Funds can invest in different types of assets. Here we explain the risks of each. There are many types of risks but generally, the higher the potential returns, the higher the risk.
Some funds can invest in more than one asset type to try to reduce the risk of losing money. This means they are not relying on the performance of an individual asset or assets of the same type. This is known as diversification.
Information on how these risk types match to our funds can be found in our fund guides.
Equities are commonly known as "shares". When a fund buys a company share, it is investing in a company and, in exchange, receives a share of the ownership of that company. Shares give two potential investment benefits:
- share prices increase as the value of the company increases
- companies may pay dividends – regular payments made to shareholders based on how well the company is doing.
Over the longer-term, equities can offer greater growth potential than many other asset types. But over the short term, the value of equities can go up and down a lot. Funds investing in equities tend to carry a higher risk of capital loss than funds investing in fixed interest securities or money market investments (see below).
The financial results of other companies and general stock market and economic conditions can all affect a company's share price, and consequently the value of any fund investing in that company.
Where a fund invests significantly in equities, we have rated the fund as having a risk type of "Equity".
Fixed interest securities, more commonly known as "bonds", are loans issued by companies or by governments in order to raise money. Bonds issued by companies are called Corporate Bonds, those issued by the UK government are often called Gilts or UK Government bonds and those issued by the US government are called Treasury Bonds. In effect all bonds are IOUs that promise to pay you a sum on a specified date and pay a fixed rate of interest along the way.
Index-linked securities are similar but the payments out are normally increased by a prices index e.g. for UK government index-linked securities, payments out are increased in line with the UK Retail Prices Index.
On the whole, investing in Government or Corporate bonds is seen as lower-risk than investing in equities. To date, no UK government has ever failed to pay back money owed to investors (Source: Debt Management Office, June 2016). However it is possible for a government bond to default. But with corporate bonds there is a risk that the company may not be able to repay its loan or that it may default on its interest payments.
The risks related to investing in bonds can be reduced if you invest through a bond fund. Where a fund manager selects a range of bonds, you are less reliant on the performance of any one company or government. If bond income generated is reinvested by the fund, bond funds can be used to provide attractive levels of growth. However, there is a risk you might not get back the amount you invest and the income you receive is neither fixed or guaranteed.
Corporate and Government bonds are sensitive to interest rate trends. An increase in interest rates is likely to reduce their value, and hence the value of any fund investing in them.
Where a fund is exposed to these types of risk, we have rated the fund as having a risk type of "Fixed Interest".
Commercial property investment generally means the fund is sharing in the returns from the ownership of some buildings (for example, offices and shopping centres). The value of the property may increase and tenants may pay rent to the owners of the building.
Investment in property can be done either by investing directly (eg owning physical property) or indirectly (eg owning shares in a property company as part of a diversified range of assets). The return achieved from investing in property is a combination of rental income and changes in the value of the property; which is generally a matter of a valuer’s opinion rather than fact. Property can be considered to be lower risk than equities, but higher risk than bonds over the long-term.
However, commercial properties can be difficult to buy and sell quickly. Fund managers may have to delay withdrawal of money by customers from a property fund until they can sell some of the buildings the fund invests in.
The actual value of a property is what someone is prepared to pay for it – an actual sale value. As sales are infrequent, interim valuations are based on a valuer's opinion and may be revised up or down from time to time. This can affect the value of a fund invested in commercial property, with the value possibly fluctuating significantly.
All of this means there are a number of risks for funds investing in property:
- Cash could remain uninvested as property assets can be difficult to buy, leading to lower returns than expected.
- The value of the fund may be reduced if a large number of withdrawals are requested and it is necessary for properties to be sold at reduced prices.
- There may be delays removing your money from the fund if the property is proving difficult to sell.
- Property fund valuations may be revised periodically, upwards or downwards.
- Rental income is not guaranteed. Defaulted rent and unoccupied properties could reduce returns.
- If the size of the fund falls significantly, the fund may have to hold fewer properties, and this reduced diversification may lead to an increase in risk.
Where a fund is exposed to these risks, we have rated the fund as having a risk type of "Property".
Overseas investments allow you to take advantage of the growth potential of markets outside of the UK, but currency changes can affect the value of overseas investments. Because the value of overseas investments is converted from local currency into pounds (Sterling), the Sterling value can fall if the local currency weakens against Sterling, independent of the performance of the asset itself.
Where a significant proportion of a fund is invested in non-Sterling assets, we have rated the fund as having a risk type of "Currency".
In comparison to larger companies, shares of smaller companies may be harder to trade and short-term performance may be more volatile. There may also be more chance the companies will become insolvent. Funds which invest in small companies can have volatile returns and a greater risk of capital loss.
Some investments are in markets which are less developed than the UK market. In such markets, the ability to trade, and the safe keeping of assets on behalf of the fund, and especially regulation may all be poorer than in well-developed markets.
This means increased risk for your investment.
Where a fund has these types of risk, we have rated it as having a risk type of "Smaller Companies and Developing Markets".
There are several financial arrangements that fund managers can use with the aim of improving fund performance. Some of the most common are:
Derivatives: These cover products such as futures and options which are generally an arrangement to buy or sell a standard quantity of a specified asset on a fixed future date at a price agreed today. This type of investment may carry a higher risk of capital loss than funds investing in other assets. Sometimes in the event of a counterparty to a derivative (the party with which the fund manager has made the agreement about future deals) being in financial difficulties, it may be difficult to obtain a price for valuations or for the investment manager to dispose of the asset – that creates risk to the value of the fund. There is a risk of capital loss in the event of the counterparty to the derivative becoming insolvent or suffering other financial difficulties.
In such circumstances the derivative may have no value.
Geared Assets: Funds that are geared or borrow assets or which use short-selling are likely to be more volatile than other funds and there is a higher risk of capital loss.
Where a fund could be exposed to these types of risk, we have rated it as having a risk type of "Financial Instruments".
Alternative Investments includes non-traditional, complex or specialist investments. Examples include hedge funds, private equity and complex derivative based strategies. Alternative investments can be less liquid than traditional assets. They can be more difficult to value and take longer to buy or sell. Where a fund could be exposed to these types of risk, we have rated it as having a risk type of "Alternative Investments".
We have rated a number of funds as having a risk type of "Other".
- In addition to the risks and characteristics of the individual asset types, specialist investments have other features that are unique to where they invest.
Specialist funds invest in particular markets or geographical areas. Because they invest in a smaller range of asset types, they tend to be more risky than non-specialist funds, but can deliver greater returns.
Ethical funds are restricted from investment in certain companies due to the criteria used to select investments for the fund. This may mean that the returns from the fund are more volatile than funds which do not have these restrictions.
The fund may have investment concentrated in relatively few individual assets. Therefore, returns from the fund can be significantly influenced by the performance of a small number of individual holdings and may be more volatile than funds with a wider spread of underlying assets.
Some funds keep a proportion of your money in cash deposits and other money market investments. Over the long-term, money market investments usually offer the lowest risk of all asset types but also the lowest potential returns. Some funds hold money market investments because they are aiming for security more than substantial growth. Others hold just enough in cash deposits to make sure money is available for customer withdrawals. Over the long term, money market investments can be a low risk asset type but may also produce low returns compared to other asset types.
A money market investment is at risk if any of the banks, building societies or other financial institutions with whom the fund's money is deposited becomes insolvent or suffers other financial difficulties. In such circumstances, the money deposited with that institution may not be returned in full. Some money market investments will be affected if interest rates rise, leading to a drop in value of any fund holding them.
Some funds may offer some form of protection from downside risks for which there will be a charge and which will normally have an impact on long-term returns. The protection may be provided through the use of derivative contracts and this may give rise to counterparty risk and liquidity problems. The provision of the guarantees may result in a significant proportion of the fund being invested in cash and other lower risk investments.
Where a fund could be exposed to these types of risk, we have rated it as having a risk type of "Other".