UK Funds FAQ

Part 1 of the Q&A on Funds by /u/pflurklurk.

This was originally posted in March 2017 – there is discussion in the original thread.

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 – if you can dream it, you can probably invest in it.

Most funds are quite traditional and more what you would think as of “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 certain size, companies that have a minimum number of shares sold to the public etc.
  • bonds – once again, with all sorts of filters such as, by credit rating, issuer type (e.g. company or government), how long they have until they mature etc.
  • 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 the markets do)
  • private equity or venture capital
  • vintage cars, art or wine

Other funds can be more speculative in nature, where what the investors buy tend to be bets – they are putting up money to make the bet, e.g.:

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

Whole departments of major investment banks are devoted to coming up with a way of letting their clients (or them!) make the bets they want, and, finding someone (usually their other clients) to take the other side of the bet.

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. This is usually at the point the fund is established, where everyone pools their money and gets shares in return.

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 – either the normal variety big name ones, or more specialised trusts like venture capital trusts.

They are though, 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 you can sell those shares on, sometimes you can’t – some of those companies are exchange traded: so you can buy and sell those shares 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 type: the “Open Ended Investment Company” (OEIC) or “Investment Company with Variable Capital” (ICVC).

OEIC and ICVC are interchangeable terms – they are the same thing, legally.

The other two types are:

  • 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

You probably won’t ever buy into an authorised unit trust (a lot of funds converted to ICVCs) or authorised contractual schemes (mainly used by big institutional funds to manage their portfolios in a legal sense).

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, but there are special rules such as:

  • 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

Most of the big name funds will appoint their operating company as the director and their asset management company as the manager: the sub-fund assets are all separate.

For instance, all of sub-favourite Vanguard’s UK funds – that is, funds that are legally set up in the UK – are one company: Vanguard Investments Funds ICVC (note, limited is not in the name!), but that company’s director is Vanguard Investments UK Limited, the investment manager is The Vanguard Group, Inc (the US parent), but 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 – those other things depending on what the objective of the fund is, whether that’s shares, bonds or bets on the weather.

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.

That’s not the same for authorised unit trusts or authorised contractual schemes but you probably won’t be buying them.

How is the price set?

That depends on what you mean by “price!”

Every fund has to calculate something called a Net Asset Value (NAV) – that is a valuation of all the assets of the fund minus its liabilities (for instance, if it’s borrowed money).

By law, it has to be done a at least once a year, and must be done as frequently as appropriate for how often people can buy in or sell up.

That means if people can buy/sell every day, it should be valued every day at least. If you can only buy/sell twice a year, twice a year valuations are allowed.

The valuation needs to be conducted by someone independent – either of the fund itself, or if done internally, by teams functionally separate with remuneration policies that prevent conflict of interest.

The NAV though, isn’t always the price that you can buy or sell shares in the fund for though!

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

If by price, you mean “what I buy and sell for” then it depends on who you are buying and selling from/to!

If you are buying into an ICVC’s fund, then you buy and sell directly from the company itself.

The fund will either be single or dual priced – if it’s single priced, then you have the same price for buying and selling. If it’s dual priced, there is a difference between the price to buy from them and the price you get when selling: the difference between those prices is called the spread.

If there is a single price, then it usually means that the fund is going to absorb all the costs of taking your money and investing it – the other shareholders’ returns will be affected.

If it’s dual priced, then the “profit” the fund is making between the two prices generally reflects those costs. That difference is called the “spread” – the funds use the extra money to try and cover costs of dealing with your buy-in or cashing-out, without penalising the other investors in the fund.

However, if you are buying an exchange traded ICVC, then 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.

Technically you could say investment trusts on stock exchanges are exchange traded funds but people would just look at you funny.

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

It’s only the same in that you buy 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: when they do that they sell shares to investors directly – that’s called an offering. You sign up to invest and the fund decides whether sell you any shares or not.

You would buy that in a different way to normal fund investing.

So they are the same thing?

No – exchange traded funds, (ETFs) are not closed-ended.

In the event there’s a lot of demand for that 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 you, the retail customer!) – they take the proceeds from the sales, buy assets that the ETF tells them to and gives them to the ETF in return for those shares they were given to sell to you.

Why bother having two ways of buying a fund anyway?

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.

For a lot of retail funds, that’s usually daily, but for many funds, especially more exotic ones, they might restrict it to monthly, or twice a year, or even annually.

The price they quote will be based on what the fund’s NAV is, so what you see is what you get, but it takes longer to process and you might get locked in.

If you buy from an exchange, then you can buy and sell whenever there’s someone else willing to sell or buy to/from you (whenever the exchange is open) – and the price isn’t set by the fund, it’s set by whatever you and the other side decide.

In practice that means closed-ended funds and ETFs trade at a premium or discount to the NAV: the shares can be worth more or less than the sum of the parts – that reflects what people think about the management of the fund (or people trying to gamble).

Some investors like the certainty of the former, others like the liquidity of the latter.

An ICVC might decide to go with one or other because of things like costs and suitability for what they are investing in – each type of fund has different back-end compliance requirements and that costs money.

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

The two main types of shares are “Accumulating” and “Income”. If you are talking about ETFs, they are usually called “Capitalising” and “Distributing”.

Whenever a company in the UK takes company money and gives it to shareholders, it’s called a “distribution”.

An Accumulating share is one where the company takes the distribution, and instead of giving it to you in cash, buys more assets with the money.

An Income share is one where the company takes the distribution and gives it 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 it is only logical the price decreases just after the payment date, because these shares represents fewer assets than before (don’t forget cash is an asset!)

If you actually measure the returns including the payments you get if you have 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 from the fund – it’s automatically reinvested by the fund itself, and that means you avoid any potential costs of reinvesting it yourself (such as trading fees). You also remove the temptation of withdrawing cash and spending it on other things!

An Inc share gives you the choice of deciding what to do with the income – you can withdraw it or make a different investment with it.

How do I make money from funds?

There are two ways you can make money from investments:

  • from the income (as in, cash money) your assets produce
  • from any increase in the value of the assets you invest in

A share in a fund is just like any other share in a company – it can go up in value, and/or it can pay you distributions.

So, from your shares in a fund you make money from:

  • 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. Your fund manager should send you (or your broker) a statement telling you what the type of distribution is – whether it’s interest, or a dividend.

There are different tax rates for both – what type you get depends on the assets in the fund.

Capital Gains – when you sell, you might be liable to Capital Gains Tax.

Of course, by 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-UCTIS and other confusing terms?

UCITS – Undertaking for Collective Investment in Transferable Securities – is a designation brought about by EU regulations about how a fund is marketed to investors.

In the UK, there are three types of marketing classification:

  • UCITS
  • NURS: non-UCITS Retail Scheme
  • QIS: Qualified Investor Scheme

QIS funds are generally reserved for more sophisticated (read: rich and advised) investors – e.g. the most complex hedge funds.

UCITS and NURS differ mainly in that rules surrounding what and how the fund can invest in. A NURS fund generally can borrow more money than a UCITS fund and invest in a wider range of assets (e.g. hold property directly).

A UCITS fund can be set up in another EU member state and sold to UK investors without much additional compliance. The other two schemes need a bit of investigation by the FCA first.

How do I buy a fund?

If it’s an exchange traded fund – either ICVC or investment trust – then you buy it like any normal share on the stock market.

If it’s a normal ICVC fund, then you have two options:

  • direct from the fund
  • via a broker/platform

If you buy from the fund itself (i.e. direct from the company), you will probably need quite a large minimum investment (most funds don’t like the hassle of dealing with lots of individual retail clients). You probably won’t end up buying from funds directly. If you do buy directly, you also usually can’t hold those shares in a wrapper like an ISA or a SIPP – you’d need a broker or platform for that.

Most retail investors buy via a broker or platform (interchangeable term).

The broker is like a reseller – they can buy the cheap share classes (i.e. the ones that, if you bought direct, would need £5 million at least) and resell them in little chunks to their client but still preserve the cheap fee.

Some brokers have “funds supermarkets” – they offer a range of funds from all sorts of providers (even if that broker is also an owner of ICVCs themselves like Fidelity): but you have to watch out for the fee they’ll charge. Like normal supermarkets, they are free to charge different prices for the same products!

They also do things like collect tax vouchers from the funds and administer your ISA/SIPP or account.

In return they charge you a trading fee (sometimes) and a platform charge, which is on top of the fund costs.

Wait, fund costs?

Yes – fund managers need to make a profit too!

Well, not all of them: sub-favourite Vanguard operates a model where the “profits” of funds go back into the funds – making them perform a little more, or reducing the effective charges.

The fund ICVC is going to have costs such as:

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

That’s reflected in your ongoing charge/annual management charge/total expense ratio.

Some funds will even charge you on entry and exit – you need to watch out for all the costs!

What’s the difference between Ongoing Charges Figure (OCF), Annual Management Charge (AMC) and Total Expense Ratio (TER)?

The Annual Management Charge is just a fee the fund charges for the privilege of investing your money. It is only their fee – it doesn’t reflect all the costs involved.

So, Total Expense Ratio was introduced – it is meant to more accurately reflect how much of your investment disappears every year – not just to the fund management fee, but other things like entry/exit costs, dilution levies etc.

That terminology moved to Ongoing Charges Figure – which is meant to include the TER but also things like running the company, e.g. audit costs, regulatory communications, shareholder communications.

But that still isn’t the full story, because other costs are borne by the fund itself (which means, borne by all the shareholders equally) and show up as reduced performance – that includes trading costs (e.g. commissions to brokers), hedging costs, borrowing costs, stamp duty etc. That’s why some funds charge dilution levies and are dual-priced: to try and insulate other shareholders from the cost of dealing with new buyers, or when one individual wants to sell. They want to avoid a situation where a large shareholder sells up and the costs are borne by lots of little shareholders: that would be unfair and not a good selling point.

That doesn’t mean that funds that don’t charge those are automatically screwing over the little shareholders though!

You have to go quite deep into the paperwork to find out exactly what they mean by their charges.

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?

How long is a piece of string? You first look at the market for the thing you are trying to buy – remember a fund is just a pooled investment into something else. So, who else is trying to offer that as well?

Compare charges – and compare how closely they 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 the benchmark more closely.

Rule of thumb: for passive investments it will depend on what you’re trying to track – Monevator has a good list of cheap funds you start your research at – for active ones, it depends entirely on what you are trying to buy – but think carefully about whether your choice is worth the money.

What about for a broker?

Cheapest for your investing habit – that means looking at how much you have to invest, how often you are putting money in and what you are buying.

Everyone is different – and you might have an ISA with one broker and a SIPP with another.

Be ruthless about the fees – no point wasting thousands (yes, over time, it could be thousands) on a shiny UI if you only check your investments once a year.

Here is a list of cheap UK online brokers: http://monevator.com/compare-uk-cheapest-online-brokers/

Don’t forget not all brokers can buy everything. Make sure your broker can buy what you want!

What if the fund goes bust?

Depends what you mean by bust.

If you mean, the fund has made some bad investments and they are now worthless, then I’m afraid you are out of luck – such is the risk of investing.

If you mean has gone insolvent for some reason – say, the ICVC has been fined millions and can’t pay – then if the fund is authorised in the UK, you will be covered by the FSCS up to £50,000, if the fund has somehow lost the underlying assets.

Don’t forget though that legally all the company’s property is held by a separate, independent custodian: these are big, nameless and boring banks whose main purpose in life is to make sure that client property is safe.

In practice what that means is that the company property will just be transferred to another fund manager or returned to shareholders.

What if my broker goes bust?

The same thing as above – 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, then you are covered up to £50,000.

The FSCS doesn’t cover you from making bad investments though!

What funds do I buy?

That’s not something this FAQ can answer – a fund is just a group of investors pooling their money together to buy something.

You first need to decide what that “something” is – how to put together your portfolio for your own needs. That’s something for another FAQ writer!

Our sidebar has a lot of reading about asset allocation. 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 for what you want it for. You’ll probably have to rebalance unless you have bought a portfolio-in-a-fund product (see, you can put anything in funds!)

You don’t want to overcheck because research shows retail investors who check a lot end up costing themselves returns.

What’s rebalancing?

You’ll have to look at the next FAQ where we talk about the more advanced concepts – but rebalancing is limited to funds, it’s about what’s in your underlying portfolio.

What will happen to my funds if x,y,z happen?

It’s all about what your fund actually buys – the fund is just a wrapper.

Yes, I’ve done some research, I want to buy some funds, but…how exactly do I find what I’m looking for?

Unfortunately there isn’t a free, easy searchable list of all funds.

There are literally thousands of funds available for sale in the UK: https://www.fca.org.uk/firms/authorised-recognised-funds – and you aren’t limited to buying just those!

There are companies that can help though, who offer easier interfaces.

A large provider of funds might also have an easy searchable list on their own website, or your broker might be helpful in helping you track one down.

Doesn’t everything you can invest in have its own serial number?

If you’re referring to ISINs – International Securities Identification Numbers – then, mostly yes, but you still need to know what you want in advance!

What if I want to buy something that isn’t based in the UK?

First, you need to see if you or your broker can actually get it.

Then, it’s just a matter of placing an order.

What should I look for then? They won’t be called the same things, right?

Of course. If you’re buying in the EU, you might see things called SICAVs – that is ICVC translated into Romance languages.

Romance languages?

An Indo-European language family that evolved from Vulgar Latin in the 6th to 9th centuries.

Right. So, ICVCs in Europe pretty much the same as the UK. What about the US?

A mutual fund is one registered with the Securities and Exchange Commission.

They even have their own Q&A about funds.

https://www.sec.gov/reportspubs/investor-publications/investorpubsinwsmfhtm.html

Ok, I’ve found a fund I want to invest in. Now what?

You should look at the documentation that a fund provides – if it’s reputable and regulated by a competent authority, then it should provide at least something tell you about it.

If you’re a retail investor in the UK, this is where UCITS and NURS comes into play.

UCITS?

Really?

Just kidding. I have the fund documents now – what’s the difference between all of them?

It depends on what fund you are buying.

The FCA has specific rules about what information needs to be provided to each type of client. As a retail client, that means quite a lot of information in as simplified form as is reasonably possible.

The things you’ll most often encounter are:

  • A factsheet
  • A “Key Investor Information Document” (KIID)
  • A “Prospectus” – simplified or otherwise

If you invest in a UCITS the fund itself must by law (in the UCITS regulations) provide a KIID or a simplified prospectus, under the FCA handbook: https://www.handbook.fca.org.uk/handbook/COBS/14/2.html – https://www.handbook.fca.org.uk/handbook/COBS/13/3.html#D64

Both a KIID and a Prospectus are supposed to give information in a standardised format so you can compare them with other UCITS funds.

A factsheet, on the other hand, is up to the fund itself – it has to be clear though, but is up to the fund manager how they want to present it.

So, what’s the difference between a prospectus and a factsheet

A prospectus is usually prepared on the company – ICVC level. It is quite complicated and the same for, say, a prospectus for an IPO. Only losers like me read these in full – and the unfortunate trainee lawyers who have to draft them.

For example, here’s sub-favourite Vanguard Lifestrategy Funds ICVC’s full prospectus – 79 pages long. It will tell you things such as all about the legal incorporation of the company, depositary, securities lending policies, etc. etc.

The factsheet for one of the sub-funds e.g. Lifestrategy 100 is only 2 pages long – and is updated much more frequently, because it contains details about the size of the fund, what it’s invested in, the ISIN and other identifiers, etc.

You probably want to look at the factsheet more than the prospectus!

What about the KIID?

This is another regulatory document you need to read in conjunction with the factsheet – it contains, in no more than two pages:

  • objectives and investment policy
  • risk and reward profile
  • charges
  • past performance in a standard format
  • practical information such as contact details

You should always look at the KIID for a UCITS, as well as the factsheet – you can tell it’s regulatory because it’s in black and white.

I see this 1-7 risk scale on a KIID quite a lot – are they all the same?

In theory yes – the 1-7 risk scale is technically called the “Synthetic Risk and Reward Indicator” – and its calculation is prescribed by the European Securities and Markets Authority.

It is developed by the Committee of European Securities Regulators and is based on the volatility of the fund, specifically:

The SRRI should be based on the volatility of the returns (past performances) of the fund; these shall be the weekly past returns of the fund or, if this is not possible because of the limited NAV calculation frequency, the monthly returns of the fund.

In the cases where there is no past performance (or limited), it is based on benchmarks and models approved by regulators.

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

In theory no – see /u/q_pop’s answer:

Officially, no. Unofficially, the IA (formerly IMA) and regulators have been very slow to bite when funds break their objectives. The most serious “punishment” funds suffer is being kicked out from their preferred sector.

What about a NURS?

They don’t have to provide a KIID, but they still usually have to provide something called a NURS-KII: which is basically the same but with a bit more flexibility (to reflect the fact they can invest in more complex things than UCITS).

And a QIS?

Now you’re playing with the big boys and you don’t get as much (or any) handholding – you’ll still get a basic amount of critical information, but not much more. Good luck!

Don’t end up like these guys: https://www.bloomberg.com/features/2016-goldman-sachs-libya/

I heard something about the RDR and Clean Share Classes?

The Retail Distribution Review was an initiative by the Financial Conduct Authority to try and force greater transparency about charges – specifically how much brokers and advisers got in commissions from fees.

Before the RDR, some classes of shares in funds had a higher charges than others – and part of those charges went to the broker/adviser.

After the RDR, that was no longer allowed (essentially) – the annual management charge was “unbundled”. That is a “clean share class”.

https://www.fca.org.uk/publication/finalised-guidance/fg14-04.pdf

These days you’ll invariably end up buying the “unbundled”/“clean” share class.

I’ve chosen my fund, but how does it work, exactly, when I buy?

Exactly depends on what fund you’ve bought and how you bought it.

If you tell your broker to get you a share of something that’s exchange traded, they will go out and try and find someone who is selling it for the price you set or better (a limit order) – friends don’t let friends place market orders – if someone is willing to make that exchange, then all you have to do is wait for the trade to be settled (your ownership is official at that point) and there you go.

Wait, what’s settled?

I thought you only wanted to know about funds – settlement is about exchanging the consideration involved in a transaction, or to fulfil contractual obligations.

Ok, carry on

If you are buying a normal ICVC, then if you bought it from your broker, it depends whether they’ve already bought a load of shares in the ICVC and are reselling them to you, or whether they need to go and place your order with the company.

In any case, eventually your money reaches the fund.

They decide to quote you a price – which we covered in the first question and answer session.

If you’re happy with that, then now you have a share (or fractional share) in the fund and the fund managers have your money.

Their own investment criteria means they have to do something with that cash. They are just like any other company: they will use their own brokers to buy and sell fund assets in the name of the fund.

That’s it?

That is basically it – but many funds will employ other strategies to measure and control risks, cut costs or try and make money to hit their targets by lending out securities.

What do you mean lending out securities?

Many funds engage in what’s called securities lending. You may have heard of shorting – where investors borrow assets to sell hoping the price drops so they can buy them back, as they have to give them back eventually.

Where do these assets come from? Big funds with lots of assets that just sit there. Vanguard and Blackrock, two of the biggest fund managers in the world, own 12% of the US stock market.

Most funds do it – yes, even sub-favourite Vanguard – and you can find their policy in the prospectus you didn’t read.

Isn’t that risky?

It’s risky in that there is non-zero risk, yes. However, counterparts need to put up collateral, in even in the last financial crisis where Lehman defaulted, most funds were able to liquidate the collateral and repurchase the missing securities themselves without any cost to them.

Here’s Blackrock’s take on the matter: https://www.blackrock.com/corporate/en-at/literature/whitepaper/balancing-risks-and-rewards-may-2012.pdf

Of course, they might be a bit biased as they make money off it – or these days, do it to push down the OCF on funds to attract new money.

What about controlling risks?

As there’s all sorts of things a fund can invest in, there are also all sorts of risks out there that a fund, or its investors, might not want to get take on board when making their investment.

There is usually a whole department at any financial institution which manages internal risk – whether that’s counterparty risk, compliance risk, operational risk etc.

We’re going to talk about risks in the portfolio rather than all of those.

How you manage your risk depends on what you are investing in and what risks you want to hedge out.

For instance:

  • 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

Really you’re switching out something uncertain for something fixed (maybe it’s for your internal profit models) – and paying for that.

Sometimes you want to swap out something fixed for something uncertain!

To do this, you use derivatives.

Deriva-what?

Derivatives – they are instruments whose value is derived from another asset.

Without going into too much detail, legally they are structured as contracts (usually from a large template such as the ISDA Master Agreement) and you are just betting between parties (called the counterparts).

You may have encountered them:

  • options
  • futures
  • swaps

are all types of derivative.

You can pretty much invent any bet or insurance you want and it can be turned into a derivative. You can even make derivatives based on other derivatives.

All you need is someone willing to take the other side of that bet – that’s why people who come up with the prices and accurately model how they’ll behave if x,y,z happens, get paid the big bucks (quants).

So if something is in a different currency, it’s using derivatives?

No – but you can use derivatives if you want to limit the impact on performance of the fund due to foreign exchange movements: we call those “hedged” funds.

Wait, so a hedge fund is just a fund that uses derivatives?

No – a hedge fund is something different!

A hedged fund, is one where something, usually currency risk, is hedged.

Funds offer those to investors because some investors are concerned about the volatility of their currency when making international investments.

The underlying performance of the fund is what really matters – something that performs well doesn’t perform intrinsically differently because another currency was used to buy it, only that its purchasing power in the currency you want to use changed.

However, the trick is that when you want to come and liquidate the fund and use the money – after all, money is eventually meant to be exchanged for goods and services – you might be exposed to a currency fluctuation at that point: that’s volatility you might not want.

You can pay to remove that volatility by hedging – either buying a fund that has a hedged share class (they will use derivatives to hedge the value of that share against the value of underlying fund assets), or you can hedge it yourself by buying your own derivative (like a currency option or forward).

If you are going to ask about exchange rate movements though, don’t bother, as they are banned on this sub.

So hedging is more about your risk tolerance – or speculation on currency, depending on your perspective.

What’s a hedge fund then?

A hedge fund is meant to hedge against the markets as a whole – they are supposed to offer returns uncorrelated with anything else in your portfolio.

The term has expanded now more to refer to any kind of unregulated pool of capital managed to make maximum returns however possible.

For instance, as well as investing in assets, they also make use of various strategies such as:

  • 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

If you want to invest in these, you’ll need to have a lot of money, pretty much waive any consumer protection and pay a lot in fees.

You might be able to find a fund of hedge funds though, but trading costs and middleman fees are going to be expensive.

I found these funds called Feeder funds, for hedge funds and some property funds. What’s the point of them?

It’s part of a distribution system called Master-Feeder. It’s a way of structuring your fund to that you can access a large pool of funding, but have lower compliance and administration costs.

Individual investors invest with the feeder funds, so the master fund which is actually doing the investment only has to deal with a few “clients”.

You usually see them in hedge funds and property funds because it allows you to very easily segregate clients based on things like their domicile or investor type (e.g. one can be for foreign investors only, one can be for retail clients, one for large institutions) – you can place more tailored restrictions on each type of client because that’s handled on the feeder fund level.

For instance, you see it with property a lot because property is quite illiquid – and can’t be held in a UCITS fund.

So, instead of a fund having to hold cash on hand at all times just in case people want to redeem, you can have your master fund allowing redemptions say, once a year, but your feeder funds allowing more frequent redemption. Your institutional clients might be happy with a less frequent redemption calendar, so they can go in a different fund – the master fund doesn’t have to deal with these problems and can put more of its assets to investment.

What about EIS/SEIS funds?

EIS (Enterprise Investment Scheme) and SEIS (Seed Enterprise Investment Scheme) are two tax-relief schemes.

When you invest in EIS/SEIS eligible companies, you get a certificate from that company in respect of your investment which you can then use on your Self Assessment to reduce either an income tax and/or capital gains tax bill.

So, when we talk about EIS/SEIS funds, the tax-treatment applies to the individual companies those funds invest in. The fund invests its money, then arranges for EIS/SEIS certificates to be issued to its shareholders, who then claim the tax treatment.

And VCT?

A VCT – Venture Capital Trust – is a closed-ended fund, like a normal investment trust.

They must be publicly listed – they then invest in unlisted companies. The fund prospectus and factsheets will tell you what kind of companies they invest in.

So, it’s the same as buying a share on an exchange for your portfolio.

It’s just that investments into these shares also qualify for tax relief via Self Assessment again.

What about SITR funds?

Social Investment Tax Relief funds work in the same way as EIS/SEIS funds at the moment. You join the fund, the fund invests, you get the certificate.

Ok. I think I get it a bit more – but I can’t buy the fund into my ISA or SIPP, but I can normally: what gives?

ISAs and SIPPs have legal rules about what type of investments you can put into them. For instance, QIS funds can’t be put in an ISA.

The more exotic, the less likely it can go into an ISA. SIPPs have broader rules but there are still rules.

Check with your broker – what’s legally permitted might not be permitted by your broker, as a broker must manage an ISA and pensions need a trustee (and you generally won’t be your own pension trustee unless you really, really want to).

Pension trustee?

That’s for someone else’s FAQ!

Happy Investing!