How to weigh up the risks and rewards of investment funds

1 WHAT DO YOU WANT?

Is it income, capital growth or a combination? If an investment has a specific objective, such as income, then you should understand that such a focus will have an impact on the potential for capital growth.

Also, it is worth considering how you structure income from your investments. It is sensible to try to have any income classified as capital so that you make use of your annual capital gains tax (CGT) allowance.

One investment trust that caters for investors in this regard is F&C's Investors Capital Trust, which offers a B share class that aims to provide investors with about 5 per cent a year, paid quarterly. However, the income generated is treated as capital for taxation purposes and it does not reduce your annual CGT allowance.

2 WHERE DO YOU WANT TO INVEST?

By focusing on a certain country, sector or asset class, you increase the investment risk because you are dependent on that one investment performing in line with expectations. Most funds have a specific focus either in terms of location and/or asset class. Some funds are more generalist in nature, in that they look to provide returns from a range of investments across different countries, sectors and asset classes.

3 LOOK FOR A TRACK RECORD

If you were looking to focus on a specific sector – UK smaller companies, for example – then look for those with a good long-term track record in that area; fund managers who have been through various economic cycles and apply a consistent process. In Edinburgh, we are lucky to have a number of experts in the UK small-caps area, including Aberforth, Artemis, Baillie Gifford, Edinburgh Partners and Standard Life.

4 ARE THEY EATING THEIR OWN COOKING?

By this, I mean: do the fund managers invest into their own fund? It is always interesting to see how fund managers perform when they also invest their personal money into the fund that they manage on behalf of investors.

5 RISK APPETITE

Generally speaking, it is accepted that stock-market based investments are historically more volatile and, in turn, considered a higher risk than fixed interest, property and cash. However, during shorter time periods, economic conditions can favour different asset classes.

A sensible approach is to keep a spread of investments across a range of countries, asset classes and sectors, to try to reduce investment risk.

6 CONSIDER THE CHARGES

An expensive fund with poor performance is going to find it difficult to attract new investors. Nearly all funds will have an initial charge and ongoing charge. Most funds should quote a TER (total expense ratio) that can be used for comparison.

7 QUESTIONS OF SIZE

Large funds might offer a level of comfort and security, but it also means they might be large and cumbersome when it comes to strategic changes. A couple of large, well-run generalist funds, with a number of smaller sector-specific funds, is not a bad approach.

8 DO YOUR HOMEWORK

Several websites carry up-to-date information on funds and trusts, including www.trustnet.com and www.citywire.co.uk. Both of these can provide you with information on a huge range of investments and the ability to screen and filter on certain criteria. But beware of going for the fund that is top of the charts in the short term, as it is difficult for them to retain that position. Look at longer-term figures and seek out consistency.

9 SHARPE RATIO

Sharpe is a ratio that tries to identify how much return is based on risk. You could compare funds in a specific sector, and the fund with the higher Sharpe ratio has technically done a better job because it has generated the returns without taking excessive risk.

10 TAKE ADVICE

As you can see, there is a lot to consider. If you speak to a good financial adviser, they should listen to what you are looking for, assess your risk and analyse your existing asset base and tax position. To find one near you, go to www.unbiased.co.uk or call 0800 085 3250.