What are unit trusts?
Unit trusts are a type of investment fund. Your money is combined with that of other investors and used to buy a number of different investments, with the resultingfund being split into equal units. Buying such units can provide a much wider spread of investment than you could have achieved for the same amount of money otherwise.
The money in the fund is invested by a fund manager according to the fund's objectives. Some funds are very general, while others are highly specialised. Most unit trust managersactively pick investments to try and beat a particular benchmark index, but some simply try to track an index, these funds are known as index trackers. Read thetrackers page for more details of actively managed funds vs trackers.
Unit trusts are 'open-ended', meaning that units can be created or cancelled to meet purchases and redemptions as necessary. Because of this the price of units(ignoring charges) trade at 'net asset value', i.e. the value of the fund's assets divided by the total number of units. This avoids the extra layer of risk inherentwith investment trusts where the share price can be higher or lower than the net asset value.
Open ended investment companies (oeics) are very similar to unit trusts, except that oeics have a single price at which units are bought and sold while unit trusts havea different price for each. For more details see the charges section below. Unless specified, please assume all references to unit trusts in this section also include oeics.
Who does what?
There are several parties involved in the running of a unit trust, as follows:
TrusteesFund ManagerRegistrarDistributor
The trustees job is to safeguard the fund's assets, so that even if the fund manager goes bankrupt your investment is safe because the assets are independently held.They also make sure that the fund manager sticks to the fund's objectives and doesn't break any rules.
A fund management group may act as fund manager, registrar and distribtor, but the trustees must be a separate entity.
Unit trust charges
There are two types of charges you'll face as a unit trust owner: charges for buying units and annual charges while you own the units.
Buying CostsAnnual Charges
When you buy or sell a unit trust there's normally a difference between the buying and selling price, much like when you buy foreign currency for a holiday and areoffered a lower price when exchanging any unused notes on your return. This difference between the buying and selling price is called a 'bid-offer spread' andrepresents the full cost to you of buying a unit trust.
Unit trust bid-offer spreads include the fund's initial charge (which tends to be zero these days) and are typically up to 2%.
Most oeics have a single price at which units are bought and sold, so there's no spread. The initial charge is simply deducted from your investment when you buy units.However, overall costs are little different from unit trusts, as you'll discover if you read the 'more details' section below.
To better understand the bid-offer spread it helps to look at the various types of price relevant to a unit trust:
- Creation Price - the cost to the manager of creating new units, i.e. the offer price of the underlying investments plus stamp duty and dealing costs.
- Cancellation Price - the amount the manager receives when cancelling units, i.e. the bid price of the underlying investments less dealing costs.
- Offer Price - the price at which investors can buy units, equal to the fund's initial charge plus at most the creation price and at least the cancellation price.
- Bid Price - the price at which investors can sell their units, at most the creation price and at least the cancellation price.
What happens with oeics? Well it's pretty much the same except that there's a single price rather than bid and offer prices. This price is normally in between the creationand cancellation prices and the initial charge is then added on top, so overall costs are little different from unit trusts.
The annual management charge is deducted automatically by the fund manager, usually on a daily basis (i.e. they divide the annual charge by the number of trading days each year and take thatfrom the fund each day). It doesn't just pay for the fund manager, but is also used to pay for any sales commissions to advisers/brokers, administration fees(including fund supermarkets), marketing expenses and the other costs of running the business (and contribute to profit!).
The 'hidden' costs incurred by a unit trust that are not included within the annual management charge are charged separately to the fund. These typically include fees forthe trustee, auditor and registrar, often adding 0.1% - 0.2% to total annual costs.
The 'ongoing charge figure' (TER) (formerly referred to as 'total expense ratio'), which includes both the annual management charge and all other annual costs paid by the fund, tends to fall slightly asa fund grows in size because some of the 'hidden' costs are often fixed. The diagram shows how a typical annual management charge (and OCF) might break down.
A few funds have performance related annual management fees, meaning the better the manager performs the more they might earn. In theory this is a good thing, as it shouldhelp align the manager's interests with yours. Unfortunately in practice most examples charge a reasonably high annual fee with a performance fee on top, this smacks of puregreed and is very unattractive to investors. Much better if a manager charges a fixed fee just high enough to cover overheads, with any balance related to performance.
Annual charges can crucify your investment return!
They're easy to overlook, but never underestimate the impact annual charges have on unit trust investment returns. Sure, a top-class fund manager may deliver performancethat more than compensates for their annual fees, but this tends to be the exception rather than the norm.
The following figures show the value of an initial £10,000 investment after 20 years assuming no initial charge and an annual return of 6% before charges.
| Fund OCF | Fund Value | Impact of charges |
|---|---|---|
| 0% | £32,071 | £0 |
| 0.5% | £29,178 | £2,893 |
| 1.5% | £24,117 | £7,954 |
| 2.5% | £19,898 | £12,173 |
What affects a unit trust bid offer spread?
The extent of the bid offer spread depends on the number of buyers and sellers. If the two broadly cancel each other out then the manager can simply pass units fromsellers to buyers, avoiding the need to create or cancel units. The spread should be pretty static and not much higher than the initial charge.
If there's far more sellers than buyers and the manager needs to cancel units, the bid price will fall to the cancellation price and widen the spread. If there's far morebuyers than sellers and the manager needs to create units, the offer price will rise to the creation price plus the initial charge and widen the spread.
In the case of oeics the manager cannot alter the spread because the buy/sell price must be the same. They instead have the option to impose a 'dilution levy' when thereare far more sellers than buyers and vice-versa. If they didn't do this then the other unit holders would bear the brunt of the costs of creating or cancelling units, whichwould be unfair.
How often is the price calculated?
Most unit trusts are priced daily, at a fixed time typically between 10am and 3pm. When you buy or sell units you'll normally do so at the next published price, known as'forward pricing'. This puts you at disadvantage because you cannot be certain at what price your units will be traded, although it should make little difference if you'reholding the units for several years.
How quickly can I get my money back?
In the normal course of events it's very easy to sell your units and receive the proceeds within a few days.
However, if there's so many sellers that the manager has to start selling the fund's underlying investments to repay them, there could be a delay if those investmentsprove difficult/slow to sell. In such cases the manager can close the fund to sellers until they've sold sufficient investments to meet the redemptions. This is mostlikely to occur on funds investing in physical property and very small illiquid companies.
What are funds of funds?
It's possible to buy unit trusts that in turn invest in other unit trusts and funds. These are called funds of funds and have become very popular in recent years.
The supposed advantage is that by combining a large investment portfolio within a single fund they can offer a 'one-stop' shop for your investment needs. The trouble isthey're usually expensive, because you end up paying not only the fund of funds manager charges, but also those of the funds held within. As a result fund of funds OCFs areusually between 1% - 2%, making them significantly more expensive than most conventional funds.
The main reason they've become so popular is that financial advisers charhge the same fee for selling funds of funds as they do for sellingconventional funds. It makes their life far easier to recommend just one or two funds of funds rather than constructing a portfolio of perhaps a dozen or moreconventional funds. They'll earn the same for less work, but you'll almost certainly end up paying higher annual charges!
Nonetheless, funds of funds that invest in a range of asset types (known as 'multi asset') can make sense if you have less than around £20,000 to invest. They shouldprovide you with a well diversified portfolio that wouldn't be practical to achieve otherwise.
What happens to income?
A unit trust might receive income from its underlying investments at various times throughout the year. To keep things simple the manager will combine the various incomesand pay it out to investors on pre-determined dates. These tend to be twice yearly, quarterly or monthly. When you buy an income producing fund you might have the option oftwo unit types:
Income UnitsAccumulation Units
If you buy income units then you'll receive income when paid out by the fund. You can, if you wish, re-invest the income in the fund by buying more units, although bewarethat some managers are particularly greedy and will apply the initial charge if you do so.
You're entitled to receive the next income payment from a fund provided you owned the units before the ex-dividend (xd) date, which is usually two monthsbefore the income is paid out. The price of units before the xd date should reflect the income due to be paid out, hence the price usually falls on the xd date (becauseanyone buying units from that date won't receive the next income payment).
If you purchase units before the xd date your first income payment could include some income covering a period before you bought the units. This part of the income iscalled an equalisation payment. It's not subject to income tax and must be deducted from the price you paid for units when calculating capital gains tax.
Does fund size matter?
Unit trusts range in size from a few million pounds to billions of pounds. Does this matter?
Fund too SmallFund too Large
If a fund is very small (less than c£25 million) and unlikely to grow in size then there's a risk the manager may lose motivation. Their earnings come from the annualmanagement fee, which is a percentage of the fund value. If the fund doesn't grow by much then neither will their earnings.
The TER is also likely to be high as the 'hidden' costs, which tend to be fixed, will have a greater impact.
On the plus side, small funds allow a manager to be very nimble. They can invest a reasonable proportion of their fund in specific companies (even very small ones) andtrade quickly.
Can I invest in a unit trust for my (grand)child?
Yes, it's very straightforward. Read the section on investing for children to find out more.
Unit trust sectors
To better help you compare like for like, the Investment Management Association (IMA) has created a range of unit trust sectors. When looking at a fund you can check it'sIMA sector then easily compare it will similar rivals. However, some sectors have fairly broad investment guidelines, so funds within a sector can sometimes vary quitemarkedly.
How can I buy unit trusts?
There are several ways to buy unit trusts, the route you choose could have a big impact on how much you pay. Whichever route you choose the minimum investment is likely tobe £500 - £1,000, or £25 - £100 if saving monthly.
Fund ManagerFund PlatformFinancial AdviserDiscount Broker
Buying a unit trust directly from the fund manager is normally the worst of all routes. You may pay an initial charge and relatively high annual charges but get no advice or guidance
There's no benefit in taking this route, so avoid.
Tax
Unit trusts pay income as either dividends or interest depending on the investments held within. There's no tax within the fund on any gains when the manager buys andsells investments, but any gains you make on selling the fund will be liable to capital gains tax.
The table below shows the tax payable on returns received from a unit trust.
| Return Type | Tax Type | Non Taxpayers | Basic Rate Taxpayers | Higher Rate Taxpayers | Top Rate Taxpayers |
|---|---|---|---|---|---|
| Interest* | Income Tax | 0% | 20% | 40% | 45% |
| Dividends* | Income Tax | 0% | 8.75% | 33.75% | 39.35% |
| Gains** | Capital Gains Tax | 0% | 10% | 20% | 20% |
| * On balance in excess of interest/dividend allowances. ** Tax only payable on gains above the annual capital gains tax allowance. | |||||
Whether the income from a unit trust is treated as interest or dividends depends on how much of the fund is invested in fixed interest and cash:
| Proportion invested in fixed interest and cash | Income treated as |
|---|---|
| More than 60% | Interest |
| 60% or less | Dividends |
From a tax point of view this makes no difference for ISA investors. If an interest bearing fund holds shares the dividends received have already suffered corporationtax, which cannot be reclaimed.
Outside of an ISA taxpayers will be a little better off by holding separate fixed interest and stock market funds rather than a fund that combines the two where incomeis treated as interest.
Jargon
Here's some of the more common unit trust jargon you might come across:
| Jargon | Meaning |
|---|---|
| Accumulation Unit | A type of unit trust unit that increases the unit price when income is distributed by the fund, rather than physically pay out income. |
| Cancellation Price | The amount a unit trust manager receives when cancelling units, the bid price of the underlying investments less dealing costs. |
| Creation Price | The cost to a fund manager of creating new units in a unit trust, includes the offer price of the underlying investments plus stamp duty and dealing costs. |
| Forward Pricing | When you buy or sell units in a unit trust you'll normally do so at the next published price, i.e. the 'forward' price. |
| Funds of Funds | An invesment fund that invests in a range of other funds (usually unit trusts). Provides a potentially wide range of investment but can be expensive. |
| IMA | Investment Management Association, the trade body for unit trust management companies. |
| Income Units | A type of unit trust unit that physically pays out an income when income is distributed by the fund. |
| OEICS | Open Ended Investment Companies, similar to unit trusts except that they have a single price at which units are bought and sold. |
| Open Ended Fund | An investment fund that can create and cancel units as required, i.e. it can expand and contract, e.g. unit trust. |
| Unit Trust | A type of investment fund, your money is combined with that of other investors and used to buy a number of different investments, with the resulting fund being split into equal units. |
