Stock selection

Hopefully by now you’ll have some idea of the sort of portfolio that will be suitable for you.  So how do you go about identifying which stocks make suitable holdings?  We’ve already suggested that used properly, “pooled” or “collective” investment funds are the easiest way to achieve some diversification …

Pooled or collective investments

A pooled or collective investment is one in which money from many individual investors is aggregated and invested in one or more asset classes by a fund manager.

There are a number of advantages to using pooled investments.  Primarily, you can spread your risk by getting exposure to a range of underlying investments at a relatively low cost – certainly at a much lower cost than if you tried to buy the underlying investments directly yourself.

In addition, you get the professional expertise of a fund manager who manages the portfolio of underlying investments. Of course, some fund managers are better than others!

There are a number of types of pooled investments, including investment funds, investment bonds and endowments.  We’re just going to focus on investment funds.

Investment funds

The main types of investment funds are:

  • Unit trusts and open-ended investment companies (OEICs)
  • Investment trusts
  • Exchange-traded funds (ETFs)
  • Hedge funds

What is a unit trust?

A unit trust is a professionally managed fund of the pooled money from a large number of investors which is spread across a range of investments such as shares and bonds.  Investors receive “units” of this fund, the value of which fluctuates with the value of the investments of the funds.  Investors can buy and sell units in the trust, paying the (higher) offer price when buying units, and receiving the (lower) bid price when selling.  The difference between the two prices (the “spread”) on the day of purchase reflects the initial charge and is typically around 5%.

Unit trust providers generally calculate their prices once a day.  When you buy a unit trust your order is turned into units when the price is next set, which could be the following day.  The fund manager creates units when investors buy and cancels units when investors sell. This “forward pricing”, where the price at which you’re dealing at is not known until the deal is done, also applies when selling units.

What is an open-ended investment company (OEIC)?

An OEIC is very similar to a unit trust, except that the fund is run as a company.  This means that the company creates or cancels shares rather than units as money flows into and out of the fund, but the share price still reflects the value of the investments held within the fund.  Additionally, OEICs only have one price, with the initial charge being taken as a separate commission.

What is an investment trust?

Investment trusts are companies that are domiciled in the UK and invest in shares and securities of other companies that trade on stock markets worldwide. They are listed on the London Stock Exchange, are run by an independent board of directors, and their shares are traded on the open market. As with any other company whose shares are quoted on the stock market, the price of a share is the reflection of what the market perceives it to be worth; an agreement between what price the seller is willing to sell it for and what the buyer is willing to pay for it.

However, an investment trust company will value its portfolio of assets differently to the market; this is known as Net Asset Value (NAV). The difference between the share price and the NAV is known as a discount or premium.

If the share price is lower than the NAV, the investment trust is trading at a discount. This means you can buy into the stocks held by the investment trust – and the income they generate – at less than their market value. Generally investment trust shares trade at a discount.

If the share price is higher than the NAV, it is trading at a premium. A small discount or premium usually means the trust is in high demand.

Many investment trusts are proactive in managing the size of the discount – issuing shares at a premium and buying back shares at a discount. The purpose of this is to reduce share price volatility and it also results in an enhanced NAV per share.

Investment trusts are closed-ended funds, which mean each has a set number of shares in issue. This allows the manager to take a longer term view of the underlying investments without having to sell and repay investors.

Investment trusts have more flexibility than unit trusts when it comes to paying dividends.  This is because investment trusts are allowed to retain up to 15% of income in a separate reserve.  This allows them to smooth dividend payments over time and can lead to impressive periods during which dividends have never been cut – a useful marketing ploy.

Another feature of investment trusts is that they are allowed to borrow money to invest. This is known as gearing and allows the manager to take advantage of investment opportunities. However, this makes investment trusts slightly riskier and more volatile than unit trusts.

What is an Exchange-traded fund (ETF)?

ETFs (and ETCs) are funds that issue shares to investors. However, rather than tracking the performance of a single company, an ETF tracks an entire equity index, sector, commodity or even a foreign currency, without the expense or hassle of investing directly in the underlying products.  This “passive approach” means that the costs of running an ETF are very low.

Like unit trusts and OEICs, ETFs are open ended with the price directly reflecting the value of the underlying investments held in the fund.  However, they are listed on a stock exchange, which means that they can be traded at any time that the market is open.

Another advantage of ETFs is that unlike conventional shares, you do not have to pay the usual 0.5% stamp duty on purchases. They are also eligible for ISAs and SIPPs.

What is a hedge fund?

A hedge fund is an aggressively managed portfolio of investments that often uses a range of strategies including leveraged, long, short and derivative positions with the objective of generating high returns, either in an absolute sense or over a specified market benchmark.

They are largely unregulated and are often set up as private investment partnerships.  They have a reputation for charging very high fees.

Selecting stocks and meeting investment objectives

With some (collective) stocks, the name gives a pretty clear indication of the investment objective and the likely exposure.  For example, it’s no surprise that buying shares in the Aberdeen Asian Smaller Companies Trust will give you exposure to smaller companies in Asia!  Fortunately, unit trusts and OEICs, together with investment trusts, are categorised by fund focus, geography and sector.  For ETFs the categorisation is a little more obscure. Websites such as enable the user to search funds by these filters.

Most simply, ETFs that track specific indices using physical replication are the easiest (and cheapest) means of getting desired exposures.  In the majority of cases, stock market indicies are weighted by market capitalisation so by definition, buying such an ETF will give you more exposure to larger companies.

If using collectives, there remains one other consideration when constructing a portfolio.  Do you go for “active” or “passive” management, or a blend of the two?

What’s the difference between “active” and “passive” management?

Active management involves fund managers seeking to outperform a particular index by taking positions in stocks that are out of line with the weighting of that stock in the index.  For example, if a fund manager is keen on a particular stock, the fund’s holding in that stock will likely be greater than its percentage weighting in the index. Being “overweight” in one or more stocks compared to an index will necessitate being “underweight” elsewhere.

Passive management involves fund managers seeking to replicate index performance simply by holding the same stocks that comprise the index in the same weighting as the index.  This is largely the approach adopted by ETFs and tracker funds.

Some investment managers combine both approaches by taking an active approach to asset allocation and then using passive ‘trackers’ to get the desired exposures.  Any individual who builds a “passive” portfolio using ETFs alone is still adopting an “active” approach in selecting their holdings and the timing of their trades.

Of course, if you ignore collectives and decide to build your portfolio only by buying stocks in single (non-investment) companies, you are taking a wholly active approach.  Personally, I think that individuals new to investing or those with modest sums to invest should have portfolios consisting entirely of collectives.  I also take the view that more experienced investors should use collectives as “core holdings” to make up the majority of their portfolios, with a few other holdings providing targeted exposure to boost income or the chance for greater capital gain as desired.

Ultimately it’s your money you’re investing, and it’s your decision what you do with it!

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