UK Funds Q&A

Part 1 of the Q&A on Funds by u/pflurklurk, originally posted in March 2017.

What is a fund?

A fund is a way for a group of investors to pool their money to invest in things, benefitting from economies of scale, more flexibility (such as having some liquidity when investing in things that aren’t very liquid, like real property) and the opportunity for smaller investors to diversify with minimal capital.

What kind of things can a fund invest in?

Literally just about anything. Most funds are quite traditional and more what you would think of as “investing” – they pool together investor money to buy things like:

• shares – with all sorts of various filters such as, from certain countries, companies of a particular size, or with certain financial characteristics
• bonds – once again, with all sorts of filters such as, by credit rating, issuer type, or maturity
• cash and cash equivalents
• property – either shares in property or actual real estate or both

Others invest in more specialised or exotic ways, such as:

• hedge funds (where the manager’s goal is simply to find “returns” no matter what happens in the market)
• private equity or venture capital
• vintage cars, art or wine

Others still are more speculative in nature – bets on:

• whether companies will go bust
• interest rates or currencies
• life expectancy through life insurance backed assets
• literal bets on sports events or bankrolling poker players

Those are probably not the kind of things that the average retail investor reading this FAQ wants to invest in though!

How are funds in the UK set up?

Funds can be divided into two types: open-ended and closed-ended.

An open-ended fund is one where the number of shares or units in it isn’t fixed. As investors give the fund more money, new shares are created. As investors redeem, shares are cancelled.

A closed-ended fund is one where the number of shares or units is fixed, usually at the point the fund is established. The only time new money goes into a closed-ended fund is if it borrows or issues more shares – when you buy shares normally, you usually buy them from someone else who wants to sell them, rather than giving money to the fund itself.

How exactly are closed-ended funds set up?

You may have heard about investment trusts. They are not actually trusts in the strict sense – they are, these days, invariably, limited liability companies. When the fund is set up, they issue shares. Sometimes those shares are exchange traded, so you can buy and sell them amongst other investors, but you don’t generally buy or sell them from/to the fund itself.

How exactly are open-ended funds set up?

There are three types of open-ended fund in the UK, but you’ll only mostly deal with one: the “Open Ended Investment Company” (OEIC) or “Investment Company with Variable Capital” (ICVC) – interchangeable terms, legally the same thing. The other two types you’re unlikely to ever buy into directly:

• authorised unit trusts – an older way of setting things up where there isn’t a company involved, but a trust
• authorised contractual schemes – a new way of setting things up where it’s a series of contracts

How is an ICVC set up?

An ICVC is an actual company – it has a board of directors and shareholders (that’s you!), it has to publish annual accounts and get audited.

• there needs to be an investment manager appointed
• it has to, by law, have a “depositary” – an external, independent company that actually legally holds all the company property: what the funds actually bought with your money and its profits
• it can be an umbrella company – one ICVC can have multiple sub-funds, each with their own manager delegated to each fund, each with its own ring-fenced property

For instance, all of Vanguard’s UK-domiciled funds are one company: Vanguard Investments Funds ICVC, directed by Vanguard Investments UK Limited, with The Vanguard Group, Inc as investment manager, which delegates management of all the sub-funds to Vanguard Asset Management Limited. This is all quite normal.

So, what exactly am I buying when I buy into a fund?

You are buying a share in that fund. You own a bit of a company that owns a lot of other things. You need to be clear that you don’t actually own a small proportion of the underlying things the fund owns – all you own is a share of the company.

How is the price set?

Every fund has to calculate a Net Asset Value (NAV) – a valuation of all the assets of the fund minus its liabilities. By law, it has to be done at least once a year, and as frequently as appropriate for how often people can buy in or sell up. The valuation needs to be conducted by someone independent. The NAV, though, isn’t always the price you can actually buy or sell shares in the fund for.

I actually meant, the price I buy or sell for…

If you are buying into an ICVC’s fund, you buy and sell directly from the company itself. The fund will either be single or dual priced – if single priced, you have the same price for buying and selling. If dual priced, the difference between the buy and sell price is called the spread, and generally reflects the fund’s costs of dealing with your buy-in or cash-out, without penalising the other investors in the fund.

However, if you are buying an exchange traded ICVC, you aren’t buying from the fund at all – you’re buying from other people, like a closed-ended fund.

Wait, what’s an exchange traded fund/ICVC?

What is usually called an exchange traded fund (ETF) is actually an exchange traded ICVC fund: underneath it all is a normal ICVC fund with one main difference – instead of buying and selling shares from the fund itself, you are buying and selling those shares on an exchange, from/to other owners of the fund.

Isn’t that the same as a closed-ended fund?

It’s only the same in that you usually buy shares in a closed-ended fund and an exchange traded ICVC in the same way: on an exchange from other people. Sometimes a closed-ended fund wants to raise more money, which happens via an “offering” – a different process to normal fund investing.

So they are the same thing?

No – ETFs are not closed-ended. In the event there’s a lot of demand for an ETF, the ICVC company issues a lot of shares to big brokers and investment banks who then add those shares to the market by selling them to retail customers, and use the proceeds to buy the assets the ETF tells them to.

The biggest noticeable difference between a normal ICVC and funds that trade on an exchange is that for normal ICVCs, they only let you buy or sell when they say you can – often daily, but for some funds, monthly or even annually. If you buy from an exchange, you can buy and sell whenever there’s someone else willing to trade with you, and the price isn’t set by the fund but by whatever you and the other side decide. In practice this means closed-ended funds and ETFs trade at a premium or discount to the NAV.

Why are there different classes and types of shares in open-ended funds?

The two main types are “Accumulating” and “Income” (or, for ETFs, “Capitalising” and “Distributing”). An Accumulating share is one where the company takes any distribution and instead of giving it to you in cash, buys more assets with the money. An Income share is one where the company gives the distribution to you physically to do what you want with it.

Why are the prices different if it’s the same fund?

For Accumulation shares, all the distributions stay in the fund, so each share represents more assets. For Income shares, cash actually leaves the fund, so the price decreases just after the payment date, since these shares represent fewer assets than before. If you measure returns including the payments you get with income shares, it is identical though.

So, what practical difference is there between having an Acc share or an Inc share?

An Acc share removes your ability to decide whether to reinvest the income – it’s automatically reinvested, saving you the hassle (and fees, if applicable) of doing it yourself, and removing the temptation to spend the cash. An Inc share gives you the choice of what to do with the income.

How do I make money from funds?

Two ways:

• from the income (as in, cash money) your assets produce
• from any increase in the value of the assets you invest in
• distributions – whether those distributions get rolled into the fund as Acc units, or you get the distributions as cash via Inc units
• capital gains – if the price of your units is higher when you sell them than when you bought them, you made a capital gain. Congratulations!

What about tax?

Distributions – Acc or Inc – are liable to income tax (the type depends on the assets in the fund – interest or dividend). Capital Gains – when you sell, you might be liable to Capital Gains Tax. Owning the funds via a pension or ISA means all those distributions and gains are exempt from those taxes!

What about Class A,B,C,D,X,Y,Z etc. alphabet soup shares I see everywhere?

That is a way for funds to sell the same fund to different types of shareholders – each share class will probably have different charges and different minimum investments, depending on who is selling the shares on the fund’s behalf. Each class might have the two types, Acc and Inc, as well.

What about UCITS and non-UCITS and other confusing terms?

UCITS (Undertaking for Collective Investment in Transferable Securities) is a designation from EU regulations about how a fund is marketed to investors. In the UK there are three marketing classifications:

• UCITS
• NURS: non-UCITS Retail Scheme
• QIS: Qualified Investor Scheme, generally reserved for sophisticated investors

UCITS and NURS differ mainly in what and how the fund can invest – a NURS fund can generally borrow more and invest in a wider range of assets.

How do I buy a fund?

If it’s exchange traded (ICVC or investment trust), you buy it like any normal share on the stock market. If it’s a normal ICVC fund, you can buy:

• direct from the fund (usually needs a large minimum investment, uncommon for retail investors)
• via a broker/platform

Most retail investors buy via a broker or platform, which can buy cheap share classes in bulk and resell them in smaller chunks to clients while preserving the cheap fee. Brokers also collect tax vouchers and administer your ISA/SIPP.

Wait, fund costs?

Yes – fund managers need to make a profit too! (Vanguard is a notable exception – their “profits” go back into the funds.) Fund costs include:

• buying and selling the underlying assets
• audit
• paying the fund manager
• dealing with shareholders

These are reflected in your ongoing charge/annual management charge/total expense ratio.

What’s the difference between OCF, AMC and TER?

The Annual Management Charge is just the fund’s own fee for managing your money – it doesn’t reflect all the costs involved. Total Expense Ratio was introduced to more accurately reflect how much of your investment disappears every year, including entry/exit costs, dilution levies etc. That terminology moved to Ongoing Charges Figure, which includes the TER plus things like audit costs and shareholder communications.

Even OCF isn’t the full story – other costs (trading costs, hedging costs, borrowing costs, stamp duty) are borne by the fund itself and show up as reduced performance rather than an explicit charge.

Rule of thumb: ignore AMC, look at OCF and see what it’s made up of. Don’t forget you are paying this charge on top of your broker’s fees.

How much is reasonable for a fund to charge?

Compare charges, and compare how closely funds follow their benchmarks. There’s no point buying a fund that’s dirt cheap but underperforms the benchmark by a considerable amount, in favour of a more expensive one that tracks it closely. For passive investments, Monevator has a good list of cheap funds to start your research at.

What about for a broker?

Cheapest for your investing habit – how much you have to invest, how often you’re putting money in, and what you’re buying. Everyone is different, and you might have an ISA with one broker and a SIPP with another. Be ruthless about fees – it’s no use wasting thousands over time on a shiny UI if you only check your investments once a year. Also double check your broker can actually buy what you want.

What if the fund goes bust?

If the fund has made bad investments and they’re now worthless, that’s the risk of investing – you’re out of luck. If the fund manager itself goes insolvent, and the fund is authorised in the UK, you’re covered by the FSCS up to £85,000 if the underlying assets have somehow been lost. In practice, the company’s property (held by a separate, independent custodian) will just be transferred to another fund manager or returned to shareholders.

What if my broker goes bust?

Same thing – your shares are held by a custodian or ring-fenced and will just be transferred to a new broker. If they are missing for some reason, you’re covered up to £85,000. The FSCS doesn’t cover you from making bad investments though!

What funds do I buy?

That’s not something this FAQ can answer – you first need to decide what you want your portfolio’s asset allocation to look like. A fund is just a way of getting access to that allocation without having to put down a lot of money.

I bought some funds. Now what?

Sit back, tell your broker to regularly invest money, and wait. Profit will (may!) come eventually. Investing is a get-rich-slow process.

Are you sure I shouldn’t check on them?

You should probably check on your funds once a year to make sure your portfolio is still on track, and rebalance if needed. You don’t want to overcheck though – research shows retail investors who check a lot end up costing themselves returns.

Finding and reading fund documentation

There isn’t a free, easy searchable list of all funds, though the FCA publishes a register of authorised funds, and sites like these offer easier interfaces:

• Trustnet
• Morningstar

If you’re referring to ISINs (International Securities Identification Numbers), yes, funds mostly have these, but you still need to know what you want in advance.

If you’re buying something not based in the UK, first check whether you or your broker can actually get it. In the EU you’ll see SICAVs (an ICVC equivalent). In the US, a “mutual fund” is one registered with the Securities and Exchange Commission.

Once you’ve found a fund, look at the documentation it provides. As a UK retail investor, you’ll typically encounter:

• A factsheet – up to the fund manager how they present it, but must be clear. Usually just 1-2 pages, updated frequently.
• A Key Investor Information Document (KIID) – a standardised, regulated document, in no more than two pages, covering:
  • objectives and investment policy
  • risk and reward profile
  • charges
  • past performance in a standard format
  • practical information such as contact details
• A Prospectus – prepared at the ICVC/company level, long and complex (e.g. Vanguard’s LifeStrategy prospectus runs to 79 pages), covering legal incorporation, depositary, securities lending policy etc.

You probably want to look at the factsheet and KIID more than the prospectus.

The 1-7 risk scale

This is technically called the “Synthetic Risk and Reward Indicator”, with its calculation prescribed by European regulators, based on the volatility of the fund’s weekly (or monthly, where NAV isn’t calculated that frequently) past returns. Where there’s no or limited past performance, it’s based on approved benchmarks and models.

Can a fund ignore what it says in the KIID, like the investment objective?

Officially, no. Unofficially, regulators have been very slow to bite when funds break their objectives – the most serious “punishment” is typically being kicked out of their preferred sector.

What about a NURS, and a QIS?

NURS funds don’t have to provide a KIID, but usually provide a NURS-KII, which is basically the same with a bit more flexibility. QIS funds come with much less handholding – you’ll get a basic amount of critical information, but not much more.

RDR and Clean Share Classes

The Retail Distribution Review was an FCA initiative to force greater transparency about charges – specifically how much brokers and advisers got in commissions from fees. Before the RDR, some share classes had higher charges, part of which went to the broker/adviser. After the RDR, that was no longer allowed – the annual management charge was “unbundled” into a “clean share class”. These days you’ll invariably end up buying the unbundled/clean share class.

How does it work, exactly, when I buy?

If it’s exchange traded, your broker will try to find someone selling at the price you set or better (a limit order), and once matched, you wait for the trade to settle (exchanging the consideration involved, or fulfilling contractual obligations) before ownership is official.

If you’re buying a normal ICVC, it depends whether your broker already holds shares and is reselling them, or needs to place your order with the company directly. Either way, eventually your money reaches the fund, which quotes you a price, and once you’re happy, you have a share (or fractional share) and the fund managers have your money, which they then invest according to their own criteria.

Securities lending

Many funds engage in securities lending – lending out assets to other investors (e.g. those who want to short them) in exchange for a fee, subject to collateral requirements. Most funds do it, including Vanguard. It’s risky in that there’s non-zero risk, but even in the 2008 financial crisis where Lehman defaulted, most funds were able to liquidate the collateral and repurchase the missing securities without cost to investors.

Controlling risks and derivatives

Funds may want to hedge out various risks depending on what they invest in, for example:

• for a credit fund, you might want to hedge default risk or interest rate movement
• maybe you’re managing a defined benefit pension fund and you need to hedge out inflation
• foreign exchange movement
• you’re investing in airlines or aircraft and you want to hedge out jet fuel costs

To do this, they use derivatives – instruments whose value is derived from another asset, structured as contracts between counterparties. All types of derivative:

• options
• futures
• swaps

If something is in a different currency, that doesn’t automatically mean derivatives are used, but you can use derivatives (or buy a “hedged” share class) to limit the impact of foreign exchange movements on a fund’s performance. This is different to a “hedge fund”, which aims to offer returns uncorrelated with anything else in your portfolio, and in modern usage refers more broadly to any unregulated pool of capital managed to make maximum returns however possible, for example:

• activist investing – taking stakes in public companies to force them to change their ways to make shareholders richer
• special situations funds – trading securities based on things like potential bankruptcy, takeover, M&A activity
• macro-economic theme strategies
• arbitrage of all types
• distressed investment – anything from turnaround specialists to vulture funds
• high-frequency trading
• black box strategies – where no one knows what happens but it makes money: see Renaissance Technologies

These require a lot of money, waiving most consumer protection, and high fees.

Feeder funds

Feeder funds are part of a “Master-Feeder” distribution structure – a way of accessing a large pool of funding with lower compliance and administration costs, where individual investors invest with feeder funds, and the master fund actually doing the investment only deals with a few “clients” (the feeders). You see this a lot in hedge funds and property funds, since property is illiquid and can’t be held in a UCITS fund – feeder funds can offer more frequent redemption to retail investors while the master fund itself redeems less often.

EIS/SEIS, VCT and SITR funds

EIS (Enterprise Investment Scheme) and SEIS (Seed Enterprise Investment Scheme) are tax-relief schemes: when you invest in eligible companies, you get a certificate you can use on your Self Assessment to reduce an income tax and/or capital gains tax bill. An EIS/SEIS fund invests its money in eligible companies, then arranges for certificates to be issued to its shareholders.

A VCT (Venture Capital Trust) is a closed-ended fund, like a normal investment trust, that must be publicly listed and invests in unlisted companies – buying shares in one is like buying any other exchange-listed share, except the investment also qualifies for tax relief via Self Assessment.

SITR (Social Investment Tax Relief) funds work the same way as EIS/SEIS funds.

Can I put these funds in an ISA or SIPP?

ISAs and SIPPs have legal rules about what type of investments you can put into them – for instance, QIS funds can’t go in an ISA. The more exotic the fund, the less likely it can go into an ISA. SIPPs have broader rules but there are still restrictions. Check with your broker, since what’s legally permitted might not be permitted by your specific broker.