This is the third post in our series looking at investment funds. In our first post we covered the main benefits of investing in funds, while last time we discussed 6 steps to successful fund investing.
There are a wide range of funds available and the choice can sometimes be overwhelming so, in this post, we'll move onto looking at the main types of investments funds. These are:
- Investment funds: Authorised unit trusts and OEICs
- Investment trusts
- Insurance-based products
Investment funds: Authorised unit trusts and OEICs
Authorised unit trusts and OEICs are investment funds that pool your money with other investors. The pooled money is then invested into things such as shares or bonds but may be invested in other assets such as properties, derivatives or cash.
The fund is managed by a professional fund manager dedicated to investing and administering your money. While technically speaking the structures of the two types of fund are different, from your perspective they are the same. You can generally buy or sell your investment on any working day and the daily price of your units or shares reflects the value of the assets in which the fund has invested.
This is because the total number of units or shares issued by the fund increases when the fund is in demand and decreases when more investors are cashing in. Funds which are marketed to the public must be authorised by a regulator and are subject to detailed rules designed to provide a high level of investor protection. The assets are held by an independent authorised firm, known as a trustee or a depository, which oversees the way that a fund is run. Most funds available in the UK are authorised by the independent regulator, the Financial Conduct Authority and are covered by the Financial Services Compensation Scheme.
The Retail Distribution Review (RDR) has already brought some welcome changes. For example, some fund supermarkets are now offering rebates of up to 0.75% on their actively managed funds range. These rebates are paid in units normally into your largest account holding and will appear on your statements. Rebates are normally paid into your account quarterly.
Some funds, however, are authorised elsewhere in the European Union, such as in Dublin or Luxembourg. Because of RDR, advisers are no longer able to be paid a trail commission from product providers. Product providers are organisations such as fund management companies (e.g. Neptune, Invesco, First State, Schroder etc). The FCA has recently announced that as from April 6th 2014, platform providers will not be able to be paid a commission from product providers. This is the FCA's attempt at trying to clean up the industry and provide transparency for private investors. For more information about fees, charges and changes within the industry and how it will affect you, take a look at our recent blog called ‘How to reduce the cost of investing’.
OEICs
Open Ended Investment Companies (OEICs) are my recommended choice for long-term ISA and SIPP investors. An OEIC has a company structure; this means that when you invest you will hold shares in it. Most OEICs are single priced which means shares in the fund are both bought and sold at the same price, which is one of the reasons I prefer them to unit trusts.
However some OEICs are dual priced, which means they have different buying and selling prices. The fund can get larger or smaller depending on the number of investors who wish to buy or sell shares, hence its name, ‘open ended’. Many investment funds in the US and Europe have a similar legal structure. They have the ability to establish a single umbrella OEIC that has a series of funds within it specialising in particular areas. These are known as sub-funds and allow your money to be put to work in specialist areas such as UK equity or emerging markets.
Unit trusts
Unit trusts are a popular type of investment fund in the UK. Just like OEICs, they involve large numbers of investors pooling their money and entrusting it to a fund manager. This manager will be a specialist investor, using their expertise to invest these pooled funds in financial markets, looking for investment opportunities across the world. The structure of a unit trust works by dividing up the pooled money into units. The number of units is not fixed and will fluctuate according to demand, as will the price of each unit. The unit price is devised by taking a valuation of all the individual companies that the pooled funds are invested in; the value is then divided by the number of units held in the fund at that time to give the unit price.
Unit trusts can be either single priced or dual priced but are typically dual priced. Dual priced funds have what's known as a ‘spread’ between the buy and sell price. This means as soon as you buy, you have to make a few percentage points just to get back to where you bought. For example, the buy price on the day you buy is 105 and the sell price is 100.
In this example, there is a 5% spread which means the fund has to gain 5% just to get to the price you paid. This is a rip off and the main reason I prefer single priced OEICs. Unit trusts are confusing because of this complicated pricing structure. If you decided to buy shares or units within a dual priced fund you will always pay the offer price. If you sell such shares or units they will be sold at the bid price.
- Offer price (also known as the buying price)
- Bid price (also known as the selling price)
The spread between the bid and the offer is typically 5–6% in most dual priced fund. This spread is similar to what you get when buying illiquid individual shares and can have a huge negative impact on your overall returns.
Investment trusts
Unlike unit trusts, investment trusts are set up as a company, which means in reality they are not a trust at all! This means they are subject to company law. Investment trusts pool investors' money just like unit trusts and OEICs. Like investment funds such as OEICs and unit trusts, they are professionally managed and diversify your risk by investing in a wide range of companies, but they have some additional characteristics. The main difference is the price or market value of shares held in an investment trust may not be the same as the value of the investment trust's assets.
This means that you do not buy in or sell out at prices that directly reflect the value of the trusts assets due to premiums and discounts. The reason why this happens is because there are a fixed number of investment trust shares available to you at any one time. Shares in an investment trust company are bought and sold on the stock market, just like other companies' shares. If an investment trust's shares are in demand, its price rises to a premium, i.e. the price will be higher than the value of the investment trust company's underlying assets. If there are more sellers than buyers however, the price can fall to a discount when the price will be lower than the value of the underlying assets.
Buying at a discount can psychologically appear to be a good deal but there are two things to take into account here. First, investment trusts trade at a discount for a reason and generally it's because of lack of demand. This could be because the sector/country/area that the trust invests in falls out of favour or it could be because investors think the trust manager is incompetent. The second thing to be aware of is that the discount could widen further.
This means discounts may seem to present an excellent opportunity, however they can be bad for you if the discount increases during the time you hold the shares. As investment trusts are traded on a stock exchange, it means you will also have 0.5% stamp duty to pay every time you place a trade.
There will also be a spread between the buying and selling price. This is generally 1–2%, but for less frequently traded trusts it can be 5–10%. They are also not as cheap as claimed and use gearing, which is borrowed money to invest. This borrowing comes with a hefty charge to you the investor. Some trusts charge a performance fee and this too can nibble away at your returns. The annual charges of investment trusts are not as transparent as they should be. For example, the average TER of a trust is approximately 0.95%. However, this fairly low TER is a bit of a smokescreen because it ignores other significant costs, such as interest payments on borrowings, tax on fund performance and performance fees – which can be ridiculously high.
When you buy (or sell) investment trust shares, commission will be payable to the stockbroker. If you frequently trade in investment trusts, these trading costs can add up and eat into your returns.
Generally, you should avoid any funds (unit trusts and OEIC’s) or trusts that charge performance fees. One thing that really bothers countless investors about performance fees is when they are charged for 'performance' even though the trust has made a negative return for the year.
Phil Oakley at Moneyweek wrote a great article called ‘We like investment trusts but they need to cut their fees’. Phil discovered that the average published TER of 32 investment trusts was 0.94%, but after the other significant costs were factored in the True TER averaged 1.71%.
Insurance-based products
There are insurance products that give you access to professionally managed pooled investments. They may be unit linked, which share many of the characteristics of investment funds, but are not subject to the same regulations as investment funds, although they may follow many of them in practice. Another form is a ‘with profits’ product, which seeks to provide a steady return by smoothing out the ups and downs of the stock market. When Paul, Steve and I were studying for our financial qualifications, we learned that these types of products have hidden charges. The lesson here is, always do your homework.
In our next post on investment funds we'll go on to look at fund's investment styles and investing for income or growth.
As always, if you have any questions or thoughts on the points covered in this post, please leave a comment below or connect with us @ISACO_ on Twitter.
About ISACO
ISACO is a specialist in ISA and SIPP Investment and the pioneer of ‘Shadow Investment’, a simple way to grow your ISA and SIPP. Together with our clients, we have £57 million actively invested in ISAs and pensions*.
Our personal investment service allows you to look over our shoulder and buy into exactly the same funds as we are buying. These are investment funds that we personally own and so you can be assured that they are good quality. We are proud to say that by ‘shadowing’ us, our clients have made an annual return of 12.5% per year over the last four years** versus the FTSE 100’s 7.4%.
We currently have close to 400 carefully selected clients. Most of them have over £100,000 actively invested and the majority are DIY investors such as business owners, self-employed professionals and corporate executives. We also have clients from the financial services sector such as IFAs, wealth managers and fund managers. ISACO Ltd is authorised and regulated by the Financial Conduct Authority (FCA). Our firm reference number is 525147.
* 15th November 2012: Internal estimation of total ISA and pension assets owned by ISACO Investment Team and ISACO premium clients.
** (31st December 2008 - 31st December 2012).
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