Unit Trusts & Investment Trusts for Beginners
Part 1 of a new 3-part series designed to provide trustees with a guide to the various types of collective investments they may come across and when and why they might wish to use them.
A private family trust might be too small to hold a portfolio of individually held shares but it may wish to have a hedge against inflation by gaining some capital growth from its investments. To preserve capital but reduce the risk of direct investment in a few equities trustees have sought to spread their risk by investing in special funds. What are they?
Unit Trust Structure (the legal form can vary)
This is an open ended structure where an investor sends money to the manager and the manager creates units in response to day to day demand. The new money is used to buy more securities in the underlying fund. If redemptions exceed the new money coming in, the manager can destroy units and the underlying fund has to realise investments.
Pricing will reflect the value of the fund’s assets directly. However, there are costs to buying shares and costs to selling shares. An investor selling 10,000 shares in BP will get less than an investor would need to pay to buy those same shares. Unit pricing is therefore likely to reflect whether there are net buyers or net sellers of the units.
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In general the underlying fund will hold physical securities rather than derivatives to achieve the investment objectives. However, there are funds with this structure which invest almost exclusively in derivatives and other funds with significant exposure to derivatives. Many funds have some derivatives exposure but that exposure is marginal.
Most funds with this structure are actively managed but some are tracker funds.
The open ended structure works well when the underlying investments are in liquid markets such as that for UK shares. Where the underlying assets are large and difficult to sell, such as individual properties, investors may suddenly find that it is impossible to realise their assets in any reasonable timescale.
Some of these type of funds are Unit Trusts but the Open Ended Investment Company (OEIC) structure is becoming more common (Coming soon: An Idiots Guide to Exchange Traded Funds (ETFs))
An Idiots Guide to Investment Trusts
An Investment Trust is a company quoted on the Stock Exchange and all it does is manage a portfolio of investments. The manager has a finite fund which he manages in accordance with his mandate.
This is a closed-end structure. In normal circumstances the underlying fund is finite and fixed.
However, it can do all the things companies can do. It can issue warrants, which are rights to buy new shares at a fixed price. These rights can expire worthless if the shares never reach the strike price. It can have a normal rights issue to shareholders entitling them to buy new shares at a discount. It can even raise new equity through a placing.
It can also borrow money and therefore magnify an investor’s exposure to the stock market. That is good if the stock market goes up, because the investor benefits from the growth on the assets bought with the borrowed money. If the stock market goes down the investor has to absorb the losses on the investments made with the borrowed money as well as the losses on the rest of the fund.
Unless the Investment Trust has a fixed life, the shares are never redeemed. An investor can only buy or sell shares on the stock market just as with any other company. The price of the shares will depend on supply and demand, but not directly on the value of the underlying fund.
The share price may therefore stand at a discount or a premium to the value of the underlying assets. If the fund manager is seen as particularly good or the underlying assets are seen as attractive but difficult to invest in, the shares might stand at a premium to the underlying assets value. If the fund manager is seen as being poor or the underlying investments are seen as being unattractive, the shares might stand at a substantial discount to the value of the underlying assets.
Countries and sectors go in, and out of fashion. If say India is seen as attractive, an Investment Trust investing in India might have its shares standing at a premium to asset value. If there is bad news and India is suddenly seen as unattractive then the shares might quickly go to a discount to asset value.
For an investor this is bad because it adds to volatility. Someone might buy at a premium because India looked good, and then there is bad news and the Investment Trust shares start trading at a discount. The investor not only loses because the value of the underlying assets of the Investment Trust have fallen in value but the fall is magnified because the Investment Trust’s shares move from a premium to a discount on the reduced underlying asset value.
On the other hand there are positive features to the Investment Trust structure, for long term holders. If you can buy at a discount you are buying an income stream at a discount. If the Investment Trust stands at a 10% discount to asset value; £90 buys you the income on £100 worth of shares. At least it helps to pay for the fund management costs.
Many of the larger and older Investment trusts have low fund management charges.
The company structure also has another advantage for income investors. The company does not have to distribute all of its income in any particular year and it may hold an income reserve. That enables some investment trusts to stabilise the dividends it pays out by using money from its income reserve to maintain dividends, even when the dividends from the underlying portfolio fall.
There are therefore quoted Investment Trusts which have not cut their dividends for forty years. This is the sort of thing that it would have been nice to know forty years ago. For the future the board of such an Investment Trust will be reluctant to destroy a record like that, which has taken years to build up. On the other hand if the yield on the fund is high, maintaining that record could place dangerous constraints on how the Investment Trust is invested.
The closed end nature of the fund has other advantages such as enabling the fund manager to invest in shares that are relatively unmarketable. Venture Capital Trusts (VCTs) therefore have this structure. It also enables investment to be made a little more tax efficiency as the absence of the need for liquidity enables investments to be made through more complex tax structures.
Split Capital Investment Trusts introduce a further level of complexity, but there are benefits (Coming soon: An Idiots Guide to Split Capital Investment Trusts).
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