Get a better understanding of the different investment sectors to help you pick the right funds
Without any form of classification, picking the right fund for you could be like finding the proverbial needle in the haystack. To help you narrow down your choices and make meaningful comparisons, the 3,000 or so funds available to retail investors are divided up into groups – or sectors – according to how and where they invest your money.
This could be according to the assets they hold – for example, equities (shares), fixed interest (mainly bonds), or both, the country or region they focus on, or the fund’s objective. The sectors have been created by the Investment Association (IA), the trade body for investment managers.
Here, Moneywise explains everything you need to know about the principal sectors.
£ Corporate bonds
Corporate bonds are loans to companies that pay a fixed rate of interest to investors. They can be a useful way of diversifying your portfolio away from equities to reduce risk and volatility. “Funds in this sector invest predominantly (80%) in the debt of companies, with two distinct and important factors,” explains Adrian Lowcock, head of personal investing at Willis Owen.
“Firstly, the debt, or bond, is sterling denominated or hedged back to sterling so the investor doesn’t have exposure to currency risk.
“Secondly, the debt is of a certain level of risk, so BBB- or above (as measured by Standard & Poors). This means the debt is a quality bond and not high yield or higher risk.”
He adds: “To decide which fund is right for you, you need to decide if income or capital return are more important as some managers focus one over the other. If it’s income you seek, then it’s critical to make sure income yields are reliable and not sought at the expense of your capital. Given that this asset class is often used to reduce risk of a portfolio, it’s important to make sure the managers are taking the risks that you want for your investment.”
£ Strategic bonds
Strategic bond funds invest in a greater variety of fixed-interest investments, so fund managers have more options.
Patrick Connolly, chartered financial planner at independent financial adviser (IFA) Chase De Vere, says: “This sector has become hugely popular over the past decade, and many investors now use it as the default way to get exposure to fixed-interest investments, such as government and corporate bonds. Funds in this sector often invest in a wide range of bonds both in the UK and overseas, and fund managers can have a great deal of flexibility.”
“This sector is for investors who want exposure to overseas fixed-income markets,” says Gavin Haynes, managing director of Whitechurch Securities.
“Taking a global approach to bond investing can help diversify a balanced portfolio and provide opportunities that are not available in the UK.”
However, while funds in this sector can invest across the globe there are no rules governing how much should be invested in specific regions and you may find that the bulk of holdings are in one particular market, such as the US.
So it is vital potential investors ensure they are comfortable with how their money will be invested.
Mr Haynes adds: “This sector offers a wide range of international bond funds with differing risk/reward profiles, so you cannot compare constituents on a like-for-like basis.”
Investors must also be able to accept the inherent risk of currency fluctuations that comes with a global fund.
Mixed investment 0-35% shares
“Funds in this sector are only able to invest up to 35% in shares,” explains Mr Connolly. “The rest of the fund is typically held in fixed interest and cash. This means that funds in this sector are most suited to cautious investors who want a return that will beat cash, but are nervous about stock-market volatility.”
He adds: “Because of the high level of fixed interest in some of these funds, they may also be suitable for those income investors who want a steady income, but who don’t necessarily need capital growth.”
Mixed investment 40%-85% shares
“This used to be called the balanced managed sector but was renamed to illustrate how much of the fund is invested in stock markets,” explains Mr Haynes. As the funds are invested in both fixed-interest, cash and equities they do provide investors with a degree of diversification, however the greater weighting in stock-market investments means they do present an above-average risk.
Mr Haynes adds: “The funds with the best performance at the current time are those with high stock-market exposure, but this doesn’t mean they are best if you are looking for a more balanced multi-asset approach.”
Make sure you are happy with the level of stock-market exposure in your chosen fund.
UK Equity Income
This sector is useful for those who want an income from their investments, as funds focus on UK companies paying strong dividends.
Sarah Coles, personal finance analyst at Hargreaves Lansdown, says: “Funds place varying emphasis on firms with strong, consistent dividends and those that look for companies that can grow their dividends over time. Investors should therefore check the objectives of any fund they are considering. This informaton should be easy to find online, in the research provided by any number of investment companies.”
The nature of these funds means they are popular among retired investors who want to generate an income from their pension savings.
However, they can also be a useful core holding for those investors who are still focused on growing their capital.
Moira O’Neill, head of personal finance at interactive investor, says: “Chosen well, UK Equity Income funds can be a jewel in the crown of a portfolio, given their focus on large, income-generating companies with stable cash flows.
“With a significant chunk of profits coming from overseas, they aren’t as UK-centric as some might think and since investors can reinvest dividends, they don’t need to be the reserve of income seekers, either. Tellingly, equity income funds consistently top our Isa tables of most popular funds.
“Albert Einstein nailed it when he reportedly called compounding the eighth wonder of the world, because dividend reinvestment is a major component of stock-market returns.”
Beware risk labels
In any of the Mixed Investment categories, 22% of multi-asset funds have risk-related labels in their name, according to research from interactive investor, the investment platform and parent company of Moneywise.
Dzmitry Lipski, investment analyst at interactive investor, explains: “Across 805 multi asset funds, 22% are using risk labels in their name, whether it is ‘Balanced’, ‘Moderate’, ‘Conservative’, ‘Adventurous’, or ‘Cautious’. But what does it actually mean? One person’s idea of a ‘balanced’ fund can be another’s definition of ‘adventurous’, and fund management groups can be just as prone to varying interpretations.
“Investors with funds using names such as these might want to review them to make sure the name matches their own definition of risk. For example, in the IA Mixed Investment 40%-85% shares sector, 59 funds have labels such as these. The majority have ‘Balanced’ in their name, but their risk profiles are likely to span a broad spectrum, and within the same sector there are also three funds with ‘Adventurous’ and one with ‘Cautious’ in the name. Ultimately, it’s best to treat fund names with a pinch of salt.”
Global equity income
At least 80% of these funds must be invested in global equities and diversified across regions.
Mr Haynes says: “The vast proportion of dividends generated from the UK stock market are attributable to a small number of stocks and sectors, and a large proportion of the most popular UK equity income funds will have a high commonality.
“In contrast, taking a global view provides an extended universe, through stock, sector and not being so reliant on the domestic economy.”
Sector requirements stipulate that 80% of the fund is invested in global equities and be diversified across regions.
UK All Companies
This sector is an obvious starting point for many investors, offering exposure to world-class companies and household names including BP, HSBC, Royal Dutch Shell, Unilever and Vodafone. However, it’s also a large and hugely diverse sector, and that means investors must be careful not to compare apples with pears. While one fund might seek out predictable companies that are regarded as best in class, others will seek out unloved firms where the manager believes a change of fortunes is due.
“It’s best to treat fund names with a pinch of salt”
Asia Pacific ex Japan
“These funds invest in Asia-based companies of all sizes, but avoid those listed in Japan,” explains Darius McDermott, managing director of Chelsea Financial Services. This includes larger developed economies such as Hong Kong, Singapore and Australia as well as less developed markets like China, India, Thailand, Malaysia and the Philippines.
Mr McDermott says: “Investments can vary widely from fund to fund, given the range of countries on the continent. There may also be a mix of developed and emerging market equities as Asia is home to both types of market. The sector will include funds that are focused purely on growth as well as some funds that are dividend focused and provide an income.”
Many of the countries included in this sector have undergone massive economic growth and industrialisation in recent decades with a growing middle class that is expected to carry on driving consumption. However, slower growth in China will continue to provide a challenge to the region as a whole.
Europe ex UK
Funds in this sector can invest anywhere across Europe. This is not limited to members of the European Union or the Eurozone, and can also include some emerging European countries. Rebecca O’Keeffe, head of investment at interactive investor, says: “There are more than 1,000 companies listed on the main markets in Europe, plus hundreds more in smaller developing European economies, which makes Europe a fascinating place to invest.
“Investors can choose from larger companies in mainstream markets such as Germany, France and Switzerland, ranging to small companies in Eastern Europe – making it full of opportunities for potential investors depending on how much risk you want to take.
“This range of different markets means that you do need to pay close attention to the underlying objective of funds you are interested in, as this is one of the most diverse sectors available,” adds Ms O’Keeffe. “The diverse nature of Europe means there are occasionally conflicting objectives between different member states, as well as tensions between countries in and out of the European Union, and that can lead to greater uncertainty in the region – but good fund managers should be able to identify relevant opportunities and threats.”
To qualify for this sector funds must have 80% of their assets invested overseas – however if they were also able to qualify for another sector, such as Europe or Global Emerging Markets, then they would be excluded on those grounds.
Global funds will typically focus on developed economies, and often with a bias towards the US, the world’s largest economy.
“A global fund tends to look for the best companies wherever they might be. Some managers, though, will follow benchmarks and invest according to the country’s market weight.” Global funds are often recommended as good starter funds for beginner investors because they offer instant diversification.
However, it is important investors know how and where the manager will invest their money. Mr Lowcock says: “Do they follow a benchmark, so have a certain percentage in Germany, UK and Japan? Or are they stock picking and finding the best pharmaceutical or best bank no matter where it is listed?”
Global emerging markets
Funds in this sector must be 80% invested in emerging market economies including regions such as China, India and Latin America. Only 20% of the total fund can be invested in so-called frontier markets, which are less developed still, such as Bangladesh, Nigeria and Botswana. The companies that these funds invest in are likely to be at an early stage of growth, which means that while they can reward investors handsomely, they are likely to be volatile.
Mr Haynes says: “For investors looking for exciting growth opportunities, then I believe having an exposure to emerging markets is justified as part of a well-diversified portfolio. However, enduring higher levels of risk is a necessary evil of investing in emerging markets.
“To get exposure it is important to find good fund managers who can find opportunities through diversifying across different sectors and markets.”
He adds: “Taking a long-term perspective is essential and drip-feeding money into this area can also help smooth short-term volatility.”
Global funds are often good starter funds for beginner investors
Japan, the third largest economy in the world, is famous for its technological innovation and is home to big global brands including electronic giants Panasonic, Hitachi and Toshiba and car manufacturers like Mitsubishi, Honda and Nissan. However, as far as investors are concerned, it’s a region that divides opinion.
“The region has been beset by economic problems over the decades but its stock market has performed well in recent times and many investors are very keen on its future prospects,” says Mr Connolly.
Much of this recent confidence is down to so-called ‘Abenomics’. Japan’s Prime Minister Shinzo Abe – who was elected in 2012 – has been on a mission to stimulate economic growth through quantitative easing (to boost wages and spending) and negative interest rates (to encourage investment).
In 2015, he also introduced broad ranging corporate governance reforms to increase investor confidence. Despite recent stock market gains, it’s too soon to tell if these policies will pay off. With a sizeable amount of debt to repay, coupled with the pressures associated with an ageing population, Japan still has plenty of economic challenges ahead.
Mr Connolly adds: “This is a high-risk area in which a small weighting is suitable for most investors.”
An investment in this sector offers exposure to some huge global brands and cutting-edge tech firms including Apple, Microsoft, Facebook and Alphabet, the parent company of Google.
America is also home to oil giants Exxon Mobil and Chevron, as well as consumers goods groups such as Johnson & Johnson and Proctor & Gamble. However, it is not the easiest market to make money from, as Mr Haynes explains.
He says: “Many UK investors have little exposure, despite it being the largest and most influential stock market containing global leading companies across a wide range of sectors. Because it is such a well-researched stock market, it can therefore be very difficult to outperform, so many investors prefer a low-risk, passive approach.”
Active managers will often find better opportunities in small- and mid-cap stocks, but these are likely to be higher risk.
Confusingly this sector is home to two very different types of fund – they must either invest at least 60% of their holdings directly into property (known as direct property or bricks and mortar funds) or be 80% invested in property shares (a property securities fund).
“Property is another and different asset class to shares and bonds and so behaves differently,” says Mr Lowcock. “It is not as liquid [easy to sell] as the other two and because of the longer-term focus on the investment, the income stream (rent) is less volatile and tends to protect against inflation as rents are reviewed upwards only.”
Yet while rising income is appealing to many investors the liquidity issue can present problems. “If the market sells off as it did after the Brexit vote in 2016, investors could become forced sellers of property – and that is never a good place to be,” he adds.
As they perform differently to other asset classes, bricks and mortar funds can be a great diversifier in a portfolio. They are also regarded as lower risk and less volatile (except in extreme situations). Nonetheless Mr Lowcock says investors still need to commit to five years at the least. Funds that buy property shares do not provide the same degree of diversification.
Mr Lowcock adds: “Property securities funds invest in shares of property companies and so, like property funds, they will provide diversification over the longer term. But in the short term they will be more akin to equities and could easily fall in an equity market sell-off.”
Often referred to as ‘the cupboard under the stairs’, the specialist sector provides a home to those funds that cannot be accommodated by other sectors. This might mean a specific region – such as Latin America – or a specific theme such as healthcare or agriculture. The sector also increasingly holds mixed-asset funds, where the level of flexibility required by the manager means it cannot be accommodated by any of the mixed asset sectors.
Mr Haynes says: “This is a sector for investors who are looking to pursue a specialist investment theme, to add diversification to their portfolio. Funds in this sector will have a narrow remit, and it’s difficult to compare funds against others in the sector given that there is such a wide range of very different strategies.”
“Property acts in a different way to shares and bonds”
Targeted absolute return
Rather than seeking to beat an index, funds in this sector use a raft of complex strategies (including derivatives and money market instruments) to generate a positive return, irrespective of what is happening in the market.
If stock markets collapse, these funds will still seek to pay a return, although this cannot be guaranteed.
“Each fund will take a different approach,” explains Mrs Coles. “You need to check the objective of the fund because they may aim to achieve something more demanding than simply not making a loss. They will also state a time frame over which they aim to meet their objective – which cannot be more than three years.”
Owing to the breadth of strategies employed by managers in this sector, it is hard to make meaningful comparisons between funds. Each should be considered on its own merits and on whether it achieves its stated objective.
For a full list of sectors and their sub-groups, visit: theinvestmentassociation.org.