Investment Funds and Management Fees Quiz

Topic 10: Collective Investments – Unit Trusts, Open-Ended Investment Companies, and Investment Trusts

• Collective investment combines investor capital for diversified asset class investments managed by experts.
• This approach offers lower dealing costs and expert management compared to direct investment.
• It allows investors access to a wider range of assets than individual investors can usually afford, like small company shares or corporate bonds.
• Unit trusts and open-ended investment companies (OEICs) share similar objectives and investment ranges, despite legal distinctions.

10.1 Introduction

• Unit trusts and OEICs combine investor capital for diversification and expert investment management.
• Dealing costs are reduced by economies of scale.
• Non-expert investors benefit from experienced managers.
• Collective funds offer access to a broader range of assets, overcoming limitations of minimum investment size.

10.2 Authorisation of Unit Trusts and OEICs

• Unit trusts and OEICs are regulated under the Financial Services and Markets Act 2000 and FCA rules.
• UK investors require FCA authorization for marketing.
• The authorization exempts the fund from capital gains tax.
• The European UCITS directive and the AIFM directive are relevant for cross-border fund marketing and cover diverse professional fund managers like hedge funds.
• UK funds are now categorised as Alternative Investment Funds (AIFs) by European Economic Area (EEA) member states. Post-Brexit, UK funds need to comply with EEA member state rules.
• The rules governing UCITS (including the legal entity) have been updated to increase investment flexibility, allowing investments in equities, bonds, derivatives, other investment funds, cash, and deposits.

10.3 Key Features of Unit Trusts

• Unit trusts involve a trustee, depositary and fund manager.
• The trust deed outlines responsibilities and powers for the manager and trustee.
• The unit trust fund is divided into units, each representing an equal fraction of the fund's total assets.
• Unit trusts are open-ended, meaning that the number of units changes based on demand.
• There are four types of unit prices: creation, offer, bid and cancellation price.

10.3.1 The Trustee

• The trustee is usually a major bank or institution.
• Duties include controlling trust assets, approving marketing materials, issuing certificates to investors, and ensuring the manager adheres to trust deed terms.

10.3.2 The Depositary

• The depositary oversees the creation, cancellation, pricing and related transactions of fund units, ensures timely disbursement of income, and safeguards assets.

10.3.3 The Fund Manager

• The fund manager (management company) manages the fund daily.
• Actively manages assets to maximize return.
• Prices units.
• Buys/sells units.
• Charges are set in relation to investment management and dealings in units.
• The fund manager will have a clearly defined mandate (rules) regarding their investment and borrowing powers, as outlined in the trust deed.

10.3.4 Unit Trust Charges

• Initial charge is deducted from the unit value on purchase. Includes fund asset purchase costs and advisor fees.
• Annual management charge is a percentage of the fund value, often 0.5%-1.5%.
• Advisors are not allowed to receive commission but may charge fees instead.

10.3.4.3 Ongoing Charges Figure (OCF)

• Represents the total annual cost of fund management, including management fees, custodian fees, and other operating expenses.
• It is a single figure that represents the annual cost of running a fund, shown as a percentage of the fund value.

10.4 Open-Ended Investment Companies (OEICs)

• OEICs are registered under UK company law.
• They are run by a depositary and an authorised corporate director.
• OEICs are open-ended, meaning the number of shares is not fixed.

10.4.1 Key Features of OEICs

• OEICs are regulated under company law.
• They involve a depositary and an authorised corporate director.
• Shares can be bought and sold like company shares.
• Investment trusts and OEICs can offer both accumulation and distribution funds reflecting the target of the investment.

10.4.4 Charges

• Initial charges are typically between 3% and 6% taken at the time of investment and are taken from the investment price rather than from the share value.
• Annual management charges usually range between 0.5% and 1.5%.

10.4.4.2 Annual Management Charge

• As with unit trusts, the annual management charge is deducted based on the value of the fund.

10.5 Unit Trusts and OEICs - Common Features

• Both involve pooled investments managed by experts.
• They are open-ended, allowing investors to buy and sell shares at any time.
• The rules regarding investment are set out in the trust deed or prospectus.
• They have a range of investment restrictions such as restrictions on holding shares of a particular company to prevent overconcentration in a company.

10.5.1 Investment Restrictions

• Unit trusts and OEICs cannot borrow long-term.
• There are restrictions on the percentage of shares of a company to avoid overconcentration or on the type of assets they hold.
• Investment must be in accordance with the trust deed or prospectus.
• Funds have a mandate requiring certain investments.

10.5.2 Forward Pricing

• Pricing is done on a forward basis (i.e., the price is set at the next valuation point), as opposed to real-time pricing.
• This is to prevent day traders.

10.6 Dealing in Unit Trusts and OEICs

• Investors can contribute with lump-sum payments, regular contributions, or a combination.
• Minimum investments often range from £500–£1,000 for lump sum and £25-£50 per month for regular investments.
• Shares can be bought and sold through financial advisors, fund supermarkets, or directly from the manager.

10.7 Types of Unit Trust and OEIC

• Funds are categorised by investment objectives, such as accumulation or distribution.
• These objectives dictate the strategies and types of assets the fund holds.

10.7.1 Tracker Funds

• Tracker funds aim to mirror the performance of a specific stock market index (e.g., FTSE 100).
• They use different strategies based on their need to replicate the index as closely as possible.

10.7.2 Funds of Funds

• Invest in many other funds, providing wider diversification.
• Managers of fund-of-funds do not directly manage the assets in the funds.

10.7.3 Total and Absolute Return Funds

• Total return funds aim for positive returns across income and long-term growth.
• Absolute return funds aim for returns regardless of market conditions. They use hedging strategies to mitigate risk.

10.7.4 Multi-Manager Funds

• These funds have several contracts with managers who are responsible for constructing portfolios to meet the fund's mandate(s), but these portfolios are usually not readily available in the open market.

10.7.5 Yield

• The prospective yield is the projected annual income the fund may earn.
• It is based on the latest annual declared dividends or distributions.

10.7.6 Taxation

• Equity unit trusts/OEICs are taxed on dividends using the annual dividend allowance and the investor's marginal tax band.
• Non-equity unit trusts/OEICs are taxed on interest distributions using personal savings allowances and marginal tax band.
• Gains are generally tax-exempt within authorized funds.

10.7.7 Risks of Unit Trusts & OEICs

• Risk is generally lower than direct investments because of diversified holdings.
• Risk will depend on fund's investment category(s) and the strategies used to mitigate risk.

10.8 Offshore Funds

• Often located in tax havens like the Channel Islands, Luxembourg, etc.
• They are regulated in the UK under FSMA 2000 requiring financial service providers to comply with FCA rules and regulations.

10.9 Investment Trusts

• Public limited companies that are listed on the stock market.
• Often offer expert investment management.
• The share capital is fixed, creating a supply/demand situation.
• They can borrow in order to reinvest.

10.9.1 Key Features of Investment Trusts

• Expert management and low costs.
• A closed-ended fund (fixed number of shares).
• Flexible investment strategies.
• Ability to borrow to invest.

10.9.2 Split Capital Trusts

• Have multiple types of shares (prior charges, zero dividends, etc) with different repayment priorities.

10.9.3 Net Asset Value (NAV)

• The market value of all assets, less liabilities, divided by the number of outstanding shares.

10.9.4 Gearing

• Uses borrowed funds for investment (higher risk but potential higher rewards).
• Risks are increased by gearing (ratio of debt to capital).

10.9.5 Charges

• Investors pay a spread (difference between bid and offer prices) for trade and an annual management charge, calculated as a percentage of assets.
• Dealing costs, stamp duty, and ISA charges may also apply.

10.9.6 General Notes

• Investment trusts allow investors to share in professional investment management and mitigate investment risks via diversification, unlike direct share or asset investment.

10.9.7 Taxation

• Gains within the trust are exempt from corporation tax and capital gains tax.
• Income, however, is subject to typical income tax regulations for regular income streams or capital gains based on type of investment in the trust.

10.10 Differences Between Investment Trusts & Unit Trusts/OEICs

• Investment trusts are publicly listed companies with fixed capital.
• Unit trusts/OEICs have variable share numbers.
• Investment trusts can borrow & operate more freely; unit trusts/OEICs have restrictions on borrowing.
• Investment trusts are typically less exposed to investor redemptions / outflows than unit trusts / OEICs.

10.11 Exchange Traded Funds (ETFs)

• Traded on securities exchanges (e.g., NYSE, NASDAQ).
• ETF shares or units can be bought/sold during the trading day.
• Passive strategies are common (e.g., tracking an index)
• Some 'active' ETFs are available.
• ETFs benefit investors from lower expense ratios.