Index funds are ideal passive investments. The fund manager maintains and rebalances the fund on your behalf, so you don't have to think about it. You just sit back and earn the return of your chosen index.
These funds are typically low-cost because there isn't much active management or stock-picking that the fund manager must do, considering the benchmark index determines the investment. However, they are specifically designed not to beat the market, so you won't get outsized returns by investing in index funds.
When it comes to index funds, there are plenty of options available on the ASX.
There are ETFs covering the ASX 200 Index, like the iShares Core S&P/ASX 200 Fund (ASX: IOZ), the BetaShares Australia 200 Fund (ASX: A200), and the SPDR S&P/ASX 200 ETF (ASX: STW).
Then there is also the most popular ETF in Australia, the Vanguard Australian Shares Index ETF (ASX: VAS), which instead tracks the ASX 300 Index.
And some ETFs track overseas indices. If you want to invest in US markets, you could choose an S&P 500 ETF, like the iShares S&P 500 ETF (ASX: IVV) or the Vanguard US Total Market Shares Index ETF (ASX: VTS).
Or perhaps you'd rather go with the popular BetaShares NASDAQ 100 ETF (ASX: NDQ), which covers the tech-heavy NASDAQ 100 Index.
There are some more obscure options available, too. The iShares MSCI South Korea ETF (ASX: IKO) tracks an index that holds purely South Korean shares. In contrast, the Vanguard MSCI International Shares Index ETF (ASX: VGAD) tracks an index that follows multiple share markets across the world's advanced economies.
Investing in managed funds
An alternative to an ETF is a managed fund.
One of the most defining traits of a managed fund is its unlisted structure. Unlike an ETF, managed funds don't usually trade on a share market and will conduct all transactions with you privately. This means that redeeming your units in the fund can often take days and may involve paperwork.
Almost all managed funds are actively managed, meaning they actively try to beat the market instead of tracking an index. The fund manager may adopt more complex and risky trading strategies to achieve this goal.
It also means that you rely entirely on the manager's stock-picking expertise in a managed fund (as opposed to an index fund). Assuming you pick the right manager, this could land you a market-beating return now and then. But it also comes at a significant cost.
The fund manager will need a team of traders and market analysts to keep up with all the latest market trends. They don't come cheap. Thus, managed funds typically charge management fees that are far more expensive than an ETF.
You'll want to do your homework before investing in a managed fund. The fund manager needs to justify their fees by delivering consistent market-crushing performances. Otherwise, those fees will quickly start eating into your long-term returns.
Speaking of market-crushing, many funds will also take a performance fee as high as a (soul-crushing) 20% for anything above their target benchmark. That might sound like a win-win for both parties, but it can put a serious dent in your potential earnings.
Another disadvantage is that many managed funds require minimum investment amounts. These can range from $5,000 to $100,000 or even higher. The high price tag will exclude many investors right off the bat.
Some investors see managed funds as a bit old-fashioned these days, given the ease with which they can buy and sell ETFs. They likely suit wealthier investors with healthy risk appetites – and, even then, the fund manager needs to have a good enough track record to earn the investment.
Investing in LICs and LITs
ASX investors can choose from other types of funds, including listed investment companies (LICs) and listed investment trusts (LITs). Both investments are pretty similar to the additional funds we've already discussed. But, there are some key differences investors may want to consider before investing.
A LIC is incorporated as a company, paying dividends from its after-tax profit (and likely carrying franking credits). On the other hand, a LIT is set up as a trust, which means all distributions are paid on a pre-tax basis (and you pay the tax bill).
The trust versus company structure also has other implications for ASX investors. Trusts are pass-through vehicles that, by law, must distribute profits and taxable income (or losses) to their investor beneficiaries yearly.
A company has no such obligations. It must pay tax on any profits (thereby generating those highly coveted franking credits for shareholders). However, it can retain cash and franking credits for as long as it deems necessary.
This means that (like other ASX companies) LICs can hoard cash over time to ensure smoother dividend payments and franking credit distributions for shareholders.
Like ETFs, LICs and LITs are always listed on a stock exchange, so they are publicly traded. However, like managed funds, most LICs and LITs are actively managed investment vehicles, which means they usually charge high fees (although there are a few exceptions).
Open and closed-ended
LICs and LITs are also 'closed-ended' investment vehicles, unlike managed funds or ETFs, which are open-ended. This means LICs and LITs can only have a finite number of shares or units outstanding at any one time (much like a regular company).
When investors sell their shares, they pass straight over to the new buyer – and are not redeemed by the LIC.
When investors redeem their units in managed funds and ETFs, the fund has to sell their underlying holdings to cash them out. This can cause instability in the fund if it processes many sell orders simultaneously, which is typical in a market crash. A closed-ended vehicle like a LIC or a LIT does not have this problem.
The ASX is home to dozens of LICs and LITs, but a few have been around for so long that they have garnered quite a reputation. The most prominent is the Australian Foundation Investment Co Ltd (ASX: AFI). AFIC is a $9 billion ASX stalwart, opening its doors in 1928. This LIC typically invests in a portfolio of ASX blue-chip shares.
Investing in mutual funds
Mutual funds are essentially the same thing as managed funds. While there are some minor technical differences (mainly nuances in how the fund's unit price is calculated), your terminology will mostly come down to where you live.
In the United States, it's more common to use the term 'mutual fund', whereas in Australia, we usually say 'managed fund'.
Foolish takeaway
Investing in funds provides investors with alternatives to buying individual shares. And, just like any other investment, we can combine funds with other assets (like property, term deposits, and shares) in a well-diversified investment portfolio. You can even combine different types of funds!
Investing in funds can be an excellent way for investors of all experience levels (but particularly beginners) to gain broad exposure to the stock market and access other asset classes, like bonds and commodities.
However, many types of funds are available to Aussie investors, and it is essential to understand the pros and cons of each before you decide to invest.
Some offer the potential for spectacular returns – but at the cost of significantly higher management fees. Others simply replicate a particular index's performance, making them great 'set and forget' investments – but not designed for market-beating returns.
So, before investing, make sure you do your homework. Understand the returns the fund is trying to deliver, how actively managed it is, and the fees. This is the best way you can set yourself up for investing success!
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This article is part of Motley Fool Australia's comprehensive Investing Education series, covering everything from budgeting and saving to basic investing concepts and how much money you'll need to start.
Packed with easy-to-understand and regularly updated information, our articles contain the answers to your most frequently asked questions about share market investing.
Motley Fool's Education series is tailored for beginner and experienced investors alike and also includes helpful tools and resources, an A-Z glossary of Investing Definitions, and guides to specific topics of interest, including retirement planning, gold and property investment.
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