Investing in Funds: First Principles

Investment funds never invest at random. Each shops for products that support its investment strategy.

Different products support different strategies because, as we have seen, different products exhibit different risk/return characteristics. The fund manager's job is to match the product with the strategy, or investment goal.

In broad terms fund strategies fall into three categories: growth funds, income funds and balanced funds.

Growth investing

With growth oriented funds returns come in the form of capital growth, and, as we saw in 'Asset Allocation', capital growth is usually delivered by equity investment.

Within the universe of potential equity investments, managers can take on different levels of risk. Large established companies stocks are obviously less risky investments than either young technology companies or companies based in emerging economies. Equally, they are unlikely to offer the same potential returns.

Income investing

With income oriented funds your payback comes as income with maybe a bit of capital growth (hopefully at least enough to cover inflation). The manager may be holding a mixture of government bonds, corporate bonds and 'reliable' stocks.

These 'reliable' stocks are not going to rise much in price. The underlying businesses have no great growth potential - usually because they have already grown to dominance and cannot really do any more. So they ‘tick over’ and distribute profits in the form of dividends.

An income approach is investing for near-term returns. And because a current income-stream is far easier to spot than future growth, this is a lower risk investment approach.

Balanced funds

A balanced fund, as the name suggests, will attempt to strike a balance between the outright pursuit of capital growth and the need for income and a degree of capital protection.

The distinction between growth, income and balanced funds is a broad one and, in practice, investment funds will not always make the distinction explicit. However, regardless of how an investment fund is described or marketed, for the investor, the same risk/return considerations will apply.