What Is an Investment Fund?

If you have a pension, Stocks and Shares ISA or investment account, there is a good chance that some of your money is invested in investment funds.

It is useful to understand the difference between the account or product and the investments held inside it.

Your pension, ISA or investment account is the financial product or account through which you invest. Depending on the type of product or account, different rules can apply to how money is paid in, held, withdrawn and treated for tax purposes.

An investment fund is one of the investments that can sit inside it.

The fund might then invest your money across shares, bonds and other assets, potentially spreading it across hundreds or even thousands of different investments.

So what exactly is an investment fund?

An Investment Fund Pools Investors’ Money

Imagine you wanted to invest £1,000 across 100 different companies.

You could choose the companies yourself, decide how much to invest in each one, buy all the individual shares and then keep track of them afterwards.

An investment fund provides another way of doing it.

It brings your money together with money from lots of other investors. That pool of money is then used to buy a collection of investments.

When you invest in a fund, you will typically buy units or shares in it. These represent your own holding in the fund, even though your money has been pooled with money from other investors.

This allows you to invest across the collection of investments held by the fund without having to personally choose, buy and manage each one yourself.

What Does an Investment Fund Actually Own?

That depends entirely on the fund.

Some invest in shares in companies. Others invest in government or corporate bonds. Some invest in property or property-related investments.

There are also funds that invest across several different types of assets.

A global share fund, for example, might hold shares in hundreds of companies across the UK, US, Europe, Asia and other parts of the world.

A bond fund could instead invest in bonds issued by a collection of governments and companies.

Another might combine shares, bonds and other assets in particular proportions.

Different funds are designed to do different jobs, which means two investments that are both described as funds can behave very differently.

How money is divided between different types of investments is known as asset allocation, which I explore in more detail in What Is Asset Allocation?

The important point for now is that the word fund doesn't tell you what you are actually invested in.

You need to look inside it.

Why Use a Fund Rather Than Buy Everything Yourself?

There is nothing to stop an investor buying individual investments directly.

Someone could buy shares in 50 different companies, for example.

The difficulty is that building and maintaining your own collection of hundreds or thousands of investments could require a considerable amount of research, administration and ongoing management.

By pooling your money with other investors, a fund can make it practical to invest across a much wider collection of investments without having to buy and manage each one yourself.

Your £1,000 might therefore give you exposure to many different companies rather than relying on the fortunes of just one.

You also don't have to make every individual transaction yourself when investments within the fund are bought or sold.

How those decisions are made depends on the type of fund.

Who Decides What the Fund Invests In?

Every fund has an investment objective and an approach that determines what it can invest in and how it is managed.

Some funds are actively managed.

A fund manager or investment team decides which investments to buy, hold or sell. They might research individual companies, consider their prospects and decide that some represent better opportunities than others.

Other funds are passively managed.

Rather than a fund manager continually choosing individual investments, a passive fund is usually designed to track a particular index or market.

An index is a way of measuring the performance of a particular group of investments.

The FTSE 100, for example, includes 100 of the largest eligible companies listed on the London Stock Exchange, measured by market capitalisation. Put simply, this is the total value of all the company's shares.

A fund tracking the FTSE 100 would aim to invest in the companies represented in that index in a way that closely follows its performance.

The important point here is that every fund follows an investment approach that determines what it holds.

Funds Can Make Diversification Easier

One reason funds are widely used is that they can make it easier to spread money across different investments.

This is known as diversification.

Suppose you invested all your money in the shares of one company.

Your investment would depend heavily on what happened to that particular business.

If instead your money was spread across hundreds of companies operating in different industries and different parts of the world, you would be less dependent on what happened to any single business.

Spreading money across different types of assets can provide another form of diversification.

Diversification is about reducing your reliance on any one investment or area of the market. It cannot remove investment risk altogether.

I explore this idea more fully in What Is Diversification?

Owning a Fund Doesn't Automatically Mean You Are Diversified

It is important not to assume that investing in a fund automatically means your money is widely spread.

One fund might invest entirely in a particular country.

Another might concentrate on a particular industry, such as technology.

Some funds hold a relatively small number of companies, while others might hold hundreds or thousands.

A fund could also invest entirely in one type of asset, such as shares or bonds.

Simply knowing that you own an investment fund therefore doesn't tell you very much about the risks you are taking.

You also need to understand what is inside it.

What Happens When the Investments Inside the Fund Rise or Fall?

The value of a fund is linked to the investments it holds.

Some of those investments might rise in value while others fall. Their combined performance influences what happens to the value of the fund.

If the overall value of the investments held by the fund rises, the value of your investment will generally rise too. If their overall value falls, your investment can fall.

Pooling money doesn't protect you from investment losses. Neither does owning hundreds of different investments guarantee that your money will grow.

The value of investments can fall as well as rise and you may get back less than you invested.

A Fund Is the Middle Layer

Perhaps the simplest way to understand an investment fund is to think about the different layers.

You might have a pension.

Inside that pension you might hold several investment funds.

Inside those funds might be shares and bonds issued by hundreds or thousands of different companies and governments.

So, in simple terms:

Pension, ISA or investment account → Investment fund → Shares, bonds and other investments

The pension, ISA or investment account determines how your investments are held and the rules that apply to them.

The fund determines what your money is invested in.

Underneath the fund are the individual investments that ultimately determine how its value changes.

Once you understand those different layers, a pension or investment statement containing unfamiliar fund names can start to make a little more sense.

Rather than simply asking, “Which funds do I own?”, there is another useful question to ask:

“What do those funds actually own?”

Although the content of the article was correct at the time of writing, the accuracy of the information should not be relied upon, as it may have been subject to subsequent tax, legislative or event changes.