Unit Trusts and OEICs

Unit Trusts and OEICs are the workhorse of much investment planning.

One of the most successful investors of all time, Warren Buffett, is reputed to have a net worth of US$78.9 billion (as of August 2020) having given US$37 billion to charity. Mr Buffet states that he read the first edition of The Intelligent Investor by Benjamin Graham when he was 19 and that ‘I thought then that it was by far the best book about investing ever written. I still think it is’.

 

Benjamin Graham (1894 to 1976) a British Born American Economist wrote his book to help ordinary long term investors find value in shares and fixed interest securities. His book deals with individual share purchases as that was what was available to investors in the 1940s and 1950s. A footnote to the revised edition that I have, published in 2006, states ‘As we have discussed in the commentaries on Chapters 5 and 9, today’s defensive investor can achieve this goal simply by buying a low cost index fund, ideally one that tracks the return of the total US stock market’.

Unit trusts and more recently, Open Ended Investment Companies (OEICs), were designed to enable ordinary investors, who do not have the time, inclination or expertise to research individual companies in the UK and other regions of the world, to invest with a measure of confidence.

Unit Trusts and OEICs

Unit trusts and OEICs (open ended investment companies) are forms of collective investment scheme.  This simply means that the investment is a very small part of a large fund being managed on behalf of thousands of other investors.  Such funds are managed by professional fund managers. 

Such investments will include one of the following types of assets or a mix of them:

  • equities (i.e. shares in companies )
  • bonds (i.e. loans to companies, usually with a fixed rate of interest)
  • gilts (i.e. loans to the UK Government, either with fixed interest or inflation-linked)
  • property (i.e. commercial property)
  • cash (i.e. cash and cash equivalents such as 90 day money or less)
  • commodities (e.g precious metals, oil, wheat etc) and
  • hedge funds (i.e. funds using derivatives such as futures and options).

 

The value of unit trusts and OEICs are very closely linked to the value of the underlying assets.

Background to Unit Trusts

The first unit trust, the First British Fixed Trust, was launched in the UK in 1931 by M&G and it held the shares of 24 leading companies.  The rationale behind the launch was to emulate the comparative robustness of US mutual funds through the 1929 Wall Street crash.  The trust was relaunched as the M&G General Trust and later renamed as the M&G Blue Chip Fund and in 2016 it was merged into the M&G UK Growth Fund whose name has now been changed to the M&G UK Select Fund.

A unit trust is an open-ended investment, which means there is no limit to how many people can invest in it or how much can be invested.  They’re termed open-ended because the fund manager can create new units (similar to shares) in the fund to meet investor demand. These units can be bought or sold at any time.

Each investor purchases units to the value of their investment and sells them back to the fund manager when they want to cash them in. The price of each unit depends on the net asset value (NAV) of the fund’s underlying investments and is priced once per day.  The value of the units the investor purchases directly reflects the underlying value of the investment.

The investments are set up under trust deeds and held for investors by a trustee, usually being a bank or insurance company, hence the name ‘unit trust’.  The funds in the trust are managed not by the trustees, but by independent fund management companies.

Unit trusts form the core of many other financial products including many ISAs, pensions and life assurance products.

Background to Open Ended Investment Companies (OEICs)

In 1997 laws were introduced allowing the creation of OEICs, which, as with unit trusts, are open-ended and the price of each unit depends on the net asset value of the fund’s investment portfolio.  Most new fund launches are now of OEICs rather than unit trusts.  This is due to the relative simplicity of OEICs and the fact they can be sold in Europe.

A subtle difference is a unit trust is governed by trust law, whereas an OEIC is governed by company law.  Technically, this means investors in a unit trust are not owners of the underlying assets, unlike investors in an OEIC.  In reality, this makes little difference to investors.

An investment in a unit trust purchases units whereas an investment in an OEIC purchases shares.

The major difference between unit trusts and OEICs is the way they’re priced. Unit trusts quote a bid (i.e. selling) price and an offer (i.e. purchasing) price.  The difference between the two prices, the bid-offer spread, aims to ensure new or redeeming investors don’t dilute the value of existing investors’ units. 

OEICs publish a single price each day, making it easier for investors to understand the cost of investing. OEICs have a mechanism called ‘swing pricing’ to protect existing investors when there’s an imbalance between buyers and sellers.  This allows the fund to artificially reduce its net asset value to account for the extra portfolio trading costs created by significant buying or selling activity.

Several unit trusts have converted to OEICs over the past decade and this trend is expected to continue.

The taxation of Unit Trusts and OEICs

Growth within the unit trust/OEIC itself is tax free and the investor will not have to pay tax on this until they decide to cash in the units.  The first £12,300 of gain on the investment in 2022/23 is free of tax and the excess would be liable for capital gains tax (CGT) of 10% or 20% in the hands of the investor.

Dividends from equity funds is subject to income tax.  In 2022/23 the first £2,000 of dividend income is free of tax and the excess is taxed at 8.75% (if it falls within the basic-rate tax band), 33.75% (if it falls within the higher-rate tax band) or 39.35% (if it falls within the additional-rate tax band).

Interest from bond and property funds is subject to income tax.  In 2022/23 the first £1,000 of interest from all sources for a basic-rate tax payer is free of tax (£500 for a higher-rate or Nil for an additional-rate tax payer).  The excess is taxed at 20%, 40% or 45% depending on the investor’s tax band.  


Links to other types of investments

 

Important

This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.

Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.

If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.