How do investment funds work?
from t1psinvesting.com

To find out how investment funds work, the first question you should ask is: what are investment funds supposed to do? The best description is a sentence written in 1868 and enshrined in the trust deed of the very first investment trust, setting out its objectives: “to provide the investor of moderate means the same advantages as the large capitalist in diminishing the risk of foreign and colonial stocks by spreading the investment over a number of stocks”.

Almost 140 years on, that's still pretty much what investment funds do: they pool the money of individual investors to provide a spread of risk by investing in a range of shares. Although they were designed to cater for people of “moderate means”, these days, their attraction is much more widespread, finding appeal with high-net worth investors who are looking to diversify and contract-out a portion of their a wealth, who may want exposure to markets in which their investment knowledge may be less than complete and see the sense of buying in the skills of a specialist fund manager.

Regardless of the amount of investment funds on offer (currently around 2,265, but that doesn't include multi-manager funds of funds or split-capital investment trusts) and the structural differences between unit and investment trusts, the principle of collective or pooled investment funds is simple.

Say you want to put a lump sum of £1,000 in the stock market, or a regular saving of £100 a month. Your modest investment isn't enough to buy diversity in the shape of a portfolio of shares, which will also spread risk and lower volatility. So, if you punt your money on a single share, the price of that share may fall and you'll lose some – or all – of your capital. Not good. But if you found a bunch of like-minded investors, clubbed together and pooled your investment cash to entrust with a manager who would then make the investment calls and manage the money on everybody's behalf, sheer economy of scale would kick in. The combined benefits of diversification, security, reduced risk and a sufficient weight of assets would ensure cost-effectiveness, both to pay the manager and keep administration and trading costs down so as not to bite into your investment returns.

So banding together with other like-minded investors means not only strength in numbers, but also a chance to enhance your wealth. And, in the 140 years since they were invented, pooled investments are still going strong. In a world where credit unions have become the province of the socially disadvantaged, where building societies can't wait to become plcs, where even something as originally noble like the trades union movement is a busted flush, it's good to see one kind of peoples' collective that's still in rude health. Who says capitalism doesn't work?

Monisha Varadan