Investment funds: what are they and how do they work?

Investment funds are an important part of investing, and there is plenty to know about them.

While the array of designations, acronyms and fees can feel overwhelming, especially for beginner investors, it is well worth taking the time to understand investment funds. The top funds can form a really integral part of your portfolio.

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“As a general rule, diversification tends to be your friend and prevents one or two isolated problems from wrecking your portfolio,” says Ben Seager-Scott, chief investment officer at Forvis Mazars.

“Funds give you ready access to a spread of companies without being overly exposed to just a handful,” he continues. He cites legendary investor Harry Markowitz who reportedly said “diversification is the only free lunch in investing”. Funds offer this diversification, without much of the cost, administration and time commitments that building your own portfolio from scratch would entail.

“You could choose to manage a portfolio directly if you have the time to understand and research all of the stocks, listen to the earnings call, decide which winners to allow to run higher versus which ones to take profit on, which stocks to top-up after a fall or close out of… and so on,” says Seager-Scott.

But if you buy a fund, a professional – whether that is a fund manager or an index compiler – is doing that for you.

The different types of investment funds

Investment funds come in various forms – so many, in fact, that categorising all of them is almost impossible. But there are three broad categories that it is especially useful for investors to be familiar with, and which cover most of the range of possible investments between them. These are ETFs, mutual funds and investment trusts.

There are two key distinctions that define these three fund types: open- versus closed-ended, and listed versus unlisted.

“Open-ended means clients can put money into the fund and take it out of the fund which makes the fund itself grow or shrink,” says Seager-Scott. Closed-ended, on the other hand, means that all the fund’s capital is raised and all of its shares are issued at its inception.

“Listed means the shares are listed on the stock exchange so can be traded through the day on this secondary market, whereas unlisted means you trade effectively directly with the fund group (although in reality it is still intermediated) once per day,” says Seager-Scott.

Exchange-traded funds (ETFs) are open-ended, listed funds. As the name suggests, they are listed on a stock exchange: you can buy and sell them in a stocks and shares ISA just as you might buy shares in a listed company.

“The advantage is that they can be bought and sold throughout the day and you can see live pricing while the market is open,” says Seager-Scott. “The downside is you generally have to trade during market hours and there is the added complexity that comes with the secondary market.”

Despite trading on a stock exchange, the price of an ETF will always reflect the net value of its underlying assets (net asset value, or ‘NAV’). This is because new shares can be created or redeemed by authorised partners to ensure that changes in demand for the ETF’s shares are always balanced against changes in its NAV. This is what is meant by ‘open-ended’.

Mutual funds

This is a broad and sometimes blurry category, but essentially it refers to open-ended, unlisted funds.

“There are lots of varieties, including OEICs (which are UK-domiciled), unit trusts (which are an older style of UK-domiciled fund) and SICAVs (which are EU equivalents),” says Seager-Scott.

The biggest difference between a mutual fund and an ETF is the fact that a mutual fund isn’t listed on a stock exchange. Units in the fund are bought directly from the fund group via an investment platform once per day.

“It is important to be aware that even though they are open-ended, they can still close if they need to,” says Seager-Scott.

This can be because they get too big and stop accepting more money, in which case existing investors will still be able to get their own money out. But sometimes it is because shares sell off too rapidly and the fund is unable to meet redemption requests. In that instance the fund is closed or ‘gated’, and no-one can buy or sell the fund. “This often causes a lot of concern,” says Seager-Scott.

Investment trusts are closed-ended funds. They are also, technically, listed companies – they are often referred to as ‘investment companies’ for that reason.

Being closed-ended means that all of their shares are created at the inception of the fund. New shares can be issued, but this is a much less common event than the daily creation and redemption of shares that occurs in open-ended funds, and is done to raise additional capital to invest rather than to manage the pricing of the fund.

The upshot is that the price of an investment trust is determined entirely by demand for its shares (as with shares in a company) rather than the value of its underlying assets (as with open-ended funds). That means investment trusts can trade at a discount or a premium to their NAV.

Some investors see this as a disadvantage, though our explainer, ‘Should investors worry about investment trust discounts?’ examines whether this is necessarily the case. At any rate, investment trusts have some key advantages over open-ended funds.

In brief, the closed-ended model means that they never have to sell assets when investors withdraw their money, enabling fund managers to pursue long-term investments with conviction. As limited companies in their own right, they can also use leverage – known as ‘gearing’ – to amplify their investment returns.

Investment trusts can also reserve up to 15% of their returns on any given year and use these to top-up dividends in future years, enabling them to offer investors a smoother dividend yield over the long term.

passive versus active. In brief, active funds have a manager who actively buys and sells securities to try to generate market-beating returns, while a passive fund simply tracks an index (such as the FTSE 100).

Investment trusts are always active funds. Broadly speaking, mutual funds and ETFs can be either active or passive. ETFs are generally associated with passive investing but there is nothing in the ETF structure that mandates this, and active ETFs are growing in significance: assets managed by European active ETFs grew almost 70% last year.

Active ETFs are managed by an expert portfolio management and research team making forward-looking investment decisions, says Rahul Bhushan, managing director at ARK Investment Management. ARK’s team, for example, focuses on companies in high-growth sectors that it believes will benefit from technological innovation.

“In fast-moving sectors like AI, robotics, blockchain, energy storage and multiomics, we believe active management can be a significant advantage,” Bhushan adds.

bonds – higher-risk and lower-risk respectively.

Similarly, you’ll want to think about what you’re gaining exposure to when buying the fund. Do you want exposure to global equities in all industries, or are you looking to buy into a specific sector? There are funds for each of these and everything in between.

After identifying the kind of fund you want to buy you’ll likely still be presented with multiple options from different providers. Fee levels, as well as the fund’s underlying strategy, can help you decide which is your best option.

Fees can eat into your overall returns so it’s important to understand them.

Active funds typically charge higher fees than passive funds, because it is more labour-intensive to run an active fund than a passive fund. In theory, this is compensated by superior returns, but that doesn’t always transpire: AJ Bell’s latest Manager versus Machine report found that just 30% of active funds outperformed passive counterparts in the 10 years to 30 June 2025.

So before buying an active fund it is important to check its annual returns over the long term and ideally comparing these to a passive fund or index in the same sector to ensure that the manager is worth the extra fees. Past returns of course do not guarantee future results, but a track record of outperformance is one indicator of a skilled investment manager.

Investors will also want to check their own understanding of how the index works (for a passive fund) or the fund manager’s strategy (for an active fund) before investing.