How Do Equity Income and Accumulation Funds Work? Mutual Fund Investing

When it comes to investing in mutual funds or open ended investments companies (OEICS) as they are called in the UK there are many questions that spring to mind. What is the difference between income and accumulation units? how do I know how the fund will perform? Will a fund continue to earn the same returns the future as it did in the past? Hopefully, this post will aim to answer questions you have on mutual funds.

Income Unit Funds Vs Accumulation Unit funds

With equity income funds, you get the dividend paid to you. With accumulation funds, your dividends get automatically re-invested in said fund. Yes, you are able to sell-off bits of your fund every year.

Please note that even though you do not physically receive a dividend when you buy accumulation units, the amounts re-invested is still taxable as dividends. Have a look at my post on the new dividend tax rates to see how dividends are taxed .

Does past performance mean a fund will continue to do well?

One of the biggest mistakes beginner investors make is they look at a particular mutual funds historical performance (5 years) and immediately assume they will continue to deliver those same returns.

Take the Fundsmith Equity Income Fund for instance which I am currently invested in. It has delivered stellar returns of 20% per annum over the past 6 years. Most investors will just look at the stat and throw money into the fund. But it is important to remember that just because a fund has done well in the past does not mean it will do well in the future

What to look for when Investing in a Mutual Fund.

When looking at which mutual fund to buy into, don’t concentrate too much on past performance. Instead you need to factor in other considerations such as the managers track record, the funds underlying holdings (the stock it owns) and the management costs/fees.

For Funds that don’t have high activity (don’t trade into and out of stocks a lot) looking at the underlying holdings is even more important. So if you are looking to invest in low activity funds like the Fundsmith Equity Fund or Lindsell Train Equity Income Fund, you need to look at what stocks the fund holds. You need to look at each holdings stock price, valuation e.t.c. If most appear to be overvalued, than why would you buy the fund at this time? If on the other hand you like the underlying holdings and think they are fairly valued, then you should consider investing in that fund.

When it comes to making money from mutual funds, your underlying holdings need to perform well. You need to understand that equity funds direct track the underlying holdings. So say a fund has Barclays, HSBC and Lloyds shares only. If all three drop by 10%, the fund will drop by 10%. If all three rise by 20%, the fund will rise by 20%. To keep it simply, I am assuming no management fee which is usually about 1%. So depending on how the underlying holdings perform that is how the fund will perform.

Should I buy stocks mutual funds hold myself?

The biggest advantages of investing directly in the underlying holdings (individual stocks) and not in a mutual fund is that you skip the management fee of about 1%.

The disadvantage is that you don’t know when the manager bought the stock (unless your willing to dig deeper), what price they bought the stock at and why they bought it. Some funds buy stocks to hedge against other stocks they have so just because they bought it, does not necessarily mean they think its price will go up.

How many funds do I need to buy to be diversified

To answer this, you once again need to look at the funds underlying holdings. There is no point buying 10 UK income funds because you know the biggest holdings in the funds will all be of the same companies e.g. GlaxosmithKline, British American Tobacco, HSBC, Royal Dutch Shell, BP e.t.c. Buying 10 UK income funds does not mean you are diversified. To be diversified via the mutual fund route, have a look at the underlying holdings and buy into several funds that own stocks in different companies.