Don’t be shy, ask ii…how do I select the best funds to invest in?

Whether you want to find out how to start investing or how the stock market works, don’t be shy, ask ii.

Margaret Nicholson asks: I have just started trading with interactive investor and have done my research to select nine shares for my portfolio in the last six weeks. I am happy with my choice. However, I would like to start looking at investing in funds in next year’s ISA. 

Could you explain to me how to select the best funds to invest in? I have been looking at Fidelity Index Emerging Markets, however there are two of them listed on the London Stock Exchange. What is the difference between them? What is a suitable ongoing charge?

Kyle Caldwell (pictured above), Collectives Editor, interactive investor, says: There are thousands of funds for investors to choose from and more than 400 investment trusts. As a result, investors face an overwhelming amount of choice. 

For those seeking ideas on funds to invest in, the first decision to make is whether to choose an active or a passive fund.

An active fund is run by a professional investor and aims to outperform an index – such as the FTSE All Share Index, which houses around 600 of the largest UK companies. 

A passive fund, on the other hand, aims to mimic the performance of an index. For example, if the FTSE All Share returns 1% in one day, the passive fund will return around 1% (it will always underperform due to the fee it levies). Passive funds are called either index funds, tracker funds or are structured as exchange-traded funds (ETFs). The fund you mention, Fidelity Index Emerging Markets, is an index fund. 

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Those opting for a passive fund have less homework to do. Decide on the stock market and index you want to track, and find the cheapest index fund or ETF that you can. Also check the fund's tracking error, which shows how efficient the passive fund is at replicating the performance of the index it follows. The lower the tracking error, the better.

You then need to decide which share class to pick. As you mention, there are two options for Fidelity Index Emerging Markets, one that ends in ‘Inc’ and the other in ‘Acc’. ‘Inc’ refers to the income share class, which pays any income generated by the fund directly to the investor as cash. The accumulation share class (‘Acc’) will reinvest the income back into the fund. Fidelity Index Emerging Markets has a yield of 2%. The choice of share class depends on whether you want, or need, the income to be paid to you, or if are happy for it to be reinvested so that you benefit from compounding (put simply, dividend income earned on dividend income paid).  

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More time and effort is required when choosing an actively managed fund, as not all funds outperform and fund managers invest in different ways. The reality is that there are only a small number of funds that stand out from the crowd. It is therefore important to do your research and understand how the fund invests. Then it is a case of taking a view on whether you think the fund could be a good choice over the long term and will deliver on its aim of outperforming an index.

With active funds there is the possibility of outperforming, whereas with index funds investors will not outperform but will also not heavily underperform.

At interactive investor, we endorse what we believe to be superior options in our Super 60 list of rated funds, which includes both active and passive options. The Super 60 is designed to provide a menu of high-quality choices suitable for all investors, regardless of experience. These are not personal recommendations but a trustworthy shortlist of rated investments from which you can choose. 

We also have a list of ethical investments, the ACE 40. This also included both active and passive options which invest in an ethical manner. As well as possessing ‘values’, they also have potential to add value for investors by way of performance.

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In terms of charges, an actively managed fund investing in developed markets typically costs 0.85% a year (the ongoing charge figure, or OCF). Those investing in more specialist areas (such as emerging market smaller companies) tend to charge 1% or more.

A passive fund that seeks to replicate the performance of the FTSE 100 index or America’s S&P 500 index, can cost as little as 0.1% a year or less. Again, an ETF that is more specialist will cost more, but will in most cases be cheaper than an equivalent active fund. Fidelity Index Emerging Markets costs 0.2% a year.