What are unit trusts?

Unit trusts are a type of investment fund. Your money is combined with that of other investors and used to buy a number of different investments, with the resulting fund being split into equal units. Buying such units can provide a much wider spread of investment than you could have achieved for the same amount of money otherwise.

The money in the fund is invested by a fund manager according to the fund’s objectives. Some funds are very general, while others are highly specialised. Most unit trust managers actively pick investments to try and beat a particular benchmark index, but some simply try to track an index, these funds are known as index trackers. Read the trackers page for more details of actively managed funds vs trackers.

Unit trusts are ‘open-ended’, meaning that units can be created or cancelled to meet purchases and redemptions as necessary. Because of this the price of units (ignoring charges) trade at ‘net asset value’, i.e. the value of the fund’s assets divided by the total number of units. This avoids the extra layer of risk inherent with investment trusts where the share price can be higher or lower than the net asset value.

Open ended investment companies (oeics) are very similar to unit trusts, except that oeics have a single price at which units are bought and sold while unit trusts have a different price for each. For more details see the charges section below. Unless specified, please assume all references to unit trusts in this section also include oeics.

Who does what?

There are several parties involved in the running of a unit trust, as follows:

Trustees Fund Manager Registrar Distributor

The trustees job is to safeguard the fund’s assets, so that even if the fund manager goes bankrupt your investment is safe because the assets are independently held. They also make sure that the fund manager sticks to the fund’s objectives and doesn’t break any rules.

The fund manager is responsible for deciding how to invest the fund’s assets, making all of the investment decisions.

The registrar keeps up to date details of all unit holders and generally acts as a middle man between the fund manager and the other parties.

The distributor is effectively the ‘shop-front’. Their role is to allow investors to buy units in the fund.

A fund management group may act as fund manager, registrar and distribtor, but the trustees must be a separate entity.

Unit trust charges

There are two types of charges you’ll face as a unit trust owner: charges for buying units and annual charges while you own the units.

Buying Costs Annual Charges

When you buy or sell a unit trust there’s normally a difference between the buying and selling price, much like when you buy foreign currency for a holiday and are offered a lower price when exchanging any unused notes on your return. This difference between the buying and selling price is called a ‘bid-offer spread’ and represents the full cost to you of buying a unit trust.

Unit trust bid-offer spreads include the fund’s initial charge (which tends to be zero these days) and are typically up to 2%.

Most oeics have a single price at which units are bought and sold, so there’s no spread. The initial charge is simply deducted from your investment when you buy units. However, overall costs are little different from unit trusts, as you’ll discover if you read the ‘more details’ section below.

For as long as you own a unit trust you’ll pay an annual management charge, typically between 0.25% — 1.75% of the value of your units. It’s used to pay for the management of the fund as well as other costs such as adviser/broker sales commissions (typically 0.5%) — note commission can no longer be paid where advice is given.

In addition to the management charge there are usually other ‘hidden’ costs incurred by a unit trust which can add 0.1% — 0.2% or more to overall annual costs. Fortunately, fund managers must display total costs as a ‘total expense ratio’ (TER) or ‘ongoing charge’. This is the best figure to use when looking at annual fund charges, as it shows the true costs you’ll pay (as a percentage of your unit value).

Annual charges can significantly impact your investment returns, just take a look at the table below.

To better understand the bid-offer spread it helps to look at the various types of price relevant to a unit trust:

• Creation Price — the cost to the manager of creating new units, i.e. the offer price of the underlying investments plus stamp duty and dealing costs.
• Cancellation Price — the amount the manager receives when cancelling units, i.e. the bid price of the underlying investments less dealing costs.
• Offer Price — the price at which investors can buy units, equal to the fund’s initial charge plus at most the creation price and at least the cancellation price.
• Bid Price — the price at which investors can sell their units, at most the creation price and at least the cancellation price.

What happens with oeics? Well it’s pretty much the same except that there’s a single price rather than bid and offer prices. This price is normally in between the creation and cancellation prices and the initial charge is then added on top, so overall costs are little different from unit trusts.

The annual management charge is deducted automatically by the fund manager, usually on a daily basis (i.e. they divide the annual charge by the number of trading days each year and take that from the fund each day). It doesn’t just pay for the fund manager, but is also used to pay for any sales commissions to advisers/brokers, administration fees (including fund supermarkets), marketing expenses and the other costs of running the business (and contribute to profit!).

The ‘hidden’ costs incurred by a unit trust that are not included within the annual management charge are charged separately to the fund. These typically include fees for the trustee, auditor and registrar, often adding 0.1% — 0.2% to total annual costs.

The ‘total expense ratio’ (TER). which includes both the annual management charge and all other annual costs paid by the fund, tends to fall slightly as a fund grows in size because some of the ‘hidden’ costs are often fixed. The diagram shows how a typical annual management charge (and TER) might break down.

A few funds have performance related annual management fees, meaning the better the manager performs the more they might earn. In theory this is a good thing, as it should help align the manager’s interests with yours. Unfortunately in practice most examples charge a reasonably high annual fee with a performance fee on top, this smacks of pure greed and is very unattractive to investors. Much better if a manager charges a fixed fee just high enough to cover overheads, with any balance related to performance.

Annual charges can crucify your investment return!

They’re easy to overlook, but never underestimate the impact annual charges have on unit trust investment returns. Sure, a top-class fund manager may deliver performance that more than compensates for their annual fees, but this tends to be the exception rather than the norm.

The following figures show the value of an initial £10,000 investment after 20 years assuming no initial charge and an annual return of 6% before charges.