Updated on 19 May 2015.
There are well over 2,000 different investment funds on offer from UK financial institutions, all with slightly different target markets and investment objectives.
With such a wide choice making sure you pick the right funds to invest in can be tricky. What's more, with the associated risk to your capital that comes with investing it's even more important you get it right.
Here are 9 key steps that will help you to choose funds that fit your investment objectives and ultimately maximise your profits:
Most funds will openly state their investment aims and philosophy; this means you can see both what they hope to achieve from their investment strategy and what type of investor they are looking for.
For instance some funds want to attract people who are happy to invest for a long period without drawing an income; while other funds target investors that want to and draw a steady income each month or quarter.
Similarly, some funds suit investors who are willing to accept greater risk in return for a chance at the biggest capital gain possible, while others are best suited to those who want to make more secure investments with less risk to their capital.
You may also be able to choose a fund that generates an income but gives you the option to re-invest your profits back into the fund, compounding your total stake.
Deciding exactly what you want from your investment should help you eliminate a large swath of investment funds that are not targeted to your needs.
Before placing your money in the hands of a fund manager you need to spend some time thinking about how much risk you are willing to take with your investment.
Unlike a cash account, most investment funds will pose some risk to your initial capital, and as a result you are not guaranteed to get back what you put in.
It is for this reason that investments should be considered as a long term strategy, rather than a place to hold your money in the short term. In theory any extreme fluctuations in value should even out over the longer term.
You are able to mitigate the risk to your money by carefully choosing the type of fund you invest in.
In general, the greater the associated risk of an investment, the greater the potential return - but the converse also applies. Choosing a low risk fund will usually mean slower growth, but the chance that you'll lose your initial investment will be substantially lower than if you opt for a fund that makes high risk investments.
It's for this reason that you need to decide how much risk you can afford to take with your capital before you start looking at funds. This will help you to determine up front which funds are likely to be suitable to your investment goals and which really aren't.
Ultimately, however, your attitude to risk should determine not only what type of fund you invest in, but whether you even invest at all. If you're likely to want to use your money in the near future or can't afford to risk your capital then a cash based savings account may be better.
You also need to consider what the money you are investing is to be used for in the long term.
For example, if you are close to retirement and need the money to provide an income then you may want a lower risk investment. Equally if you are planning to invest your money for a number of years and are happy to see you investment fluctuate in value in the pursuit of a bigger return, you might decide you can afford a more risky investment.
Deciding exactly how to invest to your cash - as a lump sum, or in monthly installments - is also essential before you start considering individual funds.
Investing a lump sum will mean your capital is immediately subjected to the rise and fall of the fund's fluctuating value. If the fund performs well you'll immediately start benefiting, however if it performs poorly your entire capital will be at risk from the offset.
Saving on a monthly basis however, especially into a unit trust or OEIC fund, can help reduce the risk your capital is exposed to. If the value of the fund drops you will be able to purchase more units for your money, however, if the fund increases in value it would also mean you get few units for your cash.
The decision to drip feed your investment, or add in a lump sum is likely to influence the funds you choose.
If you are saving monthly then you may be willing to go for a more risky investment fund as you are not risking a large amount of capital to begin with. Equally some funds may only accept monthly or lump sum investment which may limit your fund choices.
The amount you want to save may also have implications on your choice, most investments specify a minimum opening and monthly deposit. These can vary significantly but usually start from £25-£50 per month and a lump sum deposit of £500.
There are two main types of investment funds, those that are actively managed and those that are passively managed.
An actively managed fund is constantly monitored by a fund manager who chooses which companies to buy and sell shares in.
A passively managed fund, however, will try and replicate the movement an existing market or index, for example the FTSE 250, by investing across the market so as to track its rise and fall. In this case the fund manager doesn't make investment decision but buys and sells shares to reflect then index.
Both types of fund have advantages and drawbacks for you the investor.
In general the fees associated with an actively managed fund will be greater than for passive funds. This is because the fund manager and his support team are constantly managing the investment portfolio and buying and selling the fund's shares to try and maximise your profit.
Essentially this means that less of your investment is used to buy shares through the fund, but this should in theory be outweighed by the benefits of having a fund manager dedicated to maximising profits.
Passive funds tend to capture the whole market by reflecting movement of an index like the Dow Jones or FTSE index. This means that if a single market sector performs really well, or really poorly, that your fund will hold some shares in the affected area. Although your fund may be affected by the change, this impact will always be cushioned or reduced by the other shares the fund has across the market. However if you had chosen an active fund based directly in this market area your profits or losses could be greater.
You'll need to decide whether you have a preference for actively or passively managed funds before you start narrowing down your options.
Most funds specialise in a certain type of holding and this can give you a useful starting point when it comes to deciding which fund most closely match your investment aims.
However, choosing the type of assests you want to invest your money in can be difficult.To give you an idea of your options, here are some of the most common types of investment funds:
These are funds that primarily invest in stocks and shares of private companies. These shares can then either increase or decrease in value and provide a profit through dividend payments.
Equity funds can offer some of the greatest returns on your investment but equally can put your capital at the greatest risk depending on what markets you choose.
These are funds that invest in government issued securities (called gilts in the UK), which provide an income to the fund and a return on the initial deposit.
These tend to be a lower risk investment option than equity investments. However the capital value of the security will not increase in the same way as shares and the profit that gilts and fixed interest investments earn will be slowly eroded by inflation.
Property funds focus on increasing the value of your money through investing in the commercial property market. A major benefit of a property investment fund is that they have the buying power to purchase large properties that would be out of the reach of individual investors.
However, like other funds, property investment provides no guarantee to your capital as property can fall in value. Like equity investments, the market area you choose to invest in will have a big impact on the success of your property investment fund.
There are several investment funds on the market that invest in cash-based assets. Money from the investment fund is deposited in a range of cash accounts at banks and building societies potentially at a higher interest rate than would be privately available, due to the large sums being deposited.
However, unlike a cash account, these funds are not guaranteed and the value of your capital investment can still go up as well as down.
If you are unsure what type of fund to go for you can choose to invest in a balanced or diversified funds which spreads its money across several different asset classes.
Many funds specialise in certain investment areas; they can be as diverse as the US property market to Chinese telecommunications.
It may be that you want to invest a certain market for a number of reasons, perhaps wanting to support small UK business, opting to invest in manufacturing or the communications industry for your political views or choosing ethical funds which develop green and fair trade businesses.
Equally, you may feel that a certain sector of the economy is set to do well over the coming months and years and choose to invest in them for that reason.
Alternatively you can choose a fund that diversifies its investments and spreads your money across a number of different market areas.
While it's by no means a faultless strategy, choosing a fund that invests in an area or market you are knowledgeable about or interested in can be a good idea. This way you're more likely to pick up on positive or negative trends within the industry and so better able to tailor your investment accordingly.
Most investment companies now operate funds that invest in specific locations across the globe, although you can also get ones which invest across numerous regions.
Choosing where to put your money can be tricky but if you specifically want to back a certain financial market then you do have the option choose where to place your cash.
Traditionally emerging markets such as Asia and South America are seen as more high risk for UK investors, compared to the more established UK and US markets.
After deciding what asset class and market you'd like to invest in, you should have narrowed down your choice of investment funds to a more manageable level.
You can now set about the task of looking into the individual funds themselves.
There are several factors to each fund that you should consider before investing, including the size of the fund, its volatility and investment track record.
Each year you can use your ISA allowance to protect your savings and investments from tax.
If you have not yet used your Investment ISA allowance for the tax year you should seriously consider opting for a fund that can be protected as an ISA to avoid paying tax on your profits.
Not all funds will allow you to invest via an ISA so this is something worth checking if you want to use your ISA allowance.
Bigger the better?
The impact of the size of a fund on its performance is still open to debate, with some experts stating that the larger a fund the better as it is both more stable to investors withdrawing their money and has greater purchasing power.
However, there is also a school of though that at a certain point the size of the fund begins to hinder the management's ability to activley manage the money.
Every fund must publish it's performance history so that it is clearly visiable to anyone thinking of investing. Typically results are usually displayed as percentages for the past 1-5 years, although you should be able to go further back if you want to.
By checking past performance you should be able to see the size of previous returns to investors and weigh them up against the market environment at that time.
You may also want to consider the yield rates of the various funds on offer. This essentially measures the how much money each fund is making through dividend payments from the shares and investments it holds.
The volatility of a fund is based upon a standard deviation model and essentially tells you how consistent the fund has been each year. If a fund increased in value by 5% each year with no change it would have a volatility score of 0.
The greater the volatility the more chance you have of seeing big changes in your return each year. So although a fund with high volatility may have the potential for a massive return one year, they have the potential to be followed by low returns or losses as well.
You can check the fund size, volatility score and performance over the past 1-5 years, using the advanced search feature on our Unit Trust table.
Although checking the volatility score and track record of a fund will give you an idea of how it has performed in the past, it provides no guarantee for future performance.
The fund manager is the person who ultimately decides the fate of your money, although in the case of a passive fund they will only attempt to mimic indices such as the FTSE. So checking their credentials before you hand over your cash is essential.
Firstly you should check how long they've managed the fund you are considering investing in and how it's performed under their tenure in charge, before looking further back.
You should easily be able to find their previous investment record online to see how the funds they have managed have performed in the past, although this is no guarantee of future success.
However, the most telling data about a fund manager is not his or her profit margins year on year, but the performance of funds they've managed versus those managed by their peers investing in a similar market.
For example, if a fund manager is investing in a buoyant industry sector, i.e. the World Wide Web during the dotcom boom at the end of the 90's, even if they were a relatively poor fund manager they could end up with what appear to be strong growth figures.
Equally many able and experienced fund managers lost money in 2008 at the start of the financial crisis, so comparing their performance against their peers should give you a good idea of their investment credentials.
The amount you'll need to pay in fees will also impact which investment fund you ultimately opt for.
Although the amount of fees charged can vary due to a fund being either actively or passively managed, there is still some variation between funds of the same type.
Fees are usually split between transaction/deposit fees and annual management fees.
Initial deposit fees are only paid once when you first invest your money in a fund - these are usually in the region of 5%. Annual fees normally vary between 0.5% and 2% and are paid once a year to cover the cost of managing the fund.
Before you invest you should check exactly what you'll be expected to pay, these fees can be found using our investment comparison tables.
Although the points above should give you a better idea on the type of fund you want to invest in, assessing the risk of each fund is a complicated process and unless you are a confident experienced investor you should seek advice from an Independent Financial Adviser before making a final decision.
Written by Martin at money.co.uk
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