Guiding you through the fund jungle

Forget everything you've heard, there is no such thing as an ISA investment fund. An ISA (Individual Savings Account)is simply a wrapper that you place around one of three types of fund to protect the returns from tax. These underlying funds are unit trusts, open-ended investment companies (OEICs) and investment trusts. Each works in a slightly different way, but all three have the same goal - making you richer by tapping into the potentially higher returns available from investing in the stock market.

Forget everything you've heard, there is no such thing as an ISA investment fund. An ISA (Individual Savings Account)is simply a wrapper that you place around one of three types of fund to protect the returns from tax. These underlying funds are unit trusts, open-ended investment companies (OEICs) and investment trusts. Each works in a slightly different way, but all three have the same goal - making you richer by tapping into the potentially higher returns available from investing in the stock market.

What is the main aim of these types of fund?

Unit trusts, OEICs (pronounced "oiks") and investment trusts are all designed to give small investors easy access to the stock market, without having to invest in individual company's shares. They are often called collective investments, because they spread investors' money between dozens or even hundreds of different companies, reducing the damage to your pocket if any individual business fails.

They also allow those with limited time, knowledge or interest in investments to invest quickly and easily, because a professional manager does the job of picking stocks for you. Investment funds are also a cheaper way to invest in stocks and shares, bonds and property, because managers can keep charges down by buying in bulk.

Who sells them?

Fund managers, banks or building societies. All those ISA adverts by companies such as Aberdeen, Fidelity, Gartmore, Henderson, HSBC, Invesco, Jupiter, M & G, Perpetual and Virgin are actually promoting either unit trusts, OEICs or investment trusts. Buying them within the ISA structure simply means that all your returns can be taken free of income tax and capital gains tax. Investors can buy the underlying fund separately or as an ISA either direct from the company, or from an independent financial adviser, stockbroker or discount broker.

How do unit trusts, OEIC and investment trusts differ?

"All three types of fund are a basket of shares that aim to give you a diversified investment. Unit trusts and OEICs are broadly similar, but investment trusts have notable differences, and because of their structure can be a more risky place to put your money," says Anna Bowes, savings and investment manager with Chase de Vere.

Put simply, a unit trust is a pool of money from small investors that is used to buy a balanced spread of shares from a range of different companies. Investors buy units in the fund and can redeem these units whenever they wish.

OEICs arrived in the UK in May 1997 and are effectively a modern version of the unit trust. The key difference is that they operate a much simpler pricing system.

"When you buy a unit trust you will see the bid/offer spread. This is basically the difference between the price at which you buy units and the price at which you sell them. You buy at the offer price and sell at the bid price, which could be 5 or 6 per less," says Bowes.

The bid/offer spread covers managers' charges and commission paid to financial advisers. OEICs still have these charges, but they display them differently. "OEICs do away with the bid/offer spread. Charges for buying and selling are shown separately. This does not make them cheaper, but it does make charging straightforward, more transparent and easier to understand," she says.

Why are investment trusts so different?

Investment trusts also allow you to spread your money between different companies to reduce risk. They are also sold by major fund managers such as Aberdeen, Fidelity, Jupiter, Henderson and so on, although rarely by banks or building societies. Their structure is slightly more complex and the way they work makes them a riskier investment, although a potentially rewarding one.

While unit trusts simply divide a pooled fund of stocks and shares into equal units and issue them to investors, investment trusts are companies in their own right that are quoted on the Stock Exchange and invest in other companies' shares.

Unlike unit trusts and OEICs, investment trusts are closed-ended funds, which means they issue a fixed number of shares. The trust's own shares are also traded on the stock market and, like all shares, their price is determined by how much investors are willing to pay for them. When demand rises, the share price increases. This is where things get complicated. There can be a difference between the trust's share price and the value of its underlying investments. When demand is high and the share price is higher than the value of the trust's assets, it is said to the "at a premium", and when lower it is "at a discount".

Investment trusts currently trade at an average discount of 11 per cent. This means 89p will buy you £1 worth of shares, but dividends will still be based on the full £1 price. This sounds like a bargain, but may not be. If the discount narrows you can make a profit, but there is no guarantee it will narrow. It may even widen, which adds an extra element of risk to your investment.

Discounts vary according to the investment trust, and quite successful trusts may trade at a discount.

A further difference is that investment trusts can boost rewards through a process known as gearing. Again, this increases their volatility. Like any publicly-quoted company, investment trusts can borrow money and use it to buy other assets. If these assets rise in value at a greater percentage than the cost of the debt, the trust should provide higher returns. If the assets do not perform well, performance will be hit.

Which type of fund should I choose?

The differences between unit trusts and OEICs are marginal and should not trouble most investors. The only major difference is pricing. With OEICs it is easier to understand exactly what you are paying for shares in the fund, although this does not mean they will cost you less.

Fund managers such as Fidelity, Henderson and Standard Life have converted their funds from unit trusts to OEICs.

Investment trusts have more significant differences. They are typically more risky - the danger that the trust will continue to trade at a discount may cause uncertainty, as can gearing. Cautious investors and the elderly, who have less time to overcome any short-term losses, should think carefully before buying an investment trust. But if you invest for five or 10 years, with luck you should overcome any setbacks.

Average returns over the 10 years to October 2000 show that £1,000 invested in the typical unit trust or OEIC would have grown to £4,050, while it would have grown to £4,449 in the average investment trust. Both far outperform the average instant access savings account, which would have grown to just £1,480 over the same period

However, the return you receive will primarily depend on how the individual fund performs, regardless of whether it is a unit trust, OEIC or investment trust. An above-average unit trust beats an average investment trust every time, and vice versa. Picking the fund management group and individual fund is the most important decision you will make.

Investment trusts do have a clear advantage when it comes to charges. While unit trusts impose initial charges of up to 5.25 per cent and annual management fees of up to 1.5 per cent, investment trusts often have no initial charges (or around 0.25 to 0.5 per cent) and annual charges less than 1 per cent. With investment trusts you must pay stamp duty on share purchases at 0.5 per cent.

* Association of unit trusts and investment trusts (AUTIF) information service: 020-8207 1361 or www.investmentfunds.org.uk. Association of investment trust companies (AITC) information line: 020-7431 5222 or www.aitc.co.uk.