Unit Trusts and Open-Ended Investment Companies - Coursework Example

Introduction This paper sets out details about unit trusts and open-ended investment companies. It discusses their benefits, pricing structures, legal structures, and taxation. The idea is to compare both the forms of collective investments and derive a conclusion as to which is a more flexible investment vehicle, unit trusts or open-ended investment companies. Unit trusts and Open-Ended Investment Companies (OEICs) are collective investment vehicles that pool funds from various investors and with the help of a professional investment manager invest those funds in a variety of asset classes in line with the preset investment objectives. Unit trusts and OEICs share some common benefits such as diversification, simplicity, and income and growth potential (Jorion, 2005). However, OEICs outweigh unit trusts in terms of benefits that they offer. The key area of distinction is the pricing structure of an OEIC which is more straightforward and transparent. Moreover, OEIC has a more flexible structure in that it can entail a variety of sub-funds that offer different investment objectives. Adding new sub-funds and creating share classes is not only easy in the case of an OEIC but also inexpensive (Jorion, 2005). The paper also discusses the legal structures of both the investment vehicles and concludes that unit trusts are legally more complex than OEICs. However, the tax treatment for both investments is similar. Unit Trust A unit trust is a fund of stock market investments divided into equal portions called units. Unit trusts are open-ended collective investments. A unit trust is open-ended because the number of units in each trust is determined according to supply and demand factors. A unit trust is collective because it pools money from many different investors which is then looked after by a professional investment manager. Unit trust funds allow units to be created when people invest and units to be cancelled when individual investors cash in their investment. The price of the unit trust reflects the value of investments in the fund, called the net asset value, plus charges calculated within the spread. Each day the total assets of the fund are valued. The total value is divided by the number of units that are issued and the unit price is set for that day. However, the administration and charges are deducted before determining the value of the investment (www.chartwell-investment.co.uk). Unit trusts are available in different dimensions such as those that concentrate across a geographical area, a specialized sector of industry, or a specific type of stock. For example, an investor can choose a fund specializing in UK companies, or one that concentrates its investments in the Far East. Unit trusts are authorized and regulated by the Financial Services Authority (FSA). Benefits Diversification - Investment in a unit trust can limit risk by spreading your investment and pooling your money with other investors to achieve a much wider investment spread. This means that you do not have all your eggs in one basket rather your investment will be diversified across a range of investment asset classes. Simplicity - Investment in a unit trust is considered simple as compared to the alternative of investing directly in a diverse selection of shares and bonds which would demand quite a lot of research otherwise. Income and Growth Potential - Designed as a medium to long term investment vehicle, unit trusts can cater to the needs of investors with varying objectives, namely, income and growth. Unit trusts are popular investment vehicles for both capital growth as well as income, however, it must be noted that these investments are subject to risk in the short-term and, therefore, are recommended for medium to long-term investment horizon. Professional Fund Management - Unit trusts are handled by professional fund managers who ensure that the fund is appropriately allocated to asset classes as per the objectives of the investors. Pricing Structure Unit trusts have a "bid/offer spread", that is the buying (or bid) price is higher than the selling (or offer) price. This pricing structure is known as dual pricing. The difference in the bid and offer price is equivalent to the separate initial charge that investors pay when they invest in an OEIC. The bid/offer spread is sometimes quoted as a percentage and referred to as the initial charge for investing in the unit trust. Depending on the provider and the nature of unit trusts, initial charges can range from 5.5% to 0% (www.moneyextra.com). Legal Structure Unit trusts are complex legal structures. They are governed by a trust deed. The interests of investors are protected by the various regulations of the Financial Services and Markets Act 2000 and by the independent trustee, which is usually a bank or insurance company. The trustee is the registered holder of the fund's underlying assets and their responsibilities include: Overseeing the management and pricing of the trust; Maintaining a register of investors; and Collecting and paying out income from the trust (www.trustnet.com). Taxation Unit trusts are taxed in the same way as the underlying investments which the trust holds, whether cash, corporate bonds, or shares. Unit trusts are subject to income tax and capital gains tax unless the unit trusts are held in an Individual Savings Account (ISA) which is not subject to tax up to a certain threshold (www.chartwell-investment.co.uk). Open-Ended Investment Company (OEIC) An Open-Ended Investment Company (OEIC) is a pooled collective investment vehicle, in company form. OEICs first became available in 1997 when they were introduced as a more flexible alternative to established unit trusts (www.moneyextra.com). By being open-ended, OEICs can expand and contract in response to demand, just like unit trusts. OEICs allow individual investors to pool their money together and invest in bonds, equities, or other investments as a group. Essentially, an OEIC is a company whose business is managing an investment fund. As an investor, you get a stake in the fund by buying shares in the OEIC. As more people invest in an OEIC, the fund increases in size and more shares are created. Conversely, as investors withdraw their money, the fund shrinks in size and shares are cancelled. Therefore, OEIC is termed as open-ended, since there is no minimum or maximum size. The value of an OEIC is determined according to the investments the fund manager makes with the fund's money. The price of the shares is based on the value of the investments the company has invested in. An OEIC is the most widely recognized investment fund structure in Europe and allows flexibility in charging and currency structure that unit trusts do not offer. Benefits Single Pricing - the key benefit of an OEIC is its single price, designed to make investing more transparent. Single pricing means that there is only one pricing for the shares in an OEIC whether you are buying or selling - far simpler than the traditional bid/offer unit trust pricing structure. Tailored -Investment - the flexible structure of OEIC allows an investor to tailor investment to suit his/her needs. OEIC operates as an 'umbrella' structure containing a number of sub-funds each with different investment objectives (income, growth) for the investor to choose from. Switching Funds - investors can easily switch funds from one sub-fund to another within the OEIC due to its flexible umbrella structure. New sub-funds and share classes can be added quickly and cheaply. Cost-Efficiency - the single pricing structure of an OEIC makes it more cost-efficient as compared to its counterpart, Unit Trust. Diversification - Investment in an OEIC benefits from diversification by spreading your investment and pooling your money with other investors to achieve a much wider investment spread. Pricing Structure Unlike units in a unit trust which are subject to the bid/offer spread, shares in an OEIC have a single share price, the mid-market price. Any charges such as the initial charge are shown separately in the management group literature making the cost structure more transparent and easier for the investors to understand. The single pricing quality of OEIC makes it more flexible and cost-efficient. This is the reason which is making many unit trusts gradually convert into an OEIC. Legal Structure Unlike unit trusts which are legally very complex and only entitle investors to participate in the assets of the trust without actually owning a share of them, OEICs are companies in which investors buy shares, similar to buying shares in any other company. OEICs are run by an Authorized Corporate Director (ACD). The responsibility of selecting investments for the OEIC rests with the Authorized Corporate Director. The interests of the investors are protected by a Depositary, which is an independent, authorized third party. The ACD is similar to the unit trust manager and the Depositary to the trustee (www.henderson.com). Taxation OEIC is taxable in the same manner as the underlying investments that is held by the OEIC whether shares, gilts, or loan stocks. The tax situation depends on the type of distribution received from the OEIC, which in turn depends on the type of OEIC funds are invested in. If an investor holds an OEIC outside an ISA, he will receive a tax voucher from the fund manager showing the amount of tax paid on the distribution by the manager. Within the ISA, distributions are not subject to tax up to a certain threshold (www.henderson.com). Similarly, OEICs invested in gilts, loan stocks or other interest-bearing securities pay out interest distributions net of taxes. Risks As with all investments that are linked to equities, property and fixed interest securities, the value of the investments can go down as well as up. There is no capital protection guarantee and the investor may not even get the initial amount invested (Ogden, Jen & O'Connor, 2003). Risk of loss should be kept in mind before committing funds to unit trusts or OEICs. Unit Trust or OEIC, which is better OEICs are more flexible in terms of investment than unit trusts. When investors are shopping around to see which investment vehicle suits their investment objectives, one of the most important things that they keep in mind is the costs involved. Though unit trusts and OEICs are similar in many aspects, pricing is one mechanism whereby OEICs are more attractive for investors. Employing a single pricing approach, OEICs are easily understood by the investors and are viewed more transparent than unit trusts. OEICs have an umbrella structure which holds different sub-funds offering investors various investment objectives, income and growth. OEICs possess the capability to easily and cheaply add more sub-funds or share classes should the demand warrants. With OEICs, investments can be tailored to suit the needs of the investors. Such is not the case with unit trusts since they do not possess the capability to hold any sub-funds (www.henderson.com). By investing in OEICs, investors buy shares in an open-ended investment company rather than units as in a unit trust. Being entitled to shares in OEIC gives a sense of belonging to the investors as they feel part of OEIC which is not the case with unit trust holders. In essence, an OEIC offers a more efficient, flexible and transparent investment vehicle for collective funds. Conclusion Unit trusts and OEICs are both collective investment schemes that pool funds from investors and put them in the hands of a professional investment manager for investing those funds in various asset classes such as gilts, shares, property, loan stocks and other interest-bearing securities. Both unit trusts and OEICs are open-ended funds which mean that their size varies according to supply and demand factors. Unit trusts have been in operation for a longer time than OEICs which were introduced in the UK in 1997 to harmonize fund structures. Both the investment vehicles share common characteristics with some differences, the main one being the charging structure. Unit trusts employ a dual pricing structure and turn out to be more costly for an investor than OEICs which sell their shares at a single price. This single pricing structure makes OEICs more cost-efficient. Furthermore, OEICs offer investors various investment options through their umbrella structure which entails any number of sub-funds and allow for switching between the sub-funds. Unit trusts are governed by a trust deed and do not allow ownership, whereas OEICs sell shares like any other company giving the investors ownership rights. The tax treatment for both the investment vehicles is similar, therefore, it does not play a role in deciding which investment vehicle to choose. It can be concluded that OEICs are far more flexible in terms of investment as compared to unit trusts. Investors are more attracted to OEICs because they are cost-efficient and are structured in such a way that investors at any time can switch their funds within the sub-funds should their investment objectives change. Investors feel a more sense of belonging due to the ownership rights that are not part of the unit trusts package. Moreover, OEICs are not legally complex vehicles and their pricing is more straightforward and easily understandable by the investors. Internationally, the corporate structure (OEICs) is far better understood than the trust structure (unit trusts). The demand for OEICs is compelling more and more unit trusts to convert to OEICs. Many unit trust managers are changing their unit trusts into OEICs to simplify the collective investment process, reduce charges and allow greater investment freedom. REFERENCES AWD Money Extra (no date). Open-Ended Investment Companies (OEICs). Retrieved on April 19, 2007 from http://www.moneyextra.com/guides/open-ended-investment-011462.html AWD Money Extra (no date). Unit Trusts. Retrieved on April 19, 2007 from http://www.moneyextra.com/guides/unit-trusts-011458.html Chartwell (no date). What are Unit Trusts/ OEICs Retrieved on April 19, 2007 from http://www.chartwell-investment.co.uk/content/365.htm Financial Express (no date). UT & OEIC Education Guide. Retrieved on April 19, 2007 from http://www.trustnet.com/help/ut/ Henderson Global Investors (no date). OEICs & Unit Trusts. Retrieved on April 19, 2007 from http://www.henderson.com/home/uk/personal_investors/faqs/oeics_and_unit_trusts.as Jorion, P. (2005). Financial Risk Manager Handbook. John Wiley & Sons Inc., New Jersey. Ogden, J.P., Jen, F.C. & O'Connor, P.F. (2003). Advanced Corporate Finance: Policies and Strategies. Pearson Education, Singapore. Read More