What’s the difference between an investment trust and unit trust?

There are 7 differences when we look at the differences between an investment trust and unit trust.

When it comes to investing in a professionally managed fund, there are two major types: open-ended and closed-ended investments, also called Unit Trust and Investment Trust, respectively.

Both offer broader exposure to investment options and equities by pooling resources. Fund managers then make a portfolio, where the ‘pooled’ resources act as a single investment. However, the management style, performance, structure, and legalities are drastically different for these two types of funds.

This article talks about the fields and aspects where The difference between an investment trust and unit trust can affect the fund’s performance.

Structure and Functioning

Unit trusts are open-ended funds; there is no limit to the number of shares or units for the investors. When the demand increases, the trust becomes bigger to accommodate it. That is, it makes more units. Similarly, when the investors want out, the total value of the investment decreases.

The open-ended structure and operation of unit trusts also imply that when investors and investments leave, the unit trust shrinks, and its price also falls. This price won’t go up until more investments join the unit trust.

Investment trusts are closed-ended funds, which means each has a limited number of shares. After a certain amount of capital has been raised, the trust lists its shares on a major exchange such as the London Stock Exchange (LSE).

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The shares are then available at their market price. The price of the stock may vary from hour to hour or day to day, but the fund manager does not have to sell the fund’s assets when an investor sells his shares.  

Stocks held within a fund

Fund Management

Investment trusts operate as publicly-traded companies. These offer a fixed number of shares to raise capital by an Initial Public Offering (IPO) . Shares are then listed on an exchange to be traded like stocks. Like unit trusts, investment trusts are also managed by a fund manager, but the activities of the fund are supervised by a board of directors. 

The fund manager, hence, is subject to compliance with the policy of the investment trust. For instance, some trusts tend to provide long-term gains by investing in small- and medium-sized companies and stocks to provide a small income but greater capital gains.

Others carry the policy of maximum dividend income for the investors by investing in companies and stocks listed on authorized, big exchanges.

This scenario with an investment trust also implies that the board can hold the manager accountable or even replace him for the good of the investor.

The fund manager and the unit trust are basically the same entity. A unit trust is supposed to make more units when more investment comes and sell them when an investor wants out. The fund does not independently monitor or supervise the activities of the fund manager.  

Pricing

Open-ended investments are priced at their Net Asset Value (NAV), which is the total assets a fund has minus its liabilities. And these are available for purchase only one time a day for a certain offer price. Unit Trusts, hence, come once a day for one price, that reflects the value of the holdings of the fund. 

Investment stocks, being the closed-end funds, reflect the market value, which can be a discount or a premium over the NAV. Investment trusts have a fixed number of shares that can be traded freely, like stocks on exchanges like the London Stock Exchange (LSE).

These are available throughout the day, at any price decided by the demand of the particular stock and the performance of the underlying asset.

Another feature of the pricing of the investment trusts’ stocks is the bid-offer spread. Buyers quote a buying price, which can be more than the selling price. The difference goes to the earnings of the fund. In contrast, the unit trust operates on the single pricing concept.

Liquidity

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When investors sell their units, a unit trust has to eliminate its assets. In other words, a unit trust responds to the cash inflows and outflows. Considering that investors find a way out in bad times when selling assets is difficult, unit trusts often face difficulty holding up with the stock price and performance.

Investment trusts are not supposed to accommodate the cash coming in or leaving the fund. Investors make offers and bids on the exchange, just like stocks. It does not make a difference to the underlying investments and assets of the investment fund.

For this reason, unit trusts tend to stick to more liquid assets such as shares that can be sold easily to pay an investor. Illiquid assets such as infrastructure and property are more suitable for investment trusts.

Legal Duties

Unit trusts are not established as public or private companies but rather act as legal trusts. These are regulated by the Financial Conduct Authority (FCA). Investment Trusts, being public companies making a portfolio on behalf of their investors, are governed by the Companies Act 1985 [https://www.legislation.gov.uk/id/ukpga/1985/6].   

Unit trusts are subject to distributing all their returns in the same tax year. At the same time, an investment trust can hold back up to 15% of the profits to save for a rainy day. Unit trusts are also not allowed for borrowing, whereas the investment trusts can borrow capital, a process known as gearing.

Investment Trusts and Borrowing

Investment Trusts are not subject to the same legal rules and regulations as unit trusts. They have more flexibility of options when it comes to investing and borrowing. Borrowing or gearing increases the size of the investment trust by increasing the capital gains in bull markets.

Let’s go over the concept of gearing for investment trusts: let’s say a person has £2,000. He borrows £300 and invests all the money in a stock that has a potential to grow. In a month, the stock doubles, and he receives £4,600. He returns the borrowed amount with a 10% interest and is left with £4270. Without having used the borrowed amount, he would have been left with £4,000 only.

The same scenario applies to the risk of loss as well. Gearing exaggerates the losses because the borrowed amount goes back to the lender as it is with interest.

Management Charges

Unit trusts and investment trusts both provide professional fund management services for an annual fee. Investment trusts, however, have a reputation for low management charges as compared to Unit Trusts and OEICs.

Ongoing management charges for a unit trust range between 1 and 1.5% of the total assets. Unit trusts also charge an additional fee when an investor sells or buys units. Management charges for investment trusts are way lower. For instance, as of 2020, the ongoing annual charge for The City of London Investment Fund was 0.39% of the total assets.

Taxation in the UK

The Differences between an investment trust and unit trust are also evident in how they are taxed in the UK. The dividend income and the capital gains from both funds are taxable unless or until it falls in the dividend allowance.

Investment trusts, however, can be held in stocks and shares ISAs, in which case dividends and capital gains are exempt from taxation. For unit trust investment, income taxes are deferred on retirement accounts until distributions are taken from the account.

Funds & ETFs

How does The difference between an investment trust and unit trust impact Performance?

Considering the above differences between an investment trust and unit trust, both perform differently for short-term and long-term gains. Investment trusts are more suitable for a longer-term investment. The Association of Investment Companies (AIC) changed the names of five of its investment trust categories following consistent outperformance of closed-ended over open-ended funds.

Investment trusts are safer for a longer-term view. One reason for that is investment trusts do not have to liquidate assets when markets fall. At the same time, unit trusts have to shrink and get rid of assets when investors sell their units.

On the flip side, share prices of investment funds fluctuate more drastically than the unit trusts’ prices. Investment trusts, hence, cannot beat unit trusts for short-term dividends and capital gains. But as discussed above, when unit trusts face drastic selling out, their unit prices will take considerable time to recover.

Another difference between an investment trust and a unit trust is that investment trusts are more suitable for illiquid assets such as real estate. Unit trusts, however, tend to take more liquid assets that can be offloaded when selling pressure increases.

There are two major reasons for investment trusts outperforming unit trusts for long-term gains. Investment trusts can use gearing to maximise gains in a bullish market. Secondly, investment trusts can hold back a share of their returns as reserves, which helps maintain a steady income for the shareholders.

The Bottom Line

The difference between an Investment trust and unit trust use pooled investments to create a mixed portfolio on behalf of the investors. But there are significant differences between an investment trust and a unit trust in terms of performance, taxation, management, structure, and functioning.

Unit trusts have long been the most popular route for passively managed investments. Investment trusts, as investment companies in their own right, are gaining attention because of the tax exemptions (in certain cases), long-term gains, and lesser management charges.

 

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