AFA 1 Investment 2024 Topic 10 PDF

Topic 10 Collective investments – unit trusts, open‑ended investment companies and investment trusts Learning objectives After studying this topic, you will be able to demonstrate an understanding of the nature and characteristics of: ‹ unit trusts; ‹ open‑ended investment compa...

Topic 10 Collective investments – unit trusts, open‑ended investment companies and investment trusts Learning objectives After studying this topic, you will be able to demonstrate an understanding of the nature and characteristics of: ‹ unit trusts; ‹ open‑ended investment companies (OEICs); ‹ the different regulatory classifications of funds; ‹ investment trusts. 10.1 Introduction Although unit trusts and open‑ended investment companies (OEICs) are different legal entities and have different structures, their objectives, investment range and performance are virtually identical, to the extent that the Investment Association, formally known as the Investment Management Association, combines unit trusts and OEICs in its investment fund categories, as we will see later. For this reason, we will consider the basic structure of each separately and then consider the range of investment options they provide. Both unit trusts and OEICs are collective (or pooled) investments that combine the investment capital of a large number of investors to invest in a range of asset classes managed by investment experts. Collective investment offers the following general benefits. ‹ Dealing costs are lower than for direct investment due to economies of scale. ‹ Non‑expert investors benefit from the skill and expertise of experienced investment managers. ‹ From a practical point of view, a collective fund is able to invest in a wider range of shares, etc, than the individual investor. It may also open up the possibility of investing in assets that would not otherwise be available due to minimum lot/investment size (eg corporate bonds). For example, an investor with £1,000 to invest would realistically be limited to investment in the shares of perhaps three or four companies. With a collective fund, their £1,000 would typically give them a share in a portfolio of between 30 and 100 companies’ shares, or a similarly diversified investment in other assets. ©LIBF Limited 2024. All rights reserved. 291 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts Diversifying in this way spreads the portfolio risk, something an individual would find difficult to achieve with relatively modest sums available. ‹ Liquidity – in the majority of funds, the investor can realise the investment immediately by cashing in. Selling direct investments may be subject to delays in some circumstances, particularly if the assets are not particularly liquid – property or small company shares, for example. 10.2 Authorisation of unit trusts and OEICs Unit trusts and OEICs are primarily regulated under the terms of the Financial Services and Markets Act 2000 and Financial Conduct Authority (FCA) rules in the UK. The FCA authorises unit trusts and OEICs and the unit trust manager/authorised corporate director must be authorised if the fund is to be marketed to UK investors. A further benefit of authorisation is the exemption from capital gains tax within the fund. It is also important to recognise the European directive on Undertakings for Collective Investments in Transferable Securities (UCITS) and the Alternative Investment Fund Managers (AIFM) directive. The UCITS directive is designed to enable the cross‑border marketing of funds to retail and professional investors. The AIFM directive covers the fund managers of those funds that are not authorised as UCITS, including professional investor focused funds such as hedge funds and private equity funds, as well as real estate funds. As part of the process of the UK’s exit from the EU (Brexit), the UK government ‘onshored’ both the UCITS directive and the AIFM directive (onshoring refers to the process of amending EU legislation and regulations so that they work in a UK-only context). However, as the UK is no longer an EU member state, UK domiciled UCITS are now classed as alternative investment funds (AIFs) by European Economic Area (EEA) member states. UK UCITS are no longer able to be marketed across the EEA under the UCITS passport and must instead comply with the national rules in each member state. Since its launch in 1985, the EU UCITS rules have been adapted and updated; the latest directive, UCITS IV, was adopted in 2009. Under the original rules, UCITS could only invest in equities and bonds, and could invest in derivatives only for hedging purposes. Under the new rules, funds can now invest in equities, bonds, derivatives for investment purposes, other investment funds, cash and deposits. This gives managers more flexibility and scope when making investment decisions. It is important to bear in mind that managers are not obliged to widen the scope of an existing fund; UCITS purely sets out the ‘outer limits’ within which a manager must operate. 10.3 Key features of unit trusts ‹ There are three required roles in a unit trust – the trustee, the depositary and the fund manager – which have responsibilities for the efficient operation of the trust. ‹ A unit trust is a pooled investment created under trust deed. The trust deed places obligations on both the manager and the trustee, and the fund manager will have a clearly defined mandate (rules) regarding their investment and borrowing powers, as outlined in the trust deed. 292 ©LIBF Limited 2024. All rights reserved.  10.3 Key features of unit trusts ‹ The unit trust fund is divided into units, with each unit representing an equal fraction of the trust’s total assets. For example, if there were 5m units in circulation and the fund’s assets were valued at £10m, each unit would be worth £2. ‹ There are four unit prices: — Creation price – the price at which the trustee/depositary creates units on behalf of the unit trust manager. — Offer price – the price at which investors buy units in the fund. — Bid price – the lower price at which the manager buys back units from investors who wish to sell (cash in) their investment. — Cancellation price (also known as the minimum bid price) – a price lower than the bid price that is invoked if the manager is required to buy units back but has little prospect of selling them again in the short term. The cancellation price is rarely used but may apply if there are unusually large amounts of units being encashed or if the market has fallen dramatically. The units will then be cancelled rather than resold. Invoking the cancellation price will protect those investors not wishing to sell. The different prices and the associated spreads are shown in the following figure. Figure 10.1 Different unit prices and spreads Price OFFER price (OFFER BASIS) OFFER price (BID BASIS) INITIAL CHARGE BID/OFFER SPREAD (OFFER BASIS) BID/OFFER SPREAD PRICE OF CREATING UNITS BID price (OFFER BASIS) PRICE OF CANCELLING UNITS = BID price (BID BASIS) ‹ A unit trust is open ended – the number of units is not fixed. The manager can create more units in response to demand and can cancel units if they have been surrendered and there is little prospect of reselling them. ‹ The manager is obliged to buy back units from investors wishing to sell, unless the fund has suspended or gated redemptions (ie a full or partial restriction on withdrawals). ©LIBF Limited 2024. All rights reserved. 293 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts 10.3.1 The trustee The unit trust trustee is usually the trustee department of a major bank or financial institution. The trustee has an overall responsibility to ensure investor protection, to which end they will have a number of duties: ‹ to hold and control trust assets; ‹ to approve proposed advertisements and marketing material; ‹ to collect and distribute income from trust assets; ‹ to issue unit certificates to investors; ‹ to supervise the maintenance of the register of unit holders; ‹ to ensure that the manager complies with the terms of the trust deed. 10.3.2 The depositary The fund depositary is responsible for: ‹ oversight of the sale, issue, repurchase, redemption, cancellation and pricing of units; ‹ carrying out the instructions of the fund manager (unless they conflict with laws, fund rules or the prospectus); ‹ ensuring consideration from transactions involving the fund’s assets are remitted in a timely manner and that income is applied correctly; ‹ monitoring cash flows concerning the fund’s assets, making payments and booking cash correctly; ‹ safekeeping the fund’s financial instruments in custody and verifying and recording the fund’s other assets. 10.3.3 The fund manager The fund manager is responsible for: ‹ managing the unit trust fund; ‹ valuing the assets of the fund on a daily basis; ‹ setting the price of units; ‹ offering units for sale; ‹ buying back units from unit holders who wish to sell; ‹ generating profit from charging management fees and dealing in the units. The fund manager (also known as the ‘management company’) may be different from the investment manager, who is responsible for executing the investment strategy of the fund. 294 ©LIBF Limited 2024. All rights reserved.  10.3 Key features of unit trusts 10.3.4 Unit trust charges 10.3.4.1 Initial charge The initial charge is taken from the value of units when they are purchased and covers the costs of purchasing fund assets and commission payments to advisers. The initial charge is typically between 3 per cent and 5 per cent, and forms part of the bid–offer spread – the difference between the price investors pay for units (the offer price) and the price they receive when selling units back to the manager (the bid price). Similarly, an exit charge may be levied by the fund, particularly if an investor hasn’t remained subscribed to the fund for a predefined minimum period. 10.3.4.2 Annual management charge The annual management charge, as the name suggests, is the fee paid for the use of the professional investment manager. The charge will vary but is typically in the region of 0.5–1.5 per cent of fund value. Overseas funds tend to be the most expensive; gilt, fixed‑interest and tracker funds tend to be the cheapest. Although shown as an annual fee, it is commonly deducted on a pro rata monthly or daily basis from the income received by the trust from its investments. 10.3.4.2.1 Changes to fund charges and payments Advisers cannot receive commission for advising on investments; they can only charge a percentage fee, an hourly rate or an agreed fee. Most advisers use platforms to hold client funds, and many clients deal directly with platforms, many of which also offer advice. The FCA Paper PS 13/1, known as the ‘Platform Paper’, sets out rules for platform charges, effective from April 2016. Traditionally, part of a fund’s initial charge and annual management fees included an element to pay commission to the adviser and/or platform. These were known as ‘bundled’ or ‘inclusive’ funds. Platforms and advisers are now required to make their client charges transparent by showing the fund charges and their own charges separately, and make arrangements to take a platform or advice fee from the investor rather than take it as commission. All funds are required to adopt what is called ‘clean pricing’ for all new fund investments, unless the investment was part of an ongoing regular commitment entered into before 6 April 2014. Clean pricing strips out the commission element of the charges, resulting in lower initial and annual charges – these funds are commonly referred to as ‘unbundled’ or ‘clean’. Platforms and advisers are then required to show their own charges separately. Specific rules apply to investments that were made in bundled funds before April 2014, referred to as ‘legacy’ investments. ‹ Fund managers were required to provide platforms with access to clean funds by April 2016, so that they could convert or switch investors’ legacy funds into the clean funds. ‹ Platforms were expected to convert or switch investor holdings unless it was to the investor’s detriment – in other words the cost of the new units plus platform charges was higher than the previous bundled charge. ©LIBF Limited 2024. All rights reserved. 295 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts ‹ If a platform chose not to convert, or certain funds did not offer clean units, any payment received from the fund manager must be passed on to the investor as a cash rebate or as additional units. ‹ It is up to the platform whether it holds exclusively clean funds or continues to hold clean and bundled funds. This means that investors not wishing to convert may have to move to another platform or investment manager. ‹ If the investor decided not to convert or switch, and the platform continues to offer bundled funds, it must pass on all money received from the fund manager to the investor, either as a cash rebate to be set against the platform charges, or as additional units. Cash rebates to investors will be taxable as income for the investor unless they are held in ISAs or SIPPs. Although the changes mean that investors will usually pay a lower management fee, they are likely to have to pay a clearly identified platform fee. In practical terms the total cost may not be significantly different, but the separate fees will be clearly identified. 10.3.4.3 Ongoing charges figure (OCF) Investment funds are required to outline the annual management charges taken for running the fund. However, this figure on its own may provide a distorted picture of the total cost of running the fund because other costs are likely to apply and may change the picture. Cost and charges must be presented in the Key Investor Information Document (KIID), which is made available to investors when subscribing to a UCITS. Similarly, they must be presented in the Key Information Document (KID), which is made available to retail investors when subscribing to a packaged retail insurance and investment product (PRIIP) such as an alternative investment fund (AIF). The OCF replaced the total expense ratio as the FCA’s required indication of the true cost of running a UCITS. It is a single figure representing the annual charge paid by the investor and is normally shown as a percentage of the fund value. It includes all the costs of managing the fund, carrying out administration and the costs of oversight. It involves a calculation of the ‘drag’ on investment performance caused by the total cost of operating the fund, including the annual management charge and the costs of other additional charges and services paid by the fund. In simple terms, the OCF is the percentage of a fund’s assets taken by annual charges. In addition to the annual management charge, the additional costs include: ‹ trustee and depositary fees; ‹ custodian fees; ‹ auditors’ fees; ‹ tax adviser fees; ‹ legal adviser fees; ‹ registrars’ fees; ‹ regulatory fees; ‹ other operating costs. As an example of the effect of expenses, if an investment of £10,000 grew at a rate of 8 per cent a year with no management expenses, it should be worth £21,600 at the end of 296 ©LIBF Limited 2024. All rights reserved.  10.4 Open‑ended investment companies (OEICs) ten years. If the OCF was 1.5 per cent a year, the return would be reduced to £18,770 – a reduction of £2,830, and an effective rate of return of 6.5 per cent. 10.3.5 Equalisation payments Unit trust and OEIC managers must pay out all accumulated income to investors, and they set an ex‑dividend date in the same way as a company does when paying share dividends. The manager receives income at regular intervals from the underlying investments and, each time the manager receives income, it will be reflected in an increase in the unit price. This means that the buying price of units/shares between the previous and next dividend payment dates will include the income accumulated to that point. In simple terms, a new investor is using capital to buy the income accrued before they bought units. When the next distribution is made, the unitholder will receive the full dividend. However, the payment will be split in two for tax purposes: ‹ An equalisation payment, which reflects the cost of buying the dividend accrued before purchase. This is treated as a return of capital and is not taxed. ‹ A dividend payment, which reflects that part of the dividend accrued after the unit was purchased. This is taxable as a dividend in the usual way. The equalisation payment only applies to the first dividend distribution after buying units. A record should be kept of any equalisation payments as they count as return of capital and can be included in the cost of purchase when calculating gains for capital gains tax purposes. 10.4 Open‑ended investment companies (OEICs) Open‑ended investment companies (OEICs) have been popular in mainland Europe for a number of years and have become increasingly popular in the UK since their introduction in 1997; they are formally referred to as investment companies with variable capital (ICVCs). OEICs are a pooled investment offered by a company that buys and sells the shares of other companies and deals in other investments. An OEIC may offer a number of different funds with different classes of share available within each fund. 10.4.1 Key features of OEICs ‹ An OEIC is established under company law, rather than under trust. ‹ There are two required roles in an OEIC – the depositary and the authorised corporate director, both of whom have responsibilities for the efficient operation of the fund. ‹ The fund will have a clearly defined mandate (rules) regarding its investment and borrowing powers, as outlined in the prospectus. ‹ Investors buy shares in the OEIC. The authorised corporate director is able to create more shares on demand, which means that the number of shares is unlimited: the OEIC is open ended, like a unit trust. The value of the shares will vary according to the market value of the underlying investments. ©LIBF Limited 2024. All rights reserved. 297 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts ‹ An OEIC may be structured as an ‘umbrella company’ that is made up of several sub‑funds. Different types of share can be made available within each sub‑fund. ‹ The value of each share is directly related to the value of the underlying assets. In simple terms, the value of the assets in the fund is divided by the number of shares in issue. The result is the share value, or the net asset value. This means that OEIC share prices can be directly compared to the bid value of a unit trust. ‹ The manager is obliged to buy back shares from investors wishing to sell. ‹ There are some differences in pricing when OEICs are compared with unit trusts. Shares are usually single priced, which means the buying and selling prices are the same, although the manager can deduct an initial charge from the investment. This contrasts with unit trusts, where the units are bought at one price (offer) and sold at another (bid). It is possible for an OEIC to adopt dual pricing in the same way as a unit trust. ‹ In common with other companies, OEICs must arrange an annual general meeting (AGM) for the shareholders. Two key elements in the AGM will be the presentation of the annual report and the reappointment of auditors. ‹ Equalisation payments may be made with the first income distribution, as with unit trusts. 10.4.2 The depositary The depositary has a similar role to the unit trust trustee in relation to holding assets, ensuring the manager meets the investment criteria, and administering the fund assets. 10.4.3 The authorised corporate director The authorised corporate director is responsible for: ‹ managing the investments; ‹ buying and selling OEIC shares as required by investors; ‹ ensuring that the price of the shares reflects the underlying net asset value of the OEIC’s investments; ‹ other regulatory functions, including risk management, administration and marketing. These functions can be delegated, subject to limitations. 10.4.4 Charges 10.4.4.1 Initial charge Shares are normally single priced, in which case there is no bid–offer spread. An OEIC will levy an initial charge, however, normally in the region of 3–6 per cent of the value of the investment, at the time when the investment is made. The OEIC initial charge is taken from the investment rather than by adjusting the share price. Some OEICs have taken advantage of a change in the rules to establish a dual‑pricing system, where the initial charge is taken by selling shares at the offer price and buying them back at the bid price, in the same way as unit trusts. 298 ©LIBF Limited 2024. All rights reserved.  10.5 Unit trusts and OEICs – common features 10.4.4.2 Annual management charge As with unit trusts, annual management charges are deducted based on the value of the fund. The range of annual management charges is typically between 0.5 per cent for index tracking and 1.5 per cent for more active management. Other administration costs may also be deducted from the income that is generated. As with unit trusts, many funds have introduced ‘clean’ share classes to accommodate the changes to adviser remuneration that took effect from 31 December 2012. 10.4.4.3 Anti-dilution levy The anti-dilution levy (ADL) may be made where a large amount of money comes in or out of the fund at the same time. It is designed to protect the interests of other investors and will be added to the buying price or deducted from the selling price. The levy covers dealing costs and the spread between buying and selling prices of the fund assets. It performs a similar function to the unit trust cancellation price. Other ‘tools’ can be used alongside ADLs, including: ‹ dilution adjustments – similar to ADLs, but only applied to the price that substantial investors that are subscribing/redeeming to the fund on a particular day receive, rather than all investors subscribing/redeeming; ‹ large deal provisions – in accordance with FCA COLL 6.3.5C, guidance enables provision to be made in the fund’s prospectus for large deals to be carried out at a higher sale price or a lower redemption price than those published, provided they do not exceed the relevant maximum and minimum parameters. 10.4.4.4 Ongoing charges figure (OCF) OEIC managers are also required to show the OCF for OEICS. Ongoing charges are those expenses that are likely to recur in the foreseeable future, whether charged to capital or revenue, and that relate to the operation of the investment company as a collective fund, excluding the costs of acquisition/disposal of investments, financing charges and gains/ losses arising on investments. Ongoing charges are based on costs incurred in the year as being the best estimate of future costs. 10.4.4.5 Total expense ratio (TER) The TER described in section 10.3.4.3 also applies to OEICs. The TER and OCF are very similar as they include the annual management charge plus additional ongoing variable costs, but the TER does not include performance fees or one-off charges (which are shown separately on the KIID and KID). 10.5 Unit trusts and OEICs – common features As mentioned earlier, unit trusts and OEICs share a number of common features, which we will consider here. ©LIBF Limited 2024. All rights reserved. 299 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts 10.5.1 Investment restrictions Rules regarding unit trust and OEIC investment include (but are not limited to) the following: ‹ Unit trusts and OEICs cannot borrow on a long‑term basis. The manager/director can borrow up to 10 per cent of the fund’s assets on a short‑term basis against known future inflows of capital. ‹ There are a number of investment restrictions that provide a spread of investment risk within a unit trust or OEIC: — A unit trust cannot hold more than 10 per cent of the total fund value in the shares of any single quoted company unless the fund is an index tracker. Up to four separate companies’ shares can be held to this limit. Share holdings in any other company must not exceed 5 per cent of total fund value. — Tracker funds can hold up to 20 per cent of the fund value in a single company’s shares. Where it can be justified, the limit can be increased to 35 per cent. This rule is in place to allow for the fact that a tracker fund tracks a share index, which may have a weighting of more than 10 per cent for larger companies. ‹ These two rules mean that a non‑tracker equity unit trust must have share holdings split between at least 16 different companies, and in addition: — the fund cannot hold more than 10 per cent of any one class of a company’s voting shares, unless the fund is an index tracker; — the trust deed or company rules will normally allow for an investment of up to 5 per cent of the fund to be invested in unquoted shares. ‹ A fund with more than 35 per cent invested in government securities from the same issuer must invest in at least six different stock issues, with no single holding exceeding 30 per cent of the fund value. ‹ Apart from money market funds, the sole purpose of which is to hold cash‑based investments, a unit trust or OEIC can only hold cash for liquidity purposes and to provide for cash flow needs. 10.5.2 Forward pricing Unit trusts and OEICs must be priced on a forward basis. As the name suggests, forward pricing means that the investor will buy units at the price set at the next valuation point – an unknown price. So, for example, if an investor executes a purchase at 3pm, they will not know the price they will be paying until noon the next business day. The unit price shown in the financial press is the last declared price; the actual price will be unknown at the time an investor deals. Forward pricing is used to prevent so-called ‘market timing’ whereby investors buy, sell or switch investments to exploit fund prices that do not reflect the current or expected market value of the underlying securities held by the fund. 10.6 Dealing in unit trusts and OEICs An investor can contribute to a unit trust or OEIC with a lump‑sum payment, regular contributions or a combination of both. A minimum of £500–£1,000 will normally be required as a lump‑sum investment, with regular payments starting from £25 to £50 a month. 300 ©LIBF Limited 2024. All rights reserved.  10.7 Types of unit trust and OEIC Unit trusts and OEICs can be bought and sold in a variety of ways: through a financial adviser; through a fund supermarket; or directly from the manager via the internet, by telephone or through the post. One important point is that buying directly from the manager does not reduce the initial charges. In many cases it is actually less costly to buy through a discount broker or fund supermarket, which will offer a discount from the initial charge. Funds usually offer these discounts and other characteristics by issuing different classes of shares and units. Share classes may have different fees, be denominated in different currencies and have different minimum subscription limits if they are intended for different types of investor. A telephone deal has the same contractual status as a written deal, and once the ‘order’ has been received, the units/shares will be purchased at the next valuation point (or immediately, if pricing is historical) and a contract note sent out. The investor will receive a statutory cancellation notice, which gives the right to cancel the deal within 14 days of receipt. If the cancellation notice is returned, the investor will receive back the lower of their original investment and the offer price on the date of cancellation. This is designed to protect other investors by preventing investors cancelling purely because their investment has fallen in value. 10.6.1 Share exchange Many unit trusts and OEICs offer a share‑exchange facility. If a prospective investor has a portfolio of shares, the manager may agree to buy them and allocate the proceeds as an investment into the unit trust. This will save the investor the stockbroker’s dealing charges. If the shares are not attractive to the manager as an investment in their own right, then they may offer to sell them through a stockbroker at reduced charges in return for investing the proceeds in the unit trust. Although the term ‘exchange’ is used, liability for capital gains tax is not removed because the sale of the shares and the investment in the unit trust are treated as two separate transactions. Some fund managers may also offer switching (also called converting) between different sub-funds. 10.7 Types of unit trust and OEIC A wide range of unit trust and OEIC funds are available, categorised according to the nature of the investment objectives. The markets and types of investment in which the funds can invest are defined in the FCA’s Collective Investment Schemes Sourcebook. The allowable investments are equities, bonds, gilts, cash, warrants, futures and options, and property. There are two broad categories of fund – accumulation and distribution. Essentially, income received must either be paid out to investors or accumulated in the fund and reinvested. The manager has very limited scope to hold income received in reserve for distribution at a later date. Funds within each category have different strategies and objectives. ‹ Accumulation (growth) funds – the objective of accumulation funds is capital growth. The underlying investment is often in shares likely to benefit from growth, while not likely to produce significant income. Any income received from underlying ©LIBF Limited 2024. All rights reserved. 301 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts assets is automatically reinvested into the fund, thus increasing the value of each unit – hence the term ‘accumulation’. ‹ Distribution (income) funds – these have a different investment objective. The primary objective is to produce income, the level of which depends on the exact nature of the fund. Investment income received by the fund manager is paid out through dividends or interest distributions. The investor can choose either to take the income and spend it, or to reinvest the income by buying more units in the fund. This will result in the investor holding more units, rather than seeing an increase in the value of the existing units. ‹ Equity income funds aim to produce an income in excess of the yield from the FTSE All Share index by distributing the bulk of income received to unit holders. The underlying investment is primarily in shares, which means that the fund offers the potential for capital growth as well. ‹ Gilt and bond funds produce an income through investment in government securities and corporate bonds. Due to the nature of the underlying investment, the potential for capital growth is lower than for equity funds, although the funds tend to be less volatile. Income is paid on a regular basis, either monthly, quarterly, half‑yearly or annually, depending on the way the fund is structured. Many funds today offer investors the choice of buying accumulation or income units in the same fund, effectively splitting the fund into income and accumulation sectors, each investing in exactly the same assets but either accumulating income or paying it out. Unit trust and OEIC management can be broadly divided into two ‘styles’. ‹ ‘Passive’ management involves the manager tracking an index or other benchmark. It does not involve any investment decisions or analysis, other than ensuring that the fund tracks the chosen index. Management charges tend to be low. ‹ ‘Active’ management involves the manager making day‑to‑day decisions, analysing the markets and selecting shares and investments to buy and sell. The investor pays for the expertise through higher annual management charges; however, many experts are sceptical of the ability of most active fund managers to add sufficient value to the investment performance to justify the additional costs. 10.7.1 Tracker funds Tracker funds aim to track (match) the performance of a stock market index, eg the FTSE 100. The manager attempts to buy the shares appearing in the index in the proportion (weighting) in which they appear. The fund is not actively managed because the manager need only make sure that the index is replicated in the shares held. This keeps fund charges down compared with managed funds. There are three types of tracking. ‹ Full replication – the manager matches the shares and proportions of the index exactly. Although this will produce the closest tracking, it can be expensive with widespread indices (FTSE 250, etc) because a lot of small holdings may be necessary in order to match the number of shares in the index. It can also pose problems with the major indices because any one share cannot exceed 10 per cent of the trust’s total, and some shares in the index will represent more than 10 per cent of the index total. 302 ©LIBF Limited 2024. All rights reserved.  10.7 Types of unit trust and OEIC ‹ Stratified sampling – the manager divides (‘stratifies’) the index into categories and then buys a representative sample of shares from each category. This may not produce close tracking because it is not an identical replication of the index. ‹ Optimisation – the manager uses technology to produce an analytical model of the market, based on past performance statistics. This can lead to errors because the market is constantly changing and models may not accurately reflect those changes. 10.7.1.1 Tracking error Tracking error is the degree of accuracy with which a fund tracks the index. Given that the tracker fund is designed to follow the index, success is measured by closeness to the index rather than outright performance, as in managed funds. 10.7.2 Fund of funds A fund of funds invests in a variety of other funds, so achieving wider diversification than is possible using just one fund. There are two ways in which the fund of funds can operate, as follows. 10.7.2.1 Fund of funds (FoF) The fund of funds principle is very simple. The trust mandate is established and then the manager invests in a range of other unit trusts available in the market that fall within the mandate, the idea being to spread the risk even further and increase diversification, exposing the fund to different management styles. Each individual fund will have its own mandate, established by its own deed of trust, which means that the fund of funds manager will have no direct influence on the investment strategy of each one. Their only option, if they are not happy, is to change to another fund. A fund of funds can be fettered, which means it can only invest in internal funds offered by the ‘host’ provider, or unfettered, meaning that it can invest in external funds offered by other companies. A typical FoF will charge an annual management fee of around 0.75 per cent, over and above the charges that apply to each individual fund. It is therefore important for investors to consider the impact of this double layer of fees. Figure 10.2 Fund of funds structure Fund Fund A Fund B Fund C Fund D ©LIBF Limited 2024. All rights reserved. 303 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts 10.7.2.2 Multi‑manager funds Multi‑manager funds (also called manager of manager funds) operate on a different principle. The manager of the fund will have contracts with a number of portfolio managers, each of whom will construct a portfolio to meet the mandate set by the manager of the multi‑manager fund; these portfolios may not be available in the open market. The mandate will detail what is expected of each portfolio manager, including performance benchmarks, objectives and asset allocation. The role of the manager of the multi‑manager fund is to identify competitive managers, to monitor closely the performance of each fund through regular (often daily) reporting and tracking, and to replace portfolio managers who do not perform to the required standard. Figure 10.3 Multi-manager fund structure Fund Manager Manager Manager Manager A B C D 10.7.3 Total and absolute return funds In a volatile market, traditional investment funds that attempt to outperform the stock market, either by tracking an index or by setting equity‑based benchmarks, have produced mixed returns. The very nature of the target means that the funds are likely to produce gains when markets are rising but will suffer when markets fall. In addition, predictions of lower gains from equities in the foreseeable future mean that investors are looking for other ways to enhance their returns. UCITS III became effective in December 2002 and was introduced primarily to allow funds authorised in one EU country to be marketed across the EU without the need to be authorised in each member state. The updated UCITS directives allow fund managers to use a wider range of asset classes than was previously permitted, including derivatives such as futures, options, warrants and contracts for difference. As a result of the pressure to achieve performance and the changes to permitted investments, many fund managers launched new funds that take a different approach to investment, namely total return and absolute return funds. Although many investors see these two approaches as similar in principle, and fund managers use both terms to describe a range of approaches, it is important to distinguish between the two. 10.7.3.1 Total return funds The total return fund, sometimes called a ‘target return’ fund, aims to produce long‑term positive returns (over three to five years) from a combination of income and capital growth, and to minimise capital losses by adopting what are known as long positions. A long position can best be described as purchasing securities, commodities or derivatives in the anticipation that they will increase in value over time and can be sold at a profit. 304 ©LIBF Limited 2024. All rights reserved.  10.7 Types of unit trust and OEIC Total return funds are usually benchmarked against cash, although some funds benchmark against an index or a ‘peer group’. Cash‑benchmarked funds aim to achieve the same return that would be achieved by investing in cash plus a specified percentage before management fees – cash plus 3 per cent, for example. A fairly cautious fund might target cash plus 2 per cent, while an ‘adventurous’ fund might target cash plus 6 per cent. The higher the target is above the cash return, the more risk the manager must take with the capital, although total return funds are generally seen as relatively cautious. Total return funds also tend to levy relatively low charges. The funds invest in a broad range of assets to diversify risk and to benefit from the different types of returns; they are also likely to move into defensive assets and positions when stock markets are falling. This approach is referred to as ‘unconstrained’, meaning that the manager is not limited to investing in a particular type of asset, or to certain minimum holdings in certain asset types. While this approach can be an effective way of reducing risk and protecting capital, in strong markets many total return funds have produced significantly lower growth than conventional funds. 10.7.3.2 Absolute return funds Absolute return funds use an unconstrained approach to investment, including the use of derivatives, in order to make positive returns in terms of income, capital or both, even in falling markets; they are often referred to as ‘hedge funds’ due to their use of derivatives, although a distinction should be made between this type of regulated fund and the true hedge fund. The funds aim to achieve the returns with minimal volatility by using hedging techniques as well as conventional stock selection; investments include futures, options, warrants and contracts for difference as well as more conventional vehicles. Unlike the total return fund, the absolute return fund is targeted to achieve positive annual returns against a cash benchmark while preserving the investors’ capital. It can use both long and short positions to enhance returns or protect capital. In very simple terms, the manager will adopt the following strategy. ‹ Buying and holding a portfolio of shares and other assets with a view to long‑term gains (a long position). ‹ Buying put options on some (or all) of the shares, giving the manager the right to sell the share or asset at an agreed price – known as shorting. The manager might also buy put options on shares they do not own, with any settlement made in cash. Shorting can be an advantage if the share value falls below the strike price because the manager can make a profit or limit a potential loss in a falling market. ‹ If the share price rises or does not fall below the strike price, the manager can lapse the option, losing only the premium paid. However, the losses will be offset by the increase in the share price, although it will limit the growth. This explains why absolute return funds do not achieve the same level of growth as conventional funds in rising markets. In essence, the manager sacrifices some of the potential growth to buy options to hedge their position or profit in falling markets. ‹ The option will usually contain an agreement that the deal can be settled in cash rather than through transferring shares, so the manager can keep the shares but take a cash profit. ‹ The investment strategy gives absolute return funds a higher risk profile than total return funds but the prospect of better returns in a falling market, because they can switch out of equities completely or use derivatives to profit in falling markets. ©LIBF Limited 2024. All rights reserved. 305 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts A similar principle has been adopted to launch a number of diversified global fixed‑interest absolute return funds, where the manager targets an income return higher than that available from cash, while protecting the capital and minimising volatility. The target return is typically set as Libor plus a fixed percentage, with the manager attempting to take advantage of anomalies in yield curves or general credit. These funds use bond futures contracts, which are derivatives that allow the fund manager to speculate on interest rate changes. When the manager feels that interest rates will fall, which will lead to a rise in bond prices, they will buy bond futures contracts. When the manager thinks that interest rates will rise, which will lead to a fall in bond prices, they will sell bond futures contracts. 10.7.4 Fund categories There are over 2,000 unit trust and OEIC funds available in the UK. The Investment Association was formed in 2015 as a result of a merger between the Investment Management Association (IMA) and the Investment Affairs section of the Association of British Insurers (ABI). The Investment Association has continued to classify unit trusts and OEICs into five broad categories. ‹ Capital protection – funds that invest at least 95 per cent of their assets in money market instruments, or funds, other than money market funds, which principally aim to provide a return of a set amount of capital to the investor plus the potential for some investment return. ‹ Income – funds that aim principally to provide income, although many also aim to produce some capital growth in order to provide a growing income. ‹ Growth – funds that aim principally to provide capital growth. ‹ Specialist – funds that do not really fit into the other sectors due to the nature of their underlying investments. ‹ Multi-asset – funds that invest in multiple asset classes (eg equities, bonds, etc). Each of these categories is sub‑divided into a range of sub‑categories, with different strategies and objectives. The full list of categories can be found at www.theia.org. 10.7.5 Yield The yield is the prospective gross annual income that the unit trust or OEIC is forecast to earn. It is calculated using the latest annual declared dividends or distribution on the investments held by the fund less the annual management charge. This figure will then be expressed as a percentage of the current offer price. Example If a unit trust shows earnings of 4p per unit (after management charges have been deducted) and the offer price is £1.09 the yield will be: 4 ÷ 1.09 = 3.67% The yield for a unit trust that aims for capital growth may be very low or even zero. 306 ©LIBF Limited 2024. All rights reserved.  10.7 Types of unit trust and OEIC 10.7.6 Taxation For taxation purposes, unit trusts and OEICs are divided into two categories: ‹ Equity unit trusts/OEICs are those with less than 60 per cent of the assets in interest‑bearing securities (gilts, bonds, money market instruments, and so on). Equity funds distribute income in the form of dividends, which are eligible for the annual dividend allowance. ‹ Non‑equity unit trusts/OEICs are those holding at least 60 per cent of the assets in interest‑bearing securities. They are able to make distributions of interest rather than dividends. These distributions are paid gross and are eligible for the personal savings allowance. Remember The dividend allowance is, in effect, a nil-rate band, and is included in the individual’s income to determine their overall tax status. For example, assuming a dividend allowance of £1,000, an individual with £35,000 taxable earned income and dividends of £4,000 would not pay tax on the first £1,000 of the dividends. However, the first £1,000 of the dividends would be included in their income as part of their basic‑rate band. The current dividend allowance and tax rates are available at: www.gov.uk/tax-on-dividends 10.7.6.1 Capital gains tax Authorised unit trust and OEIC funds are exempt from capital gains tax. This means that the fund itself grows free from CGT. When the proceeds are taken, capital gains tax may be payable by the individual investor, depending on their situation. The annual CGT exemption can be used to mitigate the charge. Although it may appear illogical, gains from gilt and corporate bond funds are subject to CGT, even though the underlying investments would be exempt if they were held directly by the investor. 10.7.6.2 Taxation of income from an equity unit trust Authorised equity unit trust and OEIC funds are treated as companies for tax purposes. They are exempt from corporation tax on income from UK dividends and are subject to corporation tax on income received from interest or rent and overseas dividends (the current corporation tax rate is available at www.gov.uk/corporation-tax-rates). ‹ Income is paid to investors in the form of dividends which are paid gross. What the investor receives is what they are taxed on. ‹ Dividends from authorised unit trusts and OEICs are eligible for the annual dividend allowance. Once the dividend allowance has been used, investors are taxed at a marginal rate based on their income tax banding. ©LIBF Limited 2024. All rights reserved. 307 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts 10.7.6.3 Taxation of income from a non‑equity unit trust A non-equity unit trust is one that has at least 60 per cent of the fund assets in interest bearing securities, cash or money market instruments. Interest qualifies for the starting rate income tax band of £5,000 and the personal savings allowance (PSA) of £1,000 or £500 (see section 2.2.6 if you need to refresh your understanding of the PSA). 10.7.7 Risks of unit trusts and OEICs The trustee/depositary also has oversight responsibilities of the unit trust manager/ authorised corporate director’s operations, ensuring the fund’s investments are in line with the rules and the investment objective, that the fund is valued correctly and that the authorised corporate director has proper procedures to correctly process the buying and selling of units/shares by investors. As a pooled investment employing the services of professional investment management, the degree of risk inherent in a unit trust or OEIC is lower than that of direct equity investment. Risk is also mitigated by the spread that can be achieved for a relatively small investment. There is, however, no guarantee of the security of the original capital invested or the level of income that will be generated. The actual risk profile will depend on the type of fund selected. The wide range of choice means that there are funds to match most risk profiles. A cash fund will carry similar risks to a deposit account; a specialist fund, such as emerging markets, will be high risk by its very nature and will carry the added risk of currency fluctuations. For most funds, there will be no guarantees with regard to the maintenance of the initial capital invested or the amount of income generated, and the inherent risks should be understood before an investment is made. Historically, equity markets have outperformed the returns available through interest‑bearing deposits. Both unit trusts and OEICs offer an opportunity for the private investor to participate in the equity markets, albeit indirectly. The diversity of both unit trusts and OEICs available means that investors can choose their level of risk, depending on the nature of the underlying investments. 10.8 Offshore funds Offshore funds are generally unit trusts and OEICs based in and managed from tax havens such as the Channel Islands, Luxembourg, and so on. As with offshore deposit accounts, many offshore funds are run by companies with close associations with UK investment companies. Under the FSMA 2000, it is not possible to promote any collective investment scheme in the UK without authorisation or recognition by the FCA. The following types of offshore scheme are recognised by the FCA. ‹ Undertakings for Collective Investments in Transferable Securities (UCITS) – these are funds formed in EU states and, post-Brexit, under the ‘UK UCITS’ regime. ‹ Certain funds authorised in designated territories – these are countries that the FCA is satisfied provide the same level of investor protection as an authorised fund. In reality, this means the Channel Islands, the Isle of Man and Bermuda. 308 ©LIBF Limited 2024. All rights reserved.  10.9 Investment trusts ‹ Funds recognised individually by the FCA – certain funds outside the EU and designated territories are recognised by the FCA on an individual basis. 10.8.1 Types of fund Offshore funds are defined as either ‘reporting’ or ‘non‑reporting’ funds. The rules that define whether a fund is ‘offshore’ are complex but, in broad terms, an ‘offshore fund’ is any mutual fund that is a non‑UK‑resident company, trust or investment vehicle where the investor does not have control over the day‑to‑day running of the fund. A reasonable investor would expect to be able to realise the investment based almost entirely on the net asset value of the fund or the level of a particular index. The regime divides offshore funds into two categories as follows. 10.8.1.1 Reporting funds The fund management can apply for reporting fund status. The requirement is that all income received by the fund, less certain expenses, is reported to HMRC through a set of accounts that conform to international reporting standards; the income must also be reported to the investor. The reporting requirement applies whether the income is distributed by the fund or accumulated, and the investor is required to include the income reported on his income tax return, again regardless of whether the income is received or accumulated. Once a fund has been classified as a reporting fund it can obtain ‘forward looking certification’, which means that reporting fund status will continue to apply until the fund chooses to leave or is removed from the regime. The overall tax regime is the same as for onshore funds – income reported is subject to income tax as an interest distribution or dividend, and gains made by investors are subject to the normal CGT regime. 10.8.1.2 Non‑reporting funds A non‑reporting fund is one where the management has chosen not to apply for reporting fund status. Income distributed from the fund will be subject to income tax in the hands of the investor in accordance with the normal rules applying to interest or dividend payments. Income not distributed is rolled up in the fund without the deduction of tax. The major difference from a reporting fund is that any gains made by the investor on disposal, including accumulated income, will be calculated in the same way as a capital gain under the CGT regime. It will be referred to as an ‘offshore income gain’ but will then be treated as income and taxed at the appropriate rate of income tax rather than capital gains tax. The investor cannot use the capital gains tax annual exemption or set losses against other capital gains. This means that, on selling or cashing in units, the investor will be taxed at 20 per cent, 40 per cent or 45 per cent on the gain plus accumulated income (with no allowances or exemptions) rather than 10 per cent or 20 per cent (with exemptions) on a reporting fund. 10.9 Investment trusts The investment trust is one of the earliest forms of collective investment. The first of these, set up in 1868, was actually formed as a trust. Doubts about the legal standing of the original trust led to its reorganisation in 1879 as a public limited company. ©LIBF Limited 2024. All rights reserved. 309 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts Although the title of investment trust has been retained, investment trusts are public limited companies listed on the stock market. They invest their share capital in stocks, shares or sometimes property. Shares are issued through offer, tender or placing, in the same way as company shares. Investors may then buy and sell shares in the investment trust on the stock exchange, receiving dividends and the prospect of capital growth. More than 350 investment trusts are available in the UK. 10.9.1 Key features of investment trusts ‹ Investment trusts offer expert investment management and low costs, compared with direct share investment and unit trusts/OEICs, because the cost of managing the investment is borne by the trust itself. ‹ The share capital, once declared, is fixed, leading to what is called a closed‑end fund. The number of shares in circulation cannot be increased, thus producing a supply‑and‑demand situation. This might limit the individual’s ability to sell or buy and will affect the price. ‹ Investment trusts can borrow, or gear, to invest without restriction. ‹ Investment trusts have more flexibility than unit trusts and OEICs in terms of investments. For example, they can invest in unquoted private companies and they can provide venture capital to fund new companies or expansion. The rules applying to a trust’s investment and borrowing ‘rules’ will be set out in its memorandum and articles of association. ‹ As companies, investment trusts can hold back up to 15 per cent of the income received from investments in reserve, rather than pay it all out as dividends (as with unit trusts and OEICS). This means the manager has more flexibility to increase dividends paid, or to maintain dividends even if the income received drops by using the reserves. This facility has allowed a number of investment trusts to increase the dividends over a prolonged period, with several increasing them for more than ten consecutive years, 21 achieving that feat for 20 or more years and three trusts managing at least 51 consecutive years of increases. Unit trusts and OEICs must either distribute the income received or reinvest it. ‹ Investment trusts can run for a set term, with a predetermined winding‑up date. ‹ Very much like unit trusts and OEICs, investment trusts are likely to specialise in certain sectors or geographical regions, although not more than 15 per cent of the investment can be in any one company. The Association of Investment Companies has established sectors for investment trusts, in much the same way as the IA has done with unit trusts and OEICs. You can find the details at www.theaic.co.uk. 10.9.2 Split capital trusts Sometimes an investment trust has more than one type of share. These are called split capital trusts and are usually incorporated for a fixed period, with a predetermined winding‑up date. This type of trust has divided its capital into a number of different types of share. The classes are shown below, in order of priority for repayment of capital at the wind‑up date. ‹ Prior charges – these are not shares, but represent money that must be paid before capital can be distributed, such as loan stock and debts. 310 ©LIBF Limited 2024. All rights reserved.  10.9 Investment trusts ‹ Zero‑dividend preference shares (or zeros) – zeros offer a fixed capital return at the wind‑up date, which is significantly higher than the original price paid. Although zeros are preference shares, they will only be repaid in full if there is enough in the fund at the wind‑up date after prior charges have been met. They usually rank ahead of other shares for repayment. Any gain is subject to CGT. ‹ Income shares – these provide an income from the underlying trust assets. The income will be paid as dividends and might be fixed, based on a share of some of the revenue or based on receiving all of the income received by the trust. Income shares will have a stated repayment value on wind‑up – typically in the region of 1p. The value can be the issue value of the share or a lower, nominal amount, depending on the type of income share. The original income shares are known as annuity shares – they pay a relatively high income but pay back a very low amount on redemption. Income shares usually rank behind prior charges and zeros. Dividends are subject to income tax, and gains (although very unlikely) will be subject to CGT. ‹ Ordinary income (income and residual capital) shares – these are designed to provide a rising income with the prospect of capital growth. The income payable depends on the way in which the trust is structured but can be based on receiving all the income from the trust assets, the income remaining after other higher‑ranking income shares have been paid, or a share of the income with other income shares. Dividends are subject to income tax, and gains will be subject to CGT. ‹ Capital shares – shareholders receive no income during the life of the trust, but are entitled to all of the capital gain after liabilities and prior shares are repaid on liquidation. Gains will be subject to CGT. It is important to remember, however, that there is no guarantee that the capital will be repaid at the wind‑up date. The risk is higher the further down the list the shares are positioned. There are three key factors to consider when deciding the risk of a split capital share. ‹ Gross redemption yield – this shows the annual return of a share if it is held to the wind‑up date. ‹ Hurdle rate – this is the amount (as a percentage) by which the trust assets will need to grow each year in order for the share redemption value to be paid on wind‑up. A positive hurdle rate means that the assets will have to grow each year to pay the redemption value, while a negative hurdle rate means that the trust could fall by the hurdle rate shown and still repay at wind‑up. A high hurdle rate would indicate there is a risk that the redemption price may not be achieved. ‹ Cover – refers to how many times the current trust net assets can cover the share’s redemption value at wind‑up, after allowing for the repayment of liabilities and higher classes of shares. 10.9.3 Net asset value Net asset value is the market value of all trust assets, less liabilities, divided by the number of shares issued. Effectively it is the value the shareholder would receive for each share if the trust was wound up. ©LIBF Limited 2024. All rights reserved. 311 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts Example There are 100,000 issued shares in the Acme Trust. The trust has assets of £1.5m and liabilities of £500,000. The net asset value of each share is: £1.0m = £10 100,000 If the shares in the example above were being sold in the market place below £10, they would be said to be trading at a discount because the trading price would be below the net asset value. If they were trading above £10 they would be said to be trading at a premium because they would have risen above the net asset value. The calculation above results in the ‘undiluted’ NAV. The ‘diluted’ NAV takes into account any warrants and convertible loan stock that have not been converted into shares. For example, one warrant might allow the holder to buy one share at a fixed price within a defined period. The diluted NAV assumes all such options have been taken up, which increases the number of shares but not the assets in the fund. The result is a lower NAV. There are benefits to buying shares at a discount. The investor is gaining access to the underlying portfolio below its market value, which means that it could provide a higher level of income for a lower price. To use a very simple example, if the underlying portfolio has a market value of £1,000 and produces income of 5 per cent, the income will amount to £50. If the investor can buy that income through an investment trust at a 10 per cent discount, they will pay £900 – generating a return of 5.55 per cent. They will also benefit in the same way if capital values increase. 10.9.4 Gearing Gearing (also known as leverage) is an important factor with investment trusts. It is the term used when a company borrows to invest, and the level of gearing is usually expressed by showing the borrowing as a percentage of capital and reserves. It is particularly relevant to investment trusts because the companies have significant freedom to borrow, unlike unit trusts and OEICs, which have very limited ability to borrow. The higher the proportion of debt to the capital and reserves of the company, the more volatile the investment. The investment trust manager borrows the funds to buy assets that they feel are likely to increase in value. As a result of the initial purchase, the fund will see an initial rise in asset value, created by the additional assets. In simple terms, over the longer term, if the assets grow at a higher rate than the interest paid on the borrowing, the investor wins through increased dividends, share price or net asset value (NAV). The NAV can be defined as the value of the company’s assets, less liabilities, divided by the number of shares. If the assets do not outpace the interest paid, the NAV of the shares will fall. We can look at an example to see how gearing works. 312 ©LIBF Limited 2024. All rights reserved.  10.9 Investment trusts Example The Advanced Investment Trust has 10m shares issued and assets of £15m; it borrows £1.5m for a specific investment, with an interest rate of 7 per cent. The trust would have 10 per cent gearing and would have to service the annual interest payments of £105,000. The assets will have to rise by more than that figure to increase their real value to the trust. Prior to the borrowing, the NAV would be £15m/10m shares = £1.50 per share. The assets bought with the loan would increase the trust assets to £16.5m, with debts of £1.5m. This would give asset value of £16.5m less £105,000 interest = £16.395m. The NAV would be £16.395m, less £1.5m loans = £14.895m/10m shares = £1.49 per share. Assume the trust assets grew in value by 10 per cent. This would give an asset value of £18.15m less interest payments of £105,000 = £18.045m. The NAV would be £18.045m less £1.5m loans = £16.545m/10m shares = £1.6545 per share. This represents a growth in NAV of 10.3 per cent. If the company had not borrowed, the 10 per cent asset increase would have led to a NAV of £16.5m/10m shares = £1.65 per share. Assume this time that the value of the assets falls by 10 per cent. This will give an asset value of £14.85m less interest payments of £105,000 = £14.745m. The NAV would be £14.745m less £1.5m = £13.245m/10m shares = £1.3245 per share. This represents a fall of 11.7 per cent. If the company had not borrowed, the 10 per cent asset fall would have resulted in a new NAV of £13.5m/10m shares = £1.35 per share. If the assets had grown or fallen by 20 per cent, the NAV would have risen by 21 per cent and fallen by 23 per cent respectively. Gearing increases the volatility of the investment because the effect of a fall in the value of assets bought with borrowing will be made worse by the effect of the interest payments on the overall picture. 10.9.5 Charges Investment trust shares are single priced. Market‑makers will set a spread between the buying (offer) and selling (bid) prices to enable them to make a profit, which means that there will be a differential between the two prices. The prices shown in the press will be the mid‑market price – between the offer and bid prices. The fund will take an annual management charge from the assets. This is typically between 0.25 per cent and 1.5 per cent. There may also be auditors’ fees and other costs. These annual fees are usually taken from the trust’s income. There may also be dealing costs for buying the investment trust shares, stamp duty of 0.5 per cent, and charges if shares are held in an ISA. ©LIBF Limited 2024. All rights reserved. 313 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts 10.9.5.1 Ongoing charges figure (OCF) Investment trust charges can be compared with OEIC and unit trust charges by looking at the ongoing charges figure. The ongoing charge is a calculation that shows the total charges for operating the investment, expressed as a percentage of the fund value. The OCF is a more accurate method of assessing charges than merely looking at the individual charges. 10.9.6 General Most investment trusts are available as both lump‑sum investment vehicles and regular‑premium savings plans, with dealing as for shares, making them attractive to many investors. The charges are often lower than on other collective investments and, while more volatile than unit trusts, investment trusts offer the attractions of risk spread and professional management. Most investment trusts offer an ISA facility. Buying and dealing in investment trusts is basically the same as doing so in shares, although some investment trusts allow investors to deal directly. 10.9.7 Taxation ‹ Gains made within the fund are exempt from corporation tax and capital gains tax. ‹ Dividend income from UK companies, known as ‘franked investment income’, is not subject to corporation tax. ‹ All other income – interest, rent and non‑UK dividends (known as ‘unfranked income’) – is subject to corporation tax, as with any other company. Management fees and interest paid on money borrowed by the trust can, however, be charged as expenses against unfranked income. This is likely to reduce significantly any corporation tax payable, or even eliminate it altogether. Companies are able to elect to treat interest received in the fund differently. By making an election, interest received and distributed to investors can be taxed as interest rather than under the corporation tax regime. This means that companies will not be liable to tax on interest received and then distributed, but will treat it as an interest distribution in the hands of the investor. Such distributions are paid gross. If a company chooses to pay interest distributions and dividends, they will be paid separately and taxed under each specific regime. The change has led to a number of fixed‑interest investment trust launches. Investment trust investors are subject to exactly the same dividend income and capital gains tax regime as normal shareholders. ‹ Dividends are paid gross. ‹ Dividends are eligible for the annual dividend allowance. Over and above the dividend allowance, individuals will need to pay a further amount based on whether they are a basic-, higher- or additional-rate taxpayer. ‹ Capital gains tax will apply to any gain made by the investor on disposal of the shares. 314 ©LIBF Limited 2024. All rights reserved.  10.10 Differences between investment trusts and unit trusts/OEICs 10.10 Differences between investment trusts and unit trusts/OEICs Investment trusts and unit trusts/OEICs are set up and operate in different ways and it is important not to confuse them. A quoted investment trust is a stock market company with a fixed number of shares available; the manager has no ability to manipulate the number of shares available. Once the initial capital is raised on the market, the management team must work with that capital. No further funds will be added in normal circumstances. In contrast, a unit trust or OEIC manager can issue more units/shares or repurchase and cancel them according to demand: they are open‑ended funds. However, the manager is obliged to invest any new inflows of money as soon as possible and may be under pressure to make investment decisions. In turn, this means that the investment trust manager, unlike the unit trust/OEIC manager, does not have to make their investment decisions in light of sudden inflows/ outflows of money and so can plan ahead more effectively. For example, a property unit trust manager may have to sell property to raise funds if a large number of investors want to redeem units because most of the fund will be invested directly in property, with a small amount held in cash. The process can take some months and is the reason why property funds generally include a condition that redemptions can be delayed for three to six months. With an investment trust, however, investors buy and sell shares in the trust, which can be traded on the stock market; the manager does not have to sell assets to satisfy those investors wishing to sell. Another topical example can be seen in the problems facing investors in the LF Woodford Equity Income Fund, an OEIC offered by a once highly rated fund manager. The manager made a significant number of investments in unquoted companies. When investors wanted to redeem units, the fund did not have sufficient liquid assets to meet the demand and selling the unquoted shares would prove to be a difficult and lengthy process. Dealing was suspended on 3 June 2019, initially for a short period, to allow the manager to sell assets to fund the redemptions, but it soon became clear that they would have to liquidate about 20 per cent of the fund’s assets to do so, with the possibility of a ‘forced sale’ situation. As a result, the dealing suspension was extended further at regular intervals to allow the manager to raise the cash. By October 2019 it became clear that the strategy was not working, and on 16 October 2019 the authorised corporate director announced that the fund would be wound-up starting in January 2020 – the earliest possible date once investors had been given the three months’ notice required by regulations. We can contrast this with an investment trust, where investors redeem their investment by selling their shares. While problems within the fund are likely to reduce the share market value, and the number of potential buyers may be fewer than for a healthy fund, investors can still access their investment. Of course, an investment trust can be wound‑up, but the event would not be forced upon the management and shareholders would be consulted. Investment trusts can borrow over the long term to finance investment activities, while unit trusts cannot, and hence the former have the ability to generate gearing. This can improve capital and income growth if the underlying investments bought via the borrowing do well. Unit trusts and OEICs must distribute all the income received by the fund by way of dividends or interest payments, unless the fund is an accumulation fund, where all the income is reinvested. Investment trusts can retain up to 15 per cent of the income ©LIBF Limited 2024. All rights reserved. 315 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts received by the fund. This allows investment trust managers to ‘smooth out’ dividend payments by holding some income in reserve to boost payments in later years. 10.11 Exchange‑traded funds An exchange-traded fund (ETF) is a type of investment fund where the shares or units are traded on a securities exchange or other trading venue (in the same way as a listed equity). As such, ETF shares or units can be bought and sold throughout the trading day (ie intra-day). ETFs offer an array of different investment strategies. Most ETFs, by number and assets under management (AUM), follow passive strategies (ie tracking an index or benchmark). There are ETFs that offer active strategies, or can make use of leverage and/or adopt so- called ‘inverse’ strategies whereby derivatives are used to profit from the decline in value of an underlying benchmark or index, but these are relatively few in terms of number and AUM. Index-tracking ETFs can execute their investment strategy by: 1. holding all or a representative sample of the underlying securities in the relevant index (‘physical ETFs’); or 2. using derivatives such as swaps (with the associated counterparty risk), to obtain the economic exposure to the value of those securities (‘synthetic ETFs’). One unique feature of ETFs among investment funds is the different arrangements for ‘primary market’ and ‘secondary market’ transactions in the ETF shares. ETFs have the following two ‘tiers’ of investors ‘dealing’ in the shares: ‹ The first tier, in which an ETF’s shares are created (subscribed) and cancelled (redeemed) on the primary market by ‘authorised participants’ (APs). ‹ The second tier, in which an ETF’s shares are traded on a securities exchange, trading venue or over-the-counter (OTC) in the secondary market by retail and professional investors. APs are typically professional investors or market counterparties, including broker- dealers, banks and other trading houses, who seek to profit on the spread of an ETF’s shares (ie by creating shares and subsequently selling them for a profit). APs will have an agreement in place with the ETF manager to create and redeem ETF shares. The AP may apply to the ETF manager for wholesale lots of ‘creation units’ (often 10,000s) and the AP will then deliver a ‘basket’ of securities (rather than all cash) in exchange for the creation units. The redemption process is similar, whereby the redemption request from the AP is settled by exchanging a basket of securities (and maybe cash if relevant) of equal value to the ETF units that are being redeemed. Investors who purchase ETF shares on the secondary market (ie after their creation by an AP) do so with the objective of making an investment return (eg an increase in the share price, or a decrease in the case of a short sale, and the receipt of dividends). To support trading of an ETF’s shares, an official liquidity provider (OLP) undertakes to the stock exchange on which the ETF is listed to provide a certain amount of defined liquidity. This is done by entering continuous two-way prices within a maximum spread and quote size for a specified period during the trading day. In recent years, the development of exchange‑traded funds (ETFs) has provided another method of investing in tracking funds. 316 ©LIBF Limited 2024. All rights reserved.  Topic summary A major benefit of ETFs is the low charges when compared to unit trusts, OEICs and investment trusts, with annual fund management charges usually ranging from 0.20– 0.75 per cent, and a lower total expense ratio. There is no stamp duty on ETF shares in the UK, although there will be dealing charges, as with any shares. ETF dividends are taxed under the dividend income tax regime, and gains are subject to CGT. ETFs are acknowledged as an effective way to manage asset allocation because they offer a low cost and liquid way to invest in a range of asset classes that might otherwise be illiquid and/or expensive for the small investor. Topic summary ‹ Collective investments provide the small investor with ready‑made diversification and expert management, giving them access to a range of asset types and management styles. ‹ In this topic we looked at: — unit trusts; — open‑ended investment companies (OEICs); — the different regulatory classifications of funds; — investment trusts. ©LIBF Limited 2024. All rights reserved. 317 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts Review questions and activity The following questions and activity are designed to consolidate and enhance your understanding of the material that you have just studied. ‹ The review questions are designed to enable you to check your understanding of the topic. ‹ Completion of the activity will give you an opportunity to develop your understanding of the key themes in the topic. Answers to the questions are contained at the end of this book. Please note that the activity is open‑ended and that therefore a model answer is not provided. Review questions 1. John’s OEIC is structured as follows: ‹ UK gilts – 35 per cent, UK corporate bonds – 30 per cent. ‹ Cash – 10 per cent, UK equities – 25 per cent. How would income from the fund be taxed? 2. Explain the difference between a multi‑manager fund and an absolute return fund. 3. Tim’s split capital investment trust shares have a hurdle rate of 7 per cent. Tanya’s split capital investment trust shares have a hurdle rate of minus 1 per cent. Explain what these figures mean. 318 ©LIBF Limited 2024. All rights reserved.  Review questions and activity 4. Complete the following table. Unit trust OEIC Investment trust Legal constitution Open or closed‑ended? Investor buys Overseen by Investment controls/mandate Capacity to borrow Charges Taxation of dividends Taxation of interest Taxation of capital gains 5. Answer true or false to the following statements about Exchange Traded Funds (ETFs). ‹ ETF prices are established once a day, and shares are traded on a forward pricing basis. ‹ The ETF trustee’s role is to look after the ETF assets and make sure it is run in accordance with its mandate. ‹ Investors buy and sell shares in the ETF from market makers. ‹ ETFs are ‘closed‑ended’ funds, like investment trusts. ‹ ETF shares can be redeemed through the market maker or sold in the market. ‹ ETF charges are generally lower than OEICs. ‹ Stamp duty is payable on ETF shares, although there are no dealing charges. ‹ ETFs are an effective aid to managing asset allocation. ©LIBF Limited 2024. All rights reserved. 319 10: Collective investments – unit trusts, open‑ended investment companies and investment trusts Activity Go to the Investment Association website www.theia.org/fund-sectors/ and look at the latest sector definitions and classifications. Investigate each category to identify how a fund qualifies. 320 ©LIBF Limited 2024. All rights reserved.