How do funds work?

theshortstack

Probably the ultimate noobie question, but I wanted to get some clarification on how exactly income is generated from funds.

I know they're a slightly different product, but ETFs are slightly easier to understand - they have a set price which increases or decreases and if you sell at a higher price, you've made your income.

Funds obviously aren't traded on an exchange though, so:

• How are they priced?
• How do individuals gain income from a fund? Are there regular 'dividend' payments?
• How do investors gain long term growth/income from funds?

Thanks very much for your help in advance!

JohnRo

http://monevator.com/income-units-versus-accumulation-units-difference/

Reaper

Normal funds are very similar to ETFs, they are made up of shares etc, the only difference is a fund manager chooses what to buy instead of a computer following a rule. As a result charges are higher.

As described in the link above the income from those shares may be handed out or reinvested depending which type of fund you selected.

Investment Trust funds are different - in that case you are buying shares in a company whose sole business is investing. That makes it quite different but I will only delve into those differences if that is something you are considering, as I don't want to confuse you.

verybigchris

theshortstack wrote: »

How are they priced?

The fund is split into "units". At a pre-determined point on every trading day, the total value of the portfolio is assessed, and that value is divided by the number of units to give a unit price. For example, if a fund had holdings valued at £50m and was divided into 100 million units, then it would have a unit price of 50p.

The precise details for each fund (including the time of day they take prices from) will vary, and can be found in the fund's t&cs.

theshortstack wrote: »

How do individuals gain income from a fund? Are there regular 'dividend' payments?

If you hold "income" units then any income derived from the underlying investments (e.g. share dividends) will be shared out as a fund dividend (again, details will vary between funds). If you hold "accumulation" units then that money is rolled back into the fund, so the unit price goes up instead.

For example, suppose a new fund opens with a unit price of £1. After one year there is no underlying growth/loss, but there is 5% of dividends. Income units will still be priced at £1, but investors will have got 5p for each unit they held. Accumulation units will have "grown" to £1.05 each, but they get no cash payout.

theshortstack wrote: »

How do investors gain long term growth/income from funds?

From a combination of dividends (see above), capital growth (i.e. the fund portfolio increases in value because it holds shares that increase in value) or successful trading (i.e. the fund manager builds on the capital growth by selling stocks at highs and buying replacements at lows).

EdGasket

theshortstack wrote: »

Probably the ultimate noobie question, but I wanted to get some clarification on how exactly income is generated from funds.

Fund manager takes your money; throws some darts at a paper and 'invests' it; has champagne lunches and 'jollies' to view prospective investments with the rest. Then the fund manager will deduct more money each year to pay for more of the said lunches and jollies (and a few other non-mentionable things). In good times the increase in value of investments might exceed the management charges and you will be rewarded with an increase in value fo the fund but in bad times the fund will fall and fall even further than it otherwise would because of the management charges.

That is a long winded way of saying watch the charges. ETF's are generally lowest cost of all and for the most part have better performance than managed funds anyway. Look at Vanguard's range or iShares Core series.

Reaper

I like it Ed Gasket.

theshortstack - yes there is question as to whether an active fund manager can beat simple index trackers to justify the higher fees. It is an ongoing debate.

Some managers seem to, but is that just because if you take enough funds some of them will appear to do so by the law of averages? I don't know the answer.

EdGasket

Reaper wrote: »

I like it Ed Gasket.

theshortstack - yes there is question as to whether an active fund manager can beat simple index trackers to justify the higher fees. It is an ongoing debate.

Some managers seem to, but is that just because if you take enough funds some of them will appear to do so by the law of averages? I don't know the answer.

Yes, I think you have hit it on the head there. I remember one year China had a particularly good rise and there weren't many China funds back then. Of course the manager of one of the few China funds was being feted as some kind of genius when in fact it was just pure luck that he happened to be managing a China focused fund in a year that China did exceptional well. After that, never heard of him again.

I think if you take a long enough period including a market downturn, the extra charges of managed funds stack up and they don't beat index trackers. Even if one or two do, how can you pick those that will in the future beat the index from the vast majority of funds that won't beat the index trackers?

Orwell

Fund managers aim to add "alpha" which means performance in excess of the benchmark index.

Some achieve this, some don't. The idea that Woodford (for example) just invests at random is naive.

EdGasket

Orwell wrote: »

Fund managers aim to add "alpha" which means performance in excess of the benchmark index.

Some achieve this, some don't. The idea that Woodford (for example) just invests at random is naive.

Sure there is some 'science' behind it but all fund managers are competing against each other so it is a zero sum game or would be if it were not for charges that make it a negative sum game.

There have been a few studies that show that darts thrown at a newspaper listing of shares performs equally well, on average, as 'managed' funds hence my analogy.

Eco_Miser

EdGasket wrote: »

Sure there is some 'science' behind it but all fund managers are competing against each other so it is a zero sum game or would be if it were not for charges that make it a negative sum game.

It's possible to consistently make money from a zero-sum game of skill, just needs a sufficient supply of lower-skilled losers.
Now, whether employing such a winner to play on your behalf will win you more than his fee costs you is a different proposition.

EdGasket

Problem is you don't know in advance who the winner might be over your investment timeframe and so you are more likely to be paying for a loser because there are more losers than winners.