Tag: Funds

Happy ISA investment !

We are in the dying days of the ISA season and people are frantically putting money into new accounts before the deadline.
In search of higher returns than from a cash ISA, some people are turning to “stock & share” ISAs but wondering what to invest in within it…

The common answer brandied around for long-term investment success is “diversification”!

Diversification is achieved by choosing a mix of different kinds of investments. The goal of diversification is not necessarily to boost performance (it won’t ensure gains or guarantee against losses) but more to target a level of risk (based on your goals, time horizon, and tolerance for volatility) and to try and optimise returns for that level of risk.

To build a diversified portfolio, you should look for investments (stocks, bonds, cash, or others) whose returns have not historically moved in the same direction and to the same degree. This way, even if a portion of your portfolio is declining, the rest of your portfolio is more likely to be growing, or at least not declining as much. The most common way of investing is to invest in funds (or investment trusts, see my previous post) rather than individual stocks. A fund invests based on the philosophy and remit of its fund manager, who makes the decisions and manages the investments for you. The added advantage is that each fund is classified by investment category, for easy identification. The following broad fund categories are available:

Growth: Aim is for the fund price to increase because the underlying value of the company stocks held has grown so that in time the fund can be sold at a profit. Return: High, Risk: High.

Income: Aim is for the fund to provide investors with earnings from the dividends of the companies into which the fund is invested. Adding the value of these dividends to the slow growing fund value provides the profit. Return: High, Risk: Medium.

Fixed: Aim is for the fund to provide a reliable stream of income (like above) but from bonds, which are fixed term loans issued by companies and governments looking to raise money. Return: Low, Risk: Medium.

Mixed: Aim is for the fund to invest in a mixture of stocks and bonds, usually in a 80%/20% or 60%/40% mandated ratio. Return: Medium, Risk: Medium.

Total Return: A fund that tries to make positive returns over the medium-to-long-term and provide some growth when stock markets rise, as well as some shelter in falling markets. It invests in shares, bonds, cash, commodities and currencies and may use techniques like shorting and hedging. Return: Low,          Risk: Medium.

Real Estate: A fund that invests in properties, usually commercial, or in companies that own, operate or finance income-producing real estate. Return: Medium, Risk: Low.

Cash / Short term debt: A fund that invests in cash or easy access short term debts, similar in some ways to a direct access savings account. Return: Low, Risk: Low.

A diversified portfolio consists of buying funds in each one of these categories so as to constitute your own “blend” of risk and return. My evaluation above for each category is a “stereotype” view and, like in everything, there is a wide variance within categories. In the end, it often depends on the Manager’s vision and ability.

To illustrate the benefits of a diversified approach, if we consider the performance of 3 hypothetical portfolios: a diversified portfolio of 70% stocks, 25% bonds, and 5% cash; an all-stock portfolio; and an all-cash portfolio. The diversified portfolio would lose less than an all-stock portfolio in a stock market downturn, and while it would trail in the subsequent recovery, it would easily outpace cash and would capture much of the market’s gains.

As can be seen, a diversified approach helps to manage risk, while maintaining exposure to market growth. I will explore how to diversify and some of the subtleties in a follow up post.

Trusty Investments ?

Most people are familiar with investment “funds” but when asked about investment “trusts”, they usually think of setting up a trust fund for rich kids… Wrong! Investment Trusts are a bit of a hidden secret, even if they have been around for over 150 years. Let me explain:

Unit Trust Funds

When we talk abound buying a “fund” we generally refer to a Unit Trust fund which is a financial vehicle that holds individual shares or bonds or other assets. The fund manager decides what and when to buy or sell in the portfolio, so you don’t have to manage the underlying assets.

The fund unit value is determined daily after the close of financial markets by accumulating the fair value of securities owned by the fund less expenses and dividing by the number of units issued by the fund.
When you buy shares in a Unit Trust fund, the fund manager puts your money together with money from other investors and uses it to invest in the fund’s underlying assets. You own a share of the overall Unit Trust.

If the value of the underlying assets in the fund rises, the value of your units or shares will rise. Similarly, if the value of the underlying assets of the fund falls, the value of your units or shares falls. The overall fund size will grow and shrink as investors buy or sell. When more investors want to buy units than sell, the fund manager can issue more units of this fund to meet demand. If there are more sellers than buyers, then he’ll sell underlying assets and cancel units. This means the value of a fund’s units always reflect the value of its underlying assets.

Investment Trusts /vs/ Unit Trusts

Investment Trusts (IT) are a bit different from Unit Trusts (UT). Perhaps the biggest difference with Investment Trusts is in their structure. Unit Trusts are ‘open-ended’ meaning that units can be created or cancelled to match investor demand. UT tend to become bigger (or smaller) to match investors demand and forces managers to find assets to buy/sell. Investment Trusts are ‘closed-ended’ meaning that they have raised a fixed amount of cash and put a fixed number of shares in circulation. If more people want to buy some of these IT shares, they are quoted on the stock market and the share price will go up during the day like with any other listed company. Conversely if people want to sell.

Because we know what the Investment Trust is invested in, the Net Asset Value (NAV) of the Investment Trust can be worked out and compared to its share price. If it is below, then the shares are trading “at a premium” to its NAV, if it is above, then the shares are “at a discount to the NAV”. Obviously, it is always preferable to try and buy with a discount, but popular shares seldom are in this position. It’s all to do with investor sentiments about the future performance of the shares and therefore the future value of the shares.

So, in my humble untrained amateur opinion, the big advantage of an Investment Trusts (IT) over a Unit Trust (UT) is that when sentiment is low and/or people want/need to get their money out and sell, it affects the share price of an IT but not its underlying portfolio. Contrary to a UT manager who must sell assets at a bad time in a “fire sale” to cancel units, the IT manager does not have to sell anything in his portfolio, the IT shares just trade lower at below NAV. This means that if/when sentiments/market goes back up, the whole intact IT portfolio (and therefore the manager’s strategy) can benefits in-full from this change in underlying valuation.

Other differences

Another difference, which can be both good and bad, is the fact that an Investment Trust manager can borrow money to invest (whereas UT managers usually cannot). This is called gearing. If everything goes well, it can enhance the gains, but it can also increase the losses. So you should always check in the prospectus the amount of gearing allowed in each IT.

Lastly, an IT manager can hold back up to 15% of the income their investments generate each year and put it in “Reserve”. This means that in bad times, they can use this Reserve to make up for any shortfall in order to consistently pay a regular or growing dividend. This is ideal when this dividend is used by pensioners. Using this opportunity, some Investment Trusts have been paying increasing dividends for over 40 years!

Conclusion

While there is a lot of advertising and many articles written about Unit Trusts, Investment Trusts seem to be more “under the radar” and used by people “in the know”. I believe that the advantage they hold if markets become depressed (which is likely to happen sooner rather than later) is a good reason to consider holding some in a diversified portfolio.

There is also some evidence that the average IT performs better than the average UT in the long run (over a 10-year horizon). This because managers can take a long-term view (not forced to sell or overbuy as seen above). This is also because the board of the IT acts in shareholders’ best interests and can hold the fund manager to account and even replace him. However, if you look at a shorter period, say one to five years, investment trusts are less likely to beat unit trusts.

The most important thing though is not the type of vehicle you use to invest, but the UT or IT manager’s ability to outperform the market… As always, before you invest, make sure that you also check the charges specific to that UT or IT and the underlying risk associated with the assets held as well as the investment philosophy, time horizon and track-record of the manager.