B2.05 UNIT TRUSTS & OEICs - BASICS

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1 B2.05 UNIT TRUSTS & OEICs - BASICS SYLLABUS Unit trusts Accumulation units Determination of unit price Forward and historic pricing OEICs FSA COLL Sourcebook Restrictions on investment Tracker funds Role of trustee/custodian Risk Unit trusts Unit trusts are pooled investments, allowing smaller investors to participate in the performance of a large, diversified and professionally managed fund Costs, in particular, investment management costs are shared and as a result are more affordable for smaller investors Investors benefit from a proportionate part of income generated (net of charges) and of capital growth (and are similarly exposed to a proportionate part of capital losses) Unit trusts are an indirect form of equity investment Each unit trust has stated investment objectives, for example, to achieve capital growth through investment in UK equities Some invest overseas or in specialist areas such as technology stocks, or specific geographical areas, and these tend to have higher management charges The costs of diversification and management of direct investments outside of unit trusts and similar pooled vehicles may be prohibitive for small investors Unit trusts are open-ended, which means that the number of units in issue can be adjusted to balance demand The bid price therefore exactly reflects the underlying asset value Units are bought at the (higher) offer price which includes the manager s initial charge, and dealing is through the manager, so the ability to buy and sell is certain There is no fixed term, and investors can encash their investment at any time Accumulation units Accumulation units do not pay out income, but accumulate it instead Investors receive a notification of the income accumulated (effectively reinvested) and this income is taxable in the usual way, just as if it had been paid out It is reinvested net of the usual tax credit The advantage for the investor is convenience, and the fact that the reinvestment is free of charges Unit trusts and OEICs are both generally required to distribute their income

2 This is intended to avoid the potential loss of tax revenue which would result if income was turned into capital gain, and therefore subject to CGT rather than the more onerous income tax Accumulation units separate income for tax purposes and therefore meet this requirement even though no physical distribution is made Determination of unit price A unit trust is said to be on a bid basis if prices are calculated assuming the trust is selling assets and so the valuation of assets is made allowing for selling costs This could arise in adverse market conditions where more investors are selling than buying units More usually, the trust is priced on an offer basis, assuming it is buying assets and so not having to meet selling costs Forward and historic pricing Units are usually dealt on a forward basis ie at the price at the next valuation Some unit trusts are dealt on a historic price basis (ie at the price at the last valuation) but must go to forward pricing if the market moves significantly (ie by 2% or more) Historic pricing offers the advantage that the terms of the deal are known when instructions are placed It does however mean that the movement in the markets since the last valuation is known and can be used by large investors to their advantage for example, effectively buying at yesterday s price when the market has performed strongly since The effect is to sell under-priced units which gives an advantage to those buying them, but is damaging to investors more generally Forward pricing is therefore fairer, because it avoids this OEICs OEICs are Open-Ended Investment Companies, so investors buy shares rather than units However, the number of shares can be varied according to supply and demand, much as with units in a unit trust The share price of an OEIC therefore exactly reflects the underlying asset value and dealing takes place through the manager OEICs are usually single priced (ie with no bid/offer spread) but there may be a separately stated initial charge In the past, it has not been allowed to have a bid/offer spread for OEICs, but this is now possible, although in practice, few OEICs do so The OEIC can apply a dilution levy to large purchases or sales This is intended to assist in meeting the costs of dealing in the underlying assets which may be necessitated by a large transaction The levy is paid into the fund and is not an additional charge OEICs were introduced because the structure is similar to other internationally available investment vehicles As with unit trusts, there is no fixed term Many unit trusts are therefore converting to OEICs, though there is no compulsion to do so

3 FSA COLL Sourcebook The FSA introduced a new Sourcebook, generally referred to as COLL for collective investments with effect from 13 February 2007 Many unit trusts and OEICs adopted it earlier on a voluntary basis Under COLL there are distinctions between retail UCITS and non-ucits funds and Qualified Investor Schemes (QIS) UCITS (Undertakings for Collective Investments in Transferable Securities) meet certain EU rules and so are more easily marketable on a cross-border basis Most unit trusts and OEICs meet these requirements and are UCITS Investment trusts cannot meet the requirements because they are closed-ended and UCITS must be open-ended QIS are aimed at more experienced investors Unit trusts and OEICs which are retail UCITS schemes cannot gear (borrow for investment purposes) on a long term basis However, short term borrowing against known future income (dividends etc) is allowed with a maximum of 10% of the fund A non-retail UCITS scheme can borrow up to 10% of the fund value on a long term basis and a QIS can borrow up to 100% of the fund value on a long term basis Most unit trusts and OEICs are retail UCITS and it is these funds with which these notes are primarily concerned The FSA changes resulting from the introduction of COLL do not affect the tax treatment of unit trusts and OEICs, nor the requirement to distribute income Restrictions on investment An equity unit trust or OEIC other than a tracker fund cannot hold more than 10% of its assets in any one share No more than four holdings can each exceed 5% of total assets This means that a unit trust or OEIC must hold a minimum of 16 shares (4 at 10% and 12 at 5%) In practice unit trusts and OEICs tend to have many more holdings than this theoretical minimum Diversification rules apply to fixed interest unit trusts and OEICs, and essentially require at least six different holdings with no single holding exceeding 30% of the total fund As with equity based funds, in practice, much greater diversification is the norm Tracker funds Tracker funds are passively managed They therefore tend to have lower charges compared to the average and compared to actively managed funds in particular Tracker funds aim to mirror an index such as the FTSE 100 There is always some variation from the index (known as tracking error)

4 There are various approaches, with full replication being most accurate, as it aims to fully replicate the make-up of the index Stratified sampling is a more approximate approach The manager chooses shares representative of the index rather than trying to precisely match each holding making up the index This may result in a larger tracking error, but with lower dealing costs There are also various computer modelling approaches, often referred to as optimisation Role of trustee/custodian The assets of a unit trust are held by the trustee (though investment decisions and valuation fall to the manager) The trustee must be entirely independent of the manager The trustee must ensure that the manager acts correctly and safeguards the rights of unitholders The trustee must also ensure that the register of unitholders is maintained, though it will be the manager that actually maintains it The assets of an OEIC are held by the custodian, who fulfils a similar role to that of the trustee of a unit trust The custodian must be independent of the ACD (Authorised Corporate Director) of the OEIC, whose role is similar to that of the manager of a unit trust The trustees and manager of a unit trust, and the custodian and ACD of an OEIC must all be FSA authorised Risk Because unit trusts and OEICs are open-ended, and supply and demand therefore have no effect on price (except in the extreme case where low demand triggers a move to bid pricing) The price of units or shares reflects the underlying asset value and there can be no discount or premium This removes one risk and reward element relative to investment trusts (the share price of an investment trust is influenced by supply and demand as well as asset value) This reflects the fact that investment trusts are closed-ended (ie there is a fixed number of shares in issue at any time) In addition, again unlike investment trusts, unit trusts and OEICs which are retail UCITS cannot gear (borrow to invest) This removes a further factor which can add to risk and reward The manager of a unit trust or ACD of an OEIC is also obliged to repurchase an investor s holding, so the ability to dispose of the investment is certain An investment trust holding needs to be sold on the stock market in order for the investor to realise his investment, and this requires a buyer to be available The result is that, assuming similar investment strategies, the degree of risk inherent in a unit trust or an OEIC is similar, and at a lower level than for an investment trust On the other hand, the potential return is lower than for an investment trust with the same investment strategy

5 Note however that investment objectives and strategy are also very important in determining risk So, for example, an investment trust investing in blue chip shares quoted on the UK stock market is likely to be lower risk than a unit trust investing in Far East Emerging Markets