Investment fundsfall under two broad definitions – income and growth. An income fund provides investors with earnings from the dividends of the companies into which the fund manager puts money. A growth fund looks to grow the original sum invested as much as possible, or sometimes by a set amount.
To provide a stream of income to investors, fund managers look for companies that pay out relatively high dividends. An income stock generates lots of cash and pays some of it out as dividends, explains Hugh Yarrow, co-manager of the Rathbone Income fund.
Such companies are slightly more mature and dont need to put cash back into the business, so they give it to investors. A growth company, on the other hand, will tend to use its cash-flow to invest back into the business.
Whether you chose an income fund or a growth fund as your first investment depends on your circumstances and aims. With their more mature companies, income funds are often seen as less risky. However, this doesnt mean growth funds invest exclusively in high-risk young companies.
Ed Burke runs the Invesco Perpetual UK Growth fund: Im looking to have a high quality group of companies that can generate good levels of free cash-flow per share, he explains.
However, income-producing stocks are included in growth funds because the income, when reinvested, forms an important part of a companys total returns over the long term. Usually a company growing its dividend has a strong franchise and is capable of growing the cash-flow per share, Burke adds.
Generally speaking, younger investors may want to go for growth as they have a long investing future in front of them to recoup any losses. Those in later life cant afford to take such risks with their money and may be better advised to stick to safer investments. Certainly, investments in a pension need to be lower risk, particularly towards the time the investor is approaching retirement.
But income funds do offer the option of reinvesting the income to provide a growing capital sum. Brian Dennehy, managing director of financial advisers Dennehy Weller & Co, thinks this makes them all-purpose investments. The starting point should be equity income because we expect this type of fund to be less volatile, he explains.
Also, stocks with good income tend to outperform over long periods so income funds can give you a more secure investment with more growth.
The factsheet for a fund should outline if its manager is targeting growth or income, but the name of the fund could also give you a hint. Those designed to provide an income invariably have the word income in their title, but this is not the case for growth funds. However, there are other words you can look out for.
If a fund is called Alpha or Omega or Special Situations or Select Opportunities it tends to be a growth fund, explains Philippa Gee, investment director at Torquil Clark Financial Planning. The name usually gives an indication of what the manager is trying to do.
Burke, who also runs Invesco Perpetuals UK Aggressive growth fund, says: We are very clear in our literature on what the funds are trying to do. Investors need to know what is in a fund, and there is no substitute for doing some legwork and reading up very carefully on different funds.
Some growth funds performed way beyond expectations during the dotcom boom at the end of the 1990s. Fund managers made the most of rising prices in telecoms media and technology companies to achieve some outstanding returns for investors. But the boom was an anomaly and couldnt defy gravity forever. Today, growth managers dont expect a repeat of the quick profits made during that time.
Since 2000 there has been a return to the basic principles of investment, and dividends are an important part of that, explains Burke. In other words, managers who got their fingers burnt in the boom are careful not to invest in companies that promise over the top growth, because of the risks to investors money.
Equity income funds have a steadier track record, and over the long term income provides about half the total return of the equity market, points out Yarrow. He adds: Income stocks also outperform when the market is weakening because of their defensive qualities.
It is possible to buy an income fund and a growth fund to capitalise on the advantages that come with each type of investing. The charges on each type of fund are similar and selecting a good example of each type of fund could spread risk, giving exposure to a variety of companies.
Some investment houses manage both income and growth funds, which provide a little of each style in the same fund. But, explains Gee, there are only a handful of these funds: Theres nothing wrong with those funds, but there is less choice, she says. If you have a bit of money you can chose income and growth options from a whole variety of funds, which is better.