How to Choose an Investment Fund

An investment fund pools the capital of many investors into a single portfolio managed by a fund management company. Investors buy fund units and share in the gains and losses of that portfolio.

Funds can invest in equities, bonds, money market instruments or a combination of different asset classes. One of their main features is immediate access to a diversified portfolio and to professional management.

That does not mean, however, that all funds are equivalent.

Two funds that look alike can follow different strategies, carry different levels of risk and charge very different costs. That is why the choice should start with the portfolio and the strategy, not with the return shown at the top of a table.

First, understand how the fund invests

The first question should be simple:

What does this fund invest in, and what role should it play in my portfolio?

The answer is usually found in the fund’s investment policy.

A fund can be classified in several ways:

Asset class. It may invest mainly in equities, bonds, money market instruments or alternative assets, or combine several classes.

Geography. It may have a global exposure or focus on a specific region or country.

Sector or strategy. Some funds concentrate on areas such as technology, healthcare, energy or small companies, or on particular investment strategies.

Currency. The currency of the fund’s share class is not necessarily the same as that of the assets in the portfolio. Some share classes also include currency hedging.

Distribution or accumulation. Some share classes pay income out to investors, while others reinvest it automatically.

These features help you understand what the fund really adds to the portfolio.

The same fund can have different costs

An important detail is that the same fund can exist in several share classes.

These classes usually invest in the same portfolio, but they can differ in their fees, currency, distribution policy or currency hedging.

It is common to find share classes for retail investors and others for institutional investors, often with different cost structures.

So before investing, it is worth checking not only which fund it is, but also which share class you are buying.

A seemingly small difference in the annual fee can become significant when it compounds over several years.

What does the management really cost?

Costs have a direct impact on the net return the investor receives.

The main ones include:

• the management fee;
• other ongoing charges of the fund;
• any subscription or redemption fees;
• performance fees, where they exist;
• the costs of the transactions carried out within the portfolio.

The higher the costs, the more value the management has to add to justify the difference.

This is where one of the most important questions in choosing a fund comes in:

What am I getting in return for the fee I pay?

In an actively managed fund, the team usually seeks to make decisions that differ from the benchmark index, with the aim of producing a better result or managing certain risks differently.

The difficulty lies in doing so consistently after costs. Historical evidence shows that many active funds fall short of their indices over long horizons, although results vary across categories and markets.

That is why the comparison should be made against the right benchmark and within the same category.

Do not look at returns alone

Past returns are easy to compare, but on their own they say little.

A fund that delivered higher returns may simply have taken on more risk.

So it also makes sense to look at:

• volatility;
• maximum losses;
• performance in different market conditions;
• consistency of results;
• risk-adjusted return;
• stability of the management team.

Metrics such as the Sharpe ratio can help show how much return was earned per unit of risk, but no metric should be read in isolation.

It also matters whether the team behind the track record is still managing the fund, because significant changes in the team or in the investment process can make that track record less representative of what to expect in the future.

Active fund or passive alternative?

In many categories there is also a passive option, usually an index fund or an ETF.

This creates a useful comparison.

If an active fund charges more to try to produce a result different from the index, the question is whether there is a strong enough reason to pay that difference.

That reason may lie in a specific strategy, a different approach to risk management, access to less efficient markets or some other feature the index does not offer.

The decision should not be “active or passive” on principle.

It should be made product by product, comparing what each option delivers, the risk taken and the costs involved.

Four questions before choosing

Before investing in a fund, it is worth answering four questions.

1. Where does it invest? Do the fund’s strategy and exposure match the role you want for that part of the portfolio?

2. What does it cost? Consider the ongoing charges, any additional fees and the costs associated with the management.

3. How has it managed risk? Compare its performance with the right benchmark and also look at volatility, losses and consistency.

4. What justifies the management? If there is a simpler, cheaper option for the same exposure, understand what the fund aims to add.

Strategy first, then the fund

An investment fund is a vehicle, not a strategy.

The choice should come after your Investor Profile, your goals and your portfolio allocation have been defined. That is the logic of the Investment Policy Statement: first the rules and the goals, then the instruments that fulfil them.

In the end, choosing a fund is not about finding the one with the best recent return. It is about understanding what is inside the portfolio, how much you are paying and whether there is a clear reason to pay for that management.

Adapted from “O que saber para investir em fundos de investimento”, originally published on the Future Proof blog.