How to choose investment funds
Once you know your investment goals, time frame and attitude to risk, the next step is to pick investments that will help you achieve your goals.
If you’re ready to invest, and you’ve decided that investment funds are a suitable option, you’ll need to choose funds that fit with your needs and circumstances.
Here are some recommended steps to go through so that you can be confident in selecting the right type of funds, and avoid being overwhelmed by the sheer range of options.
Step 1: Get your asset allocation right
Asset allocation means choosing the right combination of assets (types of investment) to invest in. Collectively the assets that you invest in are called your portfolio.
The reason to do this step first is because how you allocate your assets has a strong bearing on the kind of performance you can hope to achieve, and the kind of risk you are taking on.
Why diversification is important
It's important to try and get a diverse mix of assets for your portfolio. Why? Because assets in the same class may all be affected by the same kind of risk, and can all move in the same direction at once.
Even if you're a brilliant investor, you can't account for every risk. The more assets you hold of the same type (or size, currency, geographic location, etc.) the more you concentrate your exposure to certain risks.
- We discuss different types of risk in more detail here
The basic principle of diversification is described by the phrase “don’t hold all your eggs in one basket”.
If you invest in a fund, the hard work of deciding which individual bonds or shares to invest in will have been done for you. You should still make sure that the blend of overall assets held within your funds are compatible with your goals and attitude to risk.
So a good first step, before looking at which specific funds you want to buy, is to decide on the overall mix of assets you want to invest in.
Make an outline of a portfolio that matches your risk tolerance. Visit our guide to asset allocation for more detail on this step.
Step 2: Think about which fund management style you prefer
These are the two main, competing styles of fund management:
- Actively managed funds aim to outperform a particular benchmark – or, in the case of Absolute Return funds, aim to deliver a positive return in all market conditions. The performance you will see from actively managed funds depends on the abilities of the fund manager, and on how much you pay in management charges.
- Passive (or tracker) funds aim to replicate the performance of an index or benchmark, such as the FTSE 100, while keeping costs lower than actively managed funds. Exchange Traded Funds (ETFs) also follow passive techniques.
Which of these approaches you choose is really a matter of your investment philosophy. If you believe in the ability of certain fund managers to outperform the market, you will be happy choosing actively managed funds. If you are skeptical of this ability and want to follow the performance of the wider stock market while paying lower charges, you may prefer passive funds.
There is another type of fund you will see on investment platforms:
- Multi-manager funds are a specific kind of actively managed fund. The fund manager invests in different underlying funds (usually single-asset) run by different fund managers. In doing so, they aim to offer you a one-stop-shop for a diversified portfolio.
Think about which kind of investment style would suit your attitude to stock markets. We discuss the merits of active vs passive funds, and multi-manager funds, in this guide.
Step 3: Decide whether to choose single or multi-asset funds
Many funds specialise in a single type of asset – for example, smaller company shares, high yielding bonds, Japanese companies. Often the name of the fund will give an indication of the strategy being adopted by the manager – “Newton Emerging Income”, for example, looks to invest in dividend-paying companies based in emerging markets.
The main arguments for choosing single asset funds are specialisation – the fund manager can be expected to know the market deeply in one area, and be better able to choose investments that will outperform – and conviction, in other words you strongly believe that a certain type of investment is due to perform well.
Building a diverse portfolio from single asset funds generally involves more work on your behalf: choosing (and monitoring the performance of) fund managers, and ensuring you still have a sufficiently diverse portfolio (as we discussed in Step 1).
You also have the option of multi-asset funds. In this type of fund, the manager creates a portfolio that includes different asset classes (such as equities, bonds, property etc) aimed at meeting specific goals, such as income, capital growth or both.
In principle, this reduces the choices you have to make – all you need to do is choose a fund that is closely aligned with your goals and attitude to risk.
If you're looking for multi-asset funds that are suitable for your risk tolerance, you can search for suitable funds on your investment platform of choice, using IA (Investment Managers Association) categories as a guide. These categories define the proportion of equities of that funds are allowed to hold:
- Mixed Investment: 0–35% shares
- Mixed Investment: 20–60% shares
- Mixed Investment: 40–85% shares
- Flexible Investment: no minimum or maximum level of equities. Multi-manager funds often fall into this category
Decide how much work you're willing to put in to researching funds; this will help narrow down your choice. You might find our DIY investing options guide helpful.
Step 4: Research fund performance and risk
If you decide to invest in an actively managed fund it is important to review the performance of the fund and manager against relevant benchmarks, and review the level of risk that the fund is taking to achieve its aims.
Funds that have a higher risk rating tend to be more volatile and can experience sudden movements in value. Analysing how the fund has performed over the long term and in different market conditions can give you some insight, but remember that past performance should not be taken as an indicator of future performance.
Companies such as Morningstar and FE Trustnet produce qualitative ratings and historic statistics on the performance of popular investment funds. These research portals offer a wealth of data, although this can be intimidating to the new investor.
Some investment platforms such as Hargreaves Lansdown, Fidelity and Bestinvest offer detailed information on the funds you can buy through their platform, and may also offer original research to help you choose.
Step 5+: Keep an eye on your portfolio
Even when you’ve invested your money, you need to monitor the fund’s position and ensure that you are aware of any significant changes to the management, such as the departure of a fund manager or a change in ownership of the company managing the fund.
For this reason many investors look for a platform that gives them the best online interface through which to view their portfolio.
Last updated: 30 September 2015