If you have a time horizon of at least five years and want to grow your wealth, investing in the stock market could offer greater returns than cash savings. It can also help you beat the corrosive impact of inflation on your cash. Historical data shows that stock markets tend to grow at or above inflation rates in the long term, as measured in decades, although there are no guarantees.

Investment funds are a popular option for both new and experienced investors. These funds pool cash from many individuals and use it to buy a range of assets such as stocks and bonds. Gains and losses are then split between investors. Investment funds are generally considered lower risk than investing in a single company, since they allow investors to diversify their holdings and effectively spread the risk.

However, investing in the stock market is not suitable for everyone. With any type of investment, capital is at risk, and the value of investments could fall as well as rise. Therefore, before going down the investment route, it's sensible to build up a cash fund worth at least three (preferably six) months' living expenses.

Pooling resources via an investment fund

Investment funds offer a way for individual investors to combine their resources and invest in a broader range of financial assets. While a single investor may only be able to invest a small amount, pooling money with other investors gives them greater collective buying power. Investment funds can be made up of different asset types, such as bonds or equities.

Funds can be managed in one of two ways: actively or passively. Actively managed funds are overseen by a fund manager who selects investments with the goal of outperforming a benchmark or index. In contrast, passively managed funds aim to replicate the growth of a specific market index by tracking it with a computer. These are often referred to as ‘tracker funds' and usually come with lower management fees.

As of January 2023, UK investors held approximately £1.4 trillion in investment funds, according to the Investment Association. PwC reports that globally, investment funds held over £91.81 trillion ($111.2 trillion) in 2020. It's important to remember that with any investment, there is always a risk, and investors should consider their own financial situation and goals before investing.

Types of investment funds

While all funds operate under the same principle of pooling resources, there are several kinds to choose from. In the UK, these include:

Open-ended investment funds

This article discusses open-ended funds, which are actively managed investment vehicles that do not have a cap on the amount of money they can accept from investors. When investors purchase units in an open-ended fund, the value of their unit fluctuates in line with the underlying assets of the fund, and they can buy and sell units at any time at a value calculated once per trading day.

Open-ended funds can be classified as either open-ended investment companies (OEICs) or unit trusts, with the latter having two daily prices, one for buying and one for selling, while OEICs have a single daily price. As a result, unit trusts are typically considered long-term investments, as investors must wait for the fund's selling price to exceed the initial buy price in order to make a profit. OEICs are regulated by company law, while unit trusts fall under trust law.

Closed-ended investment funds

Closed-ended funds are different from open-ended funds as they have a limited number of shares that can be traded through a stock exchange like company shares. The value of each share in a closed-ended fund is determined by the demand and supply, and not the value of the fund's underlying assets. Investment trusts are a common type of closed-ended fund.

Exchange Traded Funds (ETFs) are a type of passively managed fund that invests in a collection of assets in a specific geographical region or industry. ETFs are open-ended, and investors can buy and sell units as they wish, with no limit on the total investment amount.

Index funds or tracker funds aim to replicate the performance of a particular index, such as the S&P 500 or FTSE 100. They achieve this by investing in most or all of the companies that feature in a certain index. Tracker funds are typically open-ended, and investors can buy and sell units whenever they want.

When an investor buys into a fund, their money is combined with that of other investors to purchase shares, bonds, or other assets. The value of an investor's share in the fund rises and falls in line with the overall value of the assets held by the fund.

Investment funds are managed by a fund manager whose job is to buy and sell investments to achieve the fund's goals, whether using human judgement or a computer program. Investors typically choose between income units or accumulation units when buying into a fund. Income units pay out any income generated by the fund's investments, while accumulation units reinvest income back into the fund, increasing the value of each unit.

When choosing a fund, investors should consider their personal goals, such as their tolerance for risk. Younger investors may be more comfortable with higher-risk, higher-growth funds, while those approaching retirement may prefer more stable, lower-growth funds. Investors may also consider funds that align with their values, such as those focused on ESG criteria. Cost is also a factor to consider, as fees and charges can eat into returns, though the lowest cost option is not always the best. Investors should check a fund's performance history, which can be found in its factsheet or on data websites like Morningstar and Trustnet. Major investment platforms like Hargreaves Lansdown and AJ Bell may also provide a shortlist of recommended funds for those who are unsure where to start.

Investment fund pros and cons

Investing in funds comes with key advantages:

• Diversification: Since each fund consists of many individual investments, purchasing units could be a good starting point when it comes to building a diversified portfolio.
• Cost reduction: Purchasing units in a fund is more cost effective than buying its underlying investments individually, since dealing costs are spread between multiple investors.
• Market access: Funds allow investors to gain exposure to markets that may not be easily accessible, such as foreign economies, new sectors, or commodities.
• Expert management: By investing in an actively managed fund, investors benefit from the insights and experience of a fund manager who can select assets on their behalf.

As with any investment, there are also some potential drawbacks:

• Management fees: While investing in a fund incurs lower fees than investing in the same assets individually, management fees can eat into your returns — particularly for actively managed funds.
• Limited investment control: Individual investors do not have a say in how their money is allocated — they rely entirely on the fund manager. Although expert management can be advantageous, it also requires investors to place their faith in a manager.
• Unsuitable for short-term investment: Because markets fluctuate, and the value of a fund can go down as well as up, it's generally recommended that investors hold their units or shares for at least five years.

The collapse of the Neil Woodford Equity Income Fund in 2019 serves as an example of the vulnerability of open-ended funds when faced with mass investor withdrawals. The fund, launched in 2014 and managed by Neil Woodford, had invested heavily in illiquid assets, including shares in private companies that offered high growth potential but were riskier than more established, listed companies. When some of these investments issued profit warnings, investors began to withdraw their cash, causing Woodford to sell the liquid assets he had to meet the withdrawal requests, further tipping the fund's balance towards illiquid holdings. Ultimately, withdrawals were frozen, and remaining investors were unable to access their cash. The fund was broken up in 2019, with 400,000 investors losing £1 billion, leaving many still waiting to receive some of their money back.

When investing in funds, investors must consider various costs, including fund charges, platform fees, and dealing fees, which can vary depending on the funds and investment platforms chosen. Fund charges cover the cost of managing the fund and usually range from 0.75% to 1.00% for actively managed funds and 0.1% to 0.85% for passively managed tracker funds. Investment platforms may charge an annual fee for holding funds in an investment account, usually in the region of 0.25% to 0.45% of the portfolio value. Some providers do not charge a platform fee, while others only charge customers for holding funds, but not shares.

Investors may also be liable for taxes on the profits they make by investing in funds. If invested through a tax-free wrapper like an ISA or SIPP, there's no need to pay tax on any returns. However, without this wrapper, investors may have to pay income tax on dividends received on their investments, with each UK resident currently allowed to earn up to £2,000 in dividends each year tax-free. Capital gains tax may also apply to investors who make a profit of more than £12,300 each tax year through selling their investments.

Investors can buy and sell investment funds directly from a fund manager, through a trading platform, through a robo-advisor, or through a financial advisor. Trading platforms may charge dealing fees each time a unit is bought or sold, and the price paid is determined by the next daily valuation, which is unknown beforehand. To weather any stock market volatility, investors should typically hold their units or shares in an investment fund for at least five to 10 years.

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