So you’ve decided to manage your own money. Perhaps you have set up a Self-Invested Personal Pension (SIPP), or an ISA, or maybe you just have savings or a windfall that you want to put to work.
You may be a confident, well-informed investor who needs no help from regulators to make the best investment decision for your circumstances and needs. If so, then congratulations - you are in an elite minority, and you have everything under control.
Otherwise, you are one of the majority, scratching your head as you try to balance risk, potential reward, and cost, across the myriad of available investment vehicles. If so, it is quite likely you will be persuaded that funds are a good home for at least some of your capital, as a half-way house to full self-determination: you pick the funds, but the respective fund managers pick the individual assets.
But which funds? There are tens of thousands available, and they are more accessible than ever, thanks to platforms that make it possible to invest or divest with just a few clicks.
Even when, as you must, you have narrowed the options to a particular area of focus – maybe something very specific, such as vegan food producers, or the best dividend payers in the FTSE; or perhaps something more general such as European large companies – you will still likely have a range from which to choose.
So how to decide which is best for you, and what have the regulators done to help you choose the most suitable investments for your circumstances?
Depending on the type of fund you are considering, you should always read one of two types of document that must be made available to you, and which you will find on the websites of the relevant fund manager, and/or your investment platform provider of choice:
· The Key Investor Information Document or KIID was introduced in 2012, and applies to all UCITS funds. UCITS stands for ‘Undertakings for Collective Investments in Transferable Securities’ (which really just means ‘funds’,) and dates back to EU regulations introduced in 1984. The manager of a UCITS fund must adhere to a strict set of rules that are designed to ensure prudent management of the fund, with robust risk controls. UCITS funds have come to dominate the retail fund landscape in Europe, and there are thousands available.
· The Key Information Document or KID was introduced in 2018, and currently applies to any fund that is marketed to retail investors in the EU that is not a UCITS. There are hedge funds, private equity funds, property funds, and many others that do not conform to the UCITS regime, at least some of which are available to private individuals with modest sums to invest. These go under the collective name of AIFs – Alternative Investment Funds.
Yes, it’s confusing. The confusion should, in theory, be alleviated in 2022, when the newer KID is due to replace the existing KIID for UCITS funds, meaning that all funds marketed to retail investors will be accompanied by the same regulated document.
The KIID and the KID were designed with the same intent: to help investors to make good decisions based on objective and comparable information about similar products. While the documents are similar in content, there are important differences, of which more below.
Both documents are subject to strict rules about what information must be included – and anything not required must be excluded. Promotional or marketing content is strictly prohibited. Numbers that illustrate risk, performance, and the impact of costs must be calculated and presented in highly specific ways to ensure like-for-like comparability between different providers.
So what do the KIID and KID documents tell you, and how useful are they in the real world?
The KIID describes the investment objectives of the fund, gives an indicator of the level of risk involved, and shows past performance, usually compared to a benchmark such as a market index. It also explains the charges that you will have to pay.
The KID also describes the investment objectives of the fund, as well as the type of investor for whom it may be suitable. It gives a broadly equivalent risk indicator to that on the KIID, but calculated in a slightly different way. An important and controversial difference from the KIID is that the KID does not show past performance. Rather, it shows illustrations of potential future performance under four different scenarios. Like the KIID, it shows the charges you can expect to pay, but in more detail, and with an estimate of how those charges will impact the returns that you will get. The KID also has a section describing the risk that the product issuer won’t be able to pay you, and whether you will benefit from any investor protection scheme in that event.
Let’s look in more detail at how the KIID and KID present risk, performance, and cost information, which are likely to be key factors in your decision.
Inevitably, one of the primary concerns of investors is ‘risk’. We don’t like the sound of risk. It sounds off-putting and to be avoided – although a well-established rule of thumb in investment is that higher risk comes with the potential for higher rewards. But risk comes in different forms, so what does a KIID or KID tell you about the risk(s) of any given product?
The most obvious risk is that the product will not perform as well as you expect, and with funds you may actually lose money, depending on the value when you cash out.
The KIID and KID both try to capture this with a simple number from 1-7, where 1 is lowest, and 7 is highest risk. If you are comparing two funds with similar investment strategies and costs, you would naturally tend to favour the one with the lower risk indicator.
But all the risk indicator really measures is the volatility of the fund’s daily, weekly, or monthly returns – how much they go up and down from day to day*. Is this something you should worry about, given you will likely be investing for the long term?
*The KID uses a slightly different risk calculation method from the KIID in an effort also to capture ‘credit risk’, i.e. the possibility that someone who owes money to you, or to the fund in which you are invested, is unable to pay. A high credit risk will cause the volatility-based risk to be bumped up a notch or two.
Well one glaring shortcoming of volatility for this purpose is that it is blind to the direction of the movements. A fund that loses exactly 1% every month will have a volatility of zero, and appear to be risk-free, because the returns never vary – but would be unlikely to feature on anyone’s ‘buy’ lists.
The legendary investor Warren Buffet once said in a letter to shareholders that ‘I would much rather earn a lumpy 15% over time than a smooth 12%’.
In other words, volatility is useful to know, but it is not necessarily a good indicator of how likely you are to make or lose money over the long term.
Finally there is liquidity risk, i.e. the risk that you may not be able to take your money out when you want to, even though most UCITS funds only require one day’s notice of redemption. Funds that invest in assets that can be hard to sell quickly, such as property, or shares in private companies, may be forced to suspend redemptions when markets are stressed, especially when lots of investors are trying to exit at the same time. This risk is not captured at all in the risk indicator, though it must be disclosed separately on the KID, and you should certainly be aware of it.
So, the risk indicator does allow like-for-like comparison between funds, but it only captures a limited view of the risks about which you, as an investor, should be concerned, and you should certainly not rely exclusively on the KIID or KID for your risk assessment.
Potential Future Performance:
Investors are naturally keenly interested in how their investment is likely to perform. Yet the investment industry continually trots out the line that past performance is not a guide to future performance – sometimes qualified by words such as ‘necessarily’.
So how do the KIID and KID documents respectively tackle this age-old difficulty?
The KIID document includes a chart showing actual past performance of the fund, usually compared against a relevant benchmark. It must be accompanied by a statement that past performance is not necessarily a guide to future performance. At least there is no controversy over the numbers – this is merely a record of what actually happened, not some kind of theoretical forecast.
The newer KID document takes a different path: rather than show past performance, it is required to show estimated future performance of your fund over three different periods, normally 1, 3, and 5 years, each under a range of different scenarios: ‘favourable’, ‘moderate’, ‘unfavourable’, and ‘stress’. The scenarios are named, but not explained on the KID. In fact, they are statistically defined, rather than based on actual historical scenarios.
As with risk, the idea is that you can directly compare these potential outcomes between different products, as they have to be calculated in a specific way.
This has been one of the most controversial aspects of the KID document, because the scenarios are calculated entirely from past returns. The KID is not actually saying that the past will be repeated; but it is assuming that future returns will follow the same distribution as in the past, which is leaning in that direction. Any product that has performed well in the last five years will show rosier potential future returns than one whose performance has been lacklustre.
Projecting out potential returns in this way seems like a much more direct contradiction of the ‘past performance is not a guide to future performance’ principle than showing historical charts. Of course it is natural to look at the past performance of any investment, but the leap to concluding the trick will be repeated is a dangerous one.
So the scenarios may be useful purely for comparison between funds, as they are all subject to the same assumptions. But you should resist the temptation to choose a fund solely because the KID is showing impressive future potential scenarios. They are illustrations based on assumptions, nothing more – and definitely not forecasts.
Investing in funds is not, unfortunately, free. In fact it can prove rather expensive, even if the investment performs well.
So how much will you end up paying, and what does it depend on? Well, firstly there are ‘explicit’ costs. These include the annual management fee, which is normally a fixed percentage of the value of your investment.
There may also be ‘entry’ costs for the privilege of being allowed to invest in the fund, and these can be as high as 5% of your initial investment, although such fees have largely disappeared in recent times. There can also be exit costs, particularly if you cash in after a short period – although again these have become rarer.
Finally, there could also be a performance fee that you pay only if the fund performs above certain defined targets, although these are rare in funds that are sold to private investors.
So your fund must perform at least well enough to cover all of these costs, or you won’t even get your money back.
But there are other costs. The older KIID does not consider them, but the newer KID does. In fact it has performed the welcome (to investors) service of shining a light on these for the first time.
When your fund manager buys or sells assets for the fund in which you are invested, they normally pay commission to a broker. The more actively they trade for the fund, the more commission they will pay. They may also pay stamp duty (tax) on purchases, and normally they also have to contend with the ‘spread’ – the fact that the market price to buy is higher than the price to sell. These and a range of other costs will together get bundled under the heading ‘transaction costs’. Unlike management fees, you don’t pay these directly; rather, they reduce the value of your investment – but rest assured that you are paying for them.
The KID actually does a decent job of highlighting the costs, and estimating their impact on your fund returns. As well as the fee schedule and the manager’s best estimate of those transaction costs (based on past averages), you will see something called ‘Reduction in Yield’ or RIY. This is an estimate of what the fees will actually do to the returns you get, and the total cash amount you will pay on a £10,000 investment, compared with a mythical world in which investing is free. Again, the KID regulations require fund managers to calculate and present the costs and RIY in a standard way that makes it easy to compare different funds.
There is still controversy over the calculation of the transaction costs, and the method of calculation it likely to be refined in future. Currently it is highly complex, and has been implemented slightly differently by different firms, so comparability between funds is at best questionable. Also, the figure quoted on the KID is based on averages over time, and may underestimate the true figure after a period of market disturbance when significantly higher levels of trading have occurred. At least the direction is toward greater transparency, which can only be a good thing.
So in summary, are the KIID and KID your friends? The answer is that you certainly should read them, as they provide useful information, some of which you won’t find in other documents, and they are a handy comparison tool. The regulators have gone to great efforts to try to ensure the information you get is ‘simple, clear, accurate, and not misleading’ (although many would question whether they have achieved this in the case of those performance scenarios on the KID). However, don’t make the mistake of assuming they give you the full picture. The world is more complicated than that.