Types of investments – ABCs of OEICs and ETFs!
Don’t you just love an acronym?!
If you’re thinking of investing in the stock market, and don’t know your OEIC from your ETF, then read on!
As you’ll know if you’ve been reading my earlier posts, I’ve just taken the plunge and put a small lump-sum investment into my first ever stocks and shares ISA. However, that’s as far as I’ve got, as I’ve yet to decide which fund to put the money into!
One thing I do know though is that I’ll be putting my money into a fund of some sort, rather than investing directly into an individual company’s shares or bonds. So what’s the difference?
Firstly, what’s the difference between shares and bonds?
Shares (equities) – If a company wants to raise money, also called capital, it can issue shares which are then bought and sold by investors on a stock exchange. When you invest in an individual company by buying some of its shares, you are buying part-ownership in the company. In return, this entitles you to part of that company’s profits, paid as dividends. Also, as the value of the company goes up and down, dependent on revenues and profits of the business, so does the value of the share you own. If your share goes up in value over time, then you could sell it as a profit, called a capital gain.
Bonds – Another way a company can raise money is to issue a bond. Investors that buy a company’s bonds are lending it money, rather than buying part-ownership in the company. In return for lending it money, investors receive fixed interest, until the maturity date when the money is repaid (assuming the company doesn’t get into trouble – investing in the stock market is not risk-free!). You can also invest in bonds issued by a government (UK government bonds are called gilts). Bonds are generally considered lower risk than equities as the company will state in advance what rate of interest it will pay, prices fluctuate less than equities, and if the company goes bankrupt bond holders are repaid before equity holders.
The beauty of pooled investments
Rather than investing in the shares or bonds of one individual company, which is a high-risk strategy should that company fail or run into difficulties, investment companies have created pooled (or collective) investments called funds. You pay the fund management company a fee to invest in one of its funds, where you pool your money along with that of other investors and together invest into a range of assets, thus diversifying your risk.
This opens up the prospect for those of us with relatively small sums of money to gain access to the stock market, and there are vast numbers of funds to choose from. They will each have their own investment objectives, and different risk profiles, dependent on which underlying assets they buy and sell. For example, some funds will only invest in bonds, some in equities, some a mix. Some funds will focus on a particular geography, for example UK equities, some on a particular industry, for example UK banks, and others a mix.
Funds can also be set up in different ways, examples being unit trusts, or exchange traded funds.
Unit trusts / OEICs
Also called mutual funds, these are often what are referred to when talking about funds. Both unit trusts and open-ended investment companies (OEICs) are, as the name suggests, open-end investments. This means that the fund manager may increase or decrease the fund size based on investor demand. They will always accept more cash from investors.
They have differing legal structures though: unit trusts are set up as trusts and you buy units in the fund; OEICs have replaced many unit trusts and are set up as limited companies, and you buy shares in the OEIC.
When you invest into these funds, you are buying part of the overall portfolio of stocks that is held in the fund, and will share in the dividends, interest, and capital gain, of the underlying collective investments.
Actively managed funds are those where the fund manager selects which stocks to invest in, often aiming to outperform an index, for example the FTSE 100. Passive tracker funds aim to match the returns of an index by automated investing into the same stocks that form the index, often with lower charges than those of active funds.
Exchange-traded funds / products (ETFs / ETPs)
ETFs are open-ended collective investments, similar to mutual funds, and they work in a similar way to tracker funds by tracking an index. However, they are traded on a stock exchange, similar to shares, whereas unit trusts / OEICs are not. There are other types of exchange traded products also, such as exchange traded commodities and exchange traded notes, hence the broader term ETPs.
Another type of collective investment, set up as a company, and traded on an exchange. They are closed-end investments, unlike unit trusts and OEICs, which means that a fixed number of shares are issued, and the value of the shares increases or decreases with demand as they are bought and sold. They can also borrow money, unlike unit trusts and OEICs, which they can then use to invest in extra companies. This can be a benefit when the markets rise, but can lead to losses when the market falls.
There’s plenty of information on the internet on how all of these funds work, an example being the Which? guide to different types of investments. Understanding what you’re investing in, and choosing the right funds for your own personal circumstances and level of risk is essential. This is the point in the process where I’ve currently stalled…!