Types of investment funds and how we think about them at Freetrade

Funds are also one of the most discussed topics on the community, so we wanted to give some insight on how we think about funds at Freetrade and why we feature only exchange traded funds and assets.
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Back to basics: What is an investment fund?

A fund is a type of investment company that buys a bunch of assets and packages them up for investors to buy in one holding. They help investors build diversified portfolios without having to individually select 10s, 100s or even 1000s of stocks or assets. In return, the fund will charge some kind of fee on the money invested.

For retail investors, there are three major types of fund:

• Exchange traded funds/ETFs
• Investment trusts
• Mutual funds/open-ended investment companies

There are more variations (hedge funds, venture capital funds, real estate trusts etc). But these three are the most relevant and common for retail investors.

Note that a fund’s type (whether it’s an ETF or a mutual fund etc) does not determine its strategy (how the fund invests).

There are lots of strategies a fund can pursue but the two big camps that encompass them all are passive and active management.

Passive funds track the performance of an index of assets like the S&P 500. They’re often called index funds or tracker funds. Instead of looking for outperformance, they’re trying to deliver the exact return of an index. If the index as a whole grows, then the fund should have positive returns.

Actively managed funds invest with a particular style or judgement to try to outperform the broader market. An active manager investing in stocks will usually try to find companies they believe will grow faster than others.

The different fund types aren’t bound to follow a particular strategy. Both mutual funds and ETFs can index track. Many mutual funds are active, but there are also some active ETFs too. Generally though, an ETF is more likely to be a passive index tracker.

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Let’s have a quick run-through of the types of fund.

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Mutual funds/open-ended investment companies

• Not traded on a stock exchange
• Can only be bought and sold once a day
• Open-ended — the fund can create new shares and accept new investment
• Share price determined by value of underlying investments
• Passive or active

This is one of the oldest types of fund and a mainstay of traditional UK stockbrokers.

Technically, mutual funds are actually a US concept. In the UK, the equivalent type of fund is called an ‘open-ended investment company’ or OEIC. But almost everyone calls them mutual funds anyway, so that’s the term we’ll use.

(To be very thorough, there are also similar funds in the UK called unit trusts. Overall they’re very close to OEICs but have some differences in terms of structure.)

Anyway, the phrase ‘open-ended’ means that OEICs can create (and destroy) new shares in the fund at will.

It’s a very simple structure:

• The fund managers decides an investment strategy
• A customer put £100 into the fund
• The managers creates £100 worth of new shares in the fund and gives them to the customer
• The cash is used to buy £100 worth of investments based on the strategy
• If the customer wants to sell £100 of the fund, the fund sells £100 worth of its investments, destroys the customers’ shares and gives them £100 back

To buy or sell a mutual fund, customers put an instruction to their broker and the broker passes it onto the fund. Customers can also go directly to the fund themselves. The fund values its holdings and executes buys or sells into the fund once a day.

Because the value of the fund can vary between the time you place the instruction and when the manager puts a buy or sell through, you don’t necessarily know what exact price you’re going to get.

As we say, it’s a simple set-up, but potentially a bit clunky and inefficient. It’s also arguably not too transparent for customers, because they don’t get that much visibility on prices and transactions.

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Investment trusts

• Traded on a stock exchange
• Can buy and sell throughout the day
• Closed-ended — the fund has a set number of shares and a fixed amount of capital
• Price based on demand and supply on the exchange
• Always actively managed
• On Freetrade

The trust is set up by creating a set number of shares and selling them to the public or institutions. The cash raised is used to go and buy a pot of investments. Then the trust’s shares can be bought or sold on a stock exchange.

A trust is called closed-ended because the number of shares and the capital raised to invest is set at the start. If someone wants to own a bit of a trust, they have to buy shares from someone else who already owns them. The amount of money invested by the trust stays exactly the same.

That’s getting more efficient than a mutual fund, because investors can move in and out of the fund, without a mutual fund’s need to keep buying and selling new investments each time. This could mean a potential cost saving for the trust.

However, because there are only a set number of shares, trusts aren’t that good at tracking assets extremely closely. If investors get very enthusiastic about the trust and drive up demand for the limited number of shares, the overall value of the trust can rise above the value of all its investments, called the net asset value or NAV.

Likewise if investors get cold feet, the trust can get a discount to the NAV and be worth less than the investments it holds.

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ETFs

• Traded on a stock exchange
• Can buy and sell throughout the day
• Open-ended — the fund can create new shares and accept new investment
• Passive or active — but more likely passive
• On Freetrade

ETFs are a relatively recent invention. They’re often created as passive index trackers and when financial media talks about ETFs, they usually mean passive funds. But they don’t have to be.

ETFs are built to trade on an exchange and give investors near-instant liquidity. However, as we’ve seen with trusts when a fund trades on the constantly fluctuating stock market, it’s very difficult to keep the fund’s value the same as the underlying investments.

But ETFs have a clever mechanism to let them:

• Be exchange traded
• Have a flexible open-ended structure
• Track their assets very closely.

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