An Introduction to Investment Funds

Investment funds are essentially collective investments. In investment funds, you pool your money together with other people and invest it rather than buying individual stocks and shares.

The fund manager decides the exact choice of investments. They will either actively manage them, or keep them as passive funds. The difference between these are, in active funds, the investor frequently makes decisions which aim to deliver a return that’s better than the stock market, and passive funds track a market, with the aim for steady performance rather than maxing returns.

You then buy ‘units’ in your chosen fund. These units rise and fall in line with how well the overall fund performs.

Types of Investment Funds

There are two main types of investment funds. These are:

With-profits – where investment performance indirectly affects the benefits; and

Unit-linked – where investment performance directly affect the benefits.

With-profits

Historically, with-profits policies were the main investment products that insurance companies offered. They are available in both regular and single premium contracts, although the bulk of new investment is in single premium bonds.

Bonuses that attach to the policy reflect the investment performance. Bonuses are added to the value of the policy annually. The bonuses are based on the company’s profits from its investments but, over time, bonus rates have been cut severely, sometimes to zero.

Annual bonuses are generally a rate that the insurance company’s actuary believes represents the long-term returns from the funds. Annual bonuses, therefore, were not particularly volatile. However, they have been falling since the early 1990s. They mainly reflect the income yields on investments in a smoothed, long-term fashion. However, financial pressures have limited the scope for companies to take a long-term view.

Terminal bonuses are paid when the policy matures or on death and generally tend to represent more of the capital growth that the insurance company has made on its funds. Terminal bonuses are therefore more volatile and changes in the investment markets affect them more directly.

Insurance companies usually reserve the right to reduce the amount paid on the surrender (but not on maturity or death) of a policy during times of adverse market conditions. A market value reduction (MVR) is applied to unitised with-profits funds, whereas for traditional policies changing the surrender value basis achieves this.

With-profits performance

The performance of with-profit funds depends on:

  • The underlying performance of the investments
  • The profitability of their other businesses.

The size of the free asset ratio (the surplus assets held by a life office over the value of its liabilities) usually measures the strength of the company’s reserves. This can allow reserves to be maintained, even in those years when the value of investments and the income from them have fallen.

Unit-linked

With a unit-linked policy, the investor chooses the fund that premiums buy the units in. It has the following characteristics:

  • The total value of units in a policy measure the value of the policy.
  • As soon as a policy is affected, its surrender value will be lower than the premium paid. This will be because of the difference between the buying and selling price of the units, usually 5% and/or because there is an early termination penalty.
  • From then on, a policy’s value depends on the performance of the fund, or funds it is linked to.

Unit-linked performance

The more specialised the fund, the greater the chance of spectacular rises in value and spectacular falls. The more broad a fund, the more likely it is to conform to an average return and the less likely it is to suffer a disastrous fall.

There is some evidence to suggest that new funds perform better than average in their early years because their small size makes dealing easier.

There have been problems in the past with small funds investing too high in one single investment.

Unit-linked policies maturing when stock market prices are high will normally outperform their with-profits counterparts. However, policies maturing when stock market prices are low may perform badly. For this reason, most policies include an extension option so that they can be deferred at maturity date until depressed stock markets recover.

How We Can Help with Investment Funds

Here at The Compensation Experts, we work with solicitors who have years of experience dealing with financial mis-selling claims. This includes investment funds. If you need help with a potential claim, contact us by filling in our contact form. Or call us to speak to one of our friendly knowledgeable advisors.

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