Funds vs. Investment Trusts vs. ETFs

This article is part of Morningstar.co.uk's Equity Investing Week.

It's understandable if you want access to a diversified portfolio of equities but don't want the hassle of picking each individual investment on your own. In this kind of scenario, it's useful to buy into an equity fund. An equity fund will give you immediate access to a large portfolio of equity investments and you won't have to worry about buying, selling and researching any of the individual holdings.

However, keep in mind that there are three different types of funds available for UK investors, and each kind of fund provides some benefits and drawbacks. Below is a summary of the pros and cons of investing in:

- Open-end funds (These are the traditional funds most people talk about. They are also called OEICS and unit trusts in the UK, and they're called mutual funds in the US.)
- Closed-end funds (aka investment trusts)
- Exchange-traded funds (ETFs)

Open-End Funds

When you buy shares in an open-end fund, you're buying an ownership stake in a range of investments that are managed by a fund manager. The fund manager combines your money with that of other investors and uses the money to buy and sell investments, with the goal of increasing the value of the fund and helping investors grow their money (or avoid losing money in hard times).

The price for a share in an open-end fund is calculated by taking the total value of the securities owned by the fund and dividing that number by the number of fund shares outstanding. So if a fund has £1 million in assets, and there are one million shares outstanding, each share would cost £1. This per-share value is called the net asset value (NAV).

These funds are relatively easy to buy and sell. Unlike many other security types, such as individual stocks, ETFs and investment trusts, you don’t need to find a buyer when it's time to unload your shares. Investors are simply given a window of opportunity each business day to make purchases and sales, and they can choose to put in or take out as much money as they want, based on their financial needs. However, this causes a problem when too many investors want to put money in or take money out of a fund, because massive capital inflows and outflows can wreak havoc on a fund manager's investment strategy. For example, massive outflows could force a fund manager to sell investments at a bad time in order to meet redemption orders, thus hurting the overall performance of the fund.

Fund investors also have to pay fees and charges to compensate the fund manager and fund company for their work. These fees can sometimes be very high, which can take a big bite out of your investments.

Pros:
- Diversified portfolio
- Fund manager tries to maximise returns
- Price aligned with NAV
- Buying and selling is relatively easy

Cons:
- Inflow/outflow pressures
- Fees and on-going charges
- Buying and selling can only occur at certain times of the day
- Fund managers can make a bad bet and lose money for investors

Closed-End Funds (Investment Trusts)

Like open-end funds, closed-end funds allow investors to pool their money together and have a fund manager make investment decisions on their behalf. Investment trusts also have a board of directors who are tasked with providing another level of oversight for investors.

Fees and on-going charges for investment trusts tend to be lower than open-end funds, which is a benefit for investors.

One of the key advantages of closed-end funds is their fixed pool of assets. An investment trust manager starts with a certain amount of money and then manages that money in a relatively uninterrupted fashion. A trust is not subject to waves of inflows and outflows as investors try to jump on trends, and managers are not forced to sell investments at inconvenient times when investors want their money back.

However, with traditional funds, you can be assured that the price you pay or receive when you buy into a fund is directly linked to the fund’s net asset value (NAV). Closed-end funds operate differently. With an investment trust, the shares are traded on an exchange and while the market price should reflect the NAV, the price for the shares is ultimately based on the market forces of supply and demand. If demand for an investment trust is high, shares may trade at a premium to their NAV. If demand for an investment trust is low, shares may trade at a discount to their NAV. This investment trust quirk creates an additional level of volatility, but also creates some opportunity.

Investment trust managers can also use gearing to boost returns, though there is the risk that gearing might cause an outsized loss in the portfolio.

One last drawback for investment trusts: many platforms do not offer these funds. This means that individuals may find that they are difficult to access.

Pros:
- Diversified portfolio
- Fund manager tries to maximise returns
- Virtually no inflow/outflow pressures
- Generally lower fees compared to open-end funds
- Board provides additional oversight
- Gearing can give a boost to returns

Cons:
- Difficult to access since they are not available on many fund platforms
- Even though fees are generally low, they still act as a drag on your investment performance
- Like open-end funds, managers run the risk of making some bad bets and losing investors' money
- Gearing can exacerbate losses

Exchange-Traded Funds (ETFs)

Like open- and closed-end funds, ETFs allow investors to access a diversified portfolio of investments. However, ETFs do not have fund managers. Instead, ETFs are designed to track the performance of market indices and they are run by computers. 

For example, if you want to invest in the overall FTSE 100 Index, you can buy an ETF that will mimic the movements of the FTSE 100. When the FTSE 100 goes up, your ETF will increase in value. When the FTSE 100 goes down, your ETF will decrease in value. You can also buy ETFs to track other benchmark indices such as the FTSE 350, the S&P 500 or the NASDAQ 100, or smaller niche indices.

ETFs are called "passive funds" instead of "active funds" because they do not have a manager trying to actively invest and deliver superior performance for investors.

ETFs are popular because their fees are very low since they don't require much human intervention. Furthermore, investors don't have to worry about a fund manager making a bad bet.

ETFs are similar to stocks because you can easily buy and sell them on an exchange and their prices fluctuate throughout the trading day. You can short them, buy them on margin, or use stop-loss orders to sell them. In brief, anything you can do with a stock, you can do with an ETF. As with stocks, investors also pay commissions to buy and sell ETFs.

Pros:
- Diversified portfolio
- Significantly lower fees compared to other types of funds
- Tradable throughout the business day on an exchange
- No concerns about managers making bad bets
- Trades like stocks

Cons:
- There is no fund manager who is working to help investors outperform the market
- Investors cannot 'beat the market' with ETFs, they can only try to mimic performance
- Paying trading commissions to buy and sell ETFs can become expensive
- Counterparty risks exist

Note: Keep in mind, this is not an exhaustive list of pros and cons for each of the three fund types. However, it's certainly enough to help you gain a better understanding about the basic differences between open-end funds, closed-end funds and ETFs.