Fund ABCs: Types of Funds

Morningstar was founded in 1984 to help investors make better decisions. We provide a wealth of free fund data and analysis at Morningstar.co.uk to help you do just that, and we are now introducing our Fund ABCs series to help educate investors about fund investing. We will be posting new articles periodically, progressing from the most basic concepts through more complex topics such as fund evaluation and portfolio building. This is the second article in the series, “Types of Funds”. As always, we welcome your feedback. In this course:

1. Introduction
2. Unit Trusts
3. OEICs
4. Investment Trusts
5. Gearing
6. The Split Capital Scandal
7. ETFs

Introduction
There are four basic types of funds available to UK investors. Among open-end offerings are Unit Trusts, Open-End Investment Companies (OEICs), and Exchange-Traded Funds (ETFs). On the closed-end front, there are Investment Trusts. (If the terms open-end and closed-end are new to you, don’t worry—we’ll explain them below.)

To complicate matters, Unit Trusts and OEICs are often repackaged and sold as unit-linked life or pension funds (with the life companies own charging structure applied), and there are also proprietary funds offered that are only available via a life or pension company.

All of these types of funds are similar in so far as they pool investors’ assets and thus allow investors with relatively small amounts of money to gain exposure to a much larger, more diversified pool of securities than they could cost effectively obtain on their own. In the case of actively managed offerings, the funds also offer access to professional management. There are some key differences, though, and we’ll cover these for you here.

Unit Trusts
Unit Trusts are the oldest form of open-end offering in the UK. When you buy a Unit Trust, you are buying the right to participate in the benefits from any assets held by the trust. The trust is governed by the deed of trust and scheme particulars, and is overseen by an independent trustee (usually a large corporation). Unit Trusts are regulated by the FSA’s COLL/Collective Investment Schemes Sourcebook.

Unit Trusts are priced in a fashion very different from OEICs. Most OEICs list a single price, based on the net asset value (NAV) of the fund. They may also levy an initial sales charge, expressed as a percentage of your investment. Unit Trusts, however, quote both a bid and offer price.

• The bid price is the per-unit price you will receive if you sell your units back to the fund company. It is usually based on the bid price of the underlying securities held by the fund.
• The offer price is the per-unit price you will pay to purchase units in the fund. The sales charge is built into the offer price.
• The spread between the two prices represents the amount of money that is deducted from your investment, if any. It typically falls in the 5% to 6% range in the UK.

Thus if you purchase £10,000 in a Unit Trust with a 5% spread, only £9500 will be invested in the trust. The remaining £500 goes to the spread—part of which goes to compensate your financial adviser. Fund houses may also use the spread to control asset flows in and out of the fund. If they wish to slow flows, for example, they can widen the spread to make the fund less attractive.

OEICs
Open-End Investment Companies, or OEICs (pronounced “oyks”), are a more recent fund format in the UK, having been introduced in 1997. OEICs are regulated by the FSA’s COLL/Collective Investment Schemes Sourcebook and the Open-Ended Investment Companies Regulations 2001. The OEIC’s assets are held by a “depositary”, which must be independent of the fund house.

Unlike Unit Trusts, OEICs are governed by a board of directors. However, this is not much of a safeguard: The “board” can be – and typically is - a single corporate entity (known as the authorised corporate director), and this is quite often the fund house itself. If the board was independent of the fund house, it would help ensure that individual shareholder’s rights were protected against overreaching by fund management companies. In the U.S., where this structure exists, fund managers must negotiate their fees with the independent directors of the fund. There is no such requirement in the UK, and fund companies can and do raise fees at their discretion.

OEICs are fast becoming the dominant form of fund in the UK. This is partly due to their relative simplicity, and partly due to the ability of OEICs to be sold into different countries across Europe under the EU’s UCITS fund regulation framework. Unlike Unit Trusts, OEICs publish only a single price every day, their NAV. Sales charges are then added to that as desired. Thus, a fund might quote a £10 NAV with a 5% initial sales charge. In this case, to purchase 10 shares of the OEIC, an investor would need £105. £100 to cover the cost of the shares, and £5 to cover the sales charge. Put differently, were you to put £10,000 into the fund, only £9500 would be invested. The outcome, then, is virtually the same as with a Unit Trust, but complexity of the dual price structure is eliminated and the amount one pays in sales charges is made clearer.

Investment Trusts
Both Unit Trusts and OEICs are “open-ended” vehicles. That is, they can offer a theoretically limitless number of shares and also stand ready to purchase back those shares. Investment Trusts, on the other hand, are “closed-ended”. This refers to the fact that they issue a fixed number of shares at their launch (much like the IPO of a newly public company), and then do not subsequently buy shares back or issue new shares, except in rare circumstances.

Investment Trust shares trade on a stock exchange just like the shares of any other public company. Unless you buy in on the IPO, any shares you purchase in an Investment Trust will be usually be bought over an exchange, at the prevailing market price. Thus, rather than purchasing shares from or selling them back to the fund company at a price based on NAV, you are trading with other investors at a market price. Unlike OEICs and Unit Trusts, you will need to pay brokerage commissions to buy and sell Investment Trust shares, just as you would the shares of any publicly traded company.

With OEICs and Unit Trusts, you can be assured that the price you pay or receive is directly linked to the fund’s NAV, plus any sales charges. With an Investment Trust, the market price should reflect the NAV, but is ultimately based on the forces of supply and demand prevailing in the market for the trust’s shares. Many Investment Trusts trade at discounts to the value of their underlying assets. Unlike OEICs and Unit Trusts, which are priced once each day, Investment Trusts trade at different market prices throughout the day.

From the asset manager’s perspective, Investment Trusts are attractive because they give the management company the ability to earn management fees on a stable pool of capital until the trust is wound up. (Remember, if shareholders sell, they sell to other investors—the money stays inside the fund.) The format also lends itself to investments in less liquid markets and securities as the manager will not be forced to trade by inflows or outflows of cash.

Investment Trusts and Gearing
Investment Trusts have also traditionally been differentiated from OEICs and Unit Trusts by their ability to borrow money, or “gear” their portfolios. Unit Trusts and OEICs, on the other hand, have been restricted to borrowing no more than 10% of their assets. This is changing for most OEICs (but not Unit Trusts), as the EU’s UCITS regulatory structure now permits funds to use financial derivatives for investment purposes. Although this doesn’t alter the actual borrowing limit, it effectively gives OEICs that elect the UCITS structure--and most do--the ability to heavily gear their portfolios by using derivatives.

Gearing increases a fund’s upside potential but also magnifies its downside risk considerably. Take for example, an Investment Trust with £100 million in assets that borrows an additional £100 million, then invests the entire sum (£200 million) in the equity market. A 50% return on that £200 million investment would equal £100 million. Once the trust repays its loan, it is left with £200 million (its original £100 million, plus the £100 million it earned on its investments), a 100% return. On the flip side a 50% loss on that same £200 million would equate to a £100 million loss—the fund’s entire capital base would be wiped out, and investors in this example would be left with nothing.

The Split-Capital Scandal
Some Investment Trusts, known as “Split-Capital Trusts”, offer two or more classes of shares. One class, called Zero Dividend Preference Shares, receives a predetermined rate of capital return, but no income. The second class, income shares, receive the rights to any income generated by the fund, and usually carry a degree of capital protection. Heavily geared split-capital trusts were the source of large losses to many investors in the early 2000s, which resulted in a major inquiry and findings that the funds were in many cases not managed in a way that was in keeping with the industry’s practice of positioning zero-dividend preference shares as “low-risk” investments.

ETFs
ETFs are Open-End Investment Companies, but like Investment Trusts, they trade on an exchange. Investors do not buy or sell ETF shares directly from the fund, but trade with other investors over an exchange. They rely on an arbitrage mechanism to keep their market prices in line with the NAV of their portfolios, thus largely removing the trading discount or premium issue that affects Investment Trusts. For the arbitrage mechanism to work well, however, ETFS must invest in a known portfolio of liquid securities. In practice, this means ETFs are almost always index funds.

The key advantage of ETFs in the UK is that their ongoing expenses, as indicated by their Total Expense Ratios (TERs) are often much lower cost than regular funds tracking the same index. This is in part because their administrative costs are sharply reduced—they do not have individual shareholder accounts to maintain or service. They also tend to be less exposed to dealing costs, which gives them an edge over regular funds in tracking their indexes. Because there are no individual shareholder accounts, you do need to pay brokerage costs to buy or sell ETFs, however, and depending on the amount you are investing, this may make them costlier. You can read much more about ETFs here.