Different Types of Funds – a Comparison

There are a number of different types of funds available in in the UK. These include Unit Trusts, OEICS, Investment Trusts and ETFs.

We’ll be covering:

• The reasons for investing in funds in the first place
• What they are
• The key differences between them
• Which one may be right for you

Why Invest in a Fund

Investing in funds enables average investors to pool their money together. This is a great way to reduce risk, because it allows investment across a wide range of companies. Avoiding putting your eggs in one basket is one of the most important concepts in investing.

If you have £1000 to invest and company A’s shares sell for £1000, you’d only be able to invest in that one company. That’s fine if their stock price goes up, but what if it goes down? Worse still, what if they go bankrupt? You could lose all your money!

If you invest in a fund, the situation would be a little different. Funds tend to invest in lots of different companies.

If we assume £1000 is the average price of each companies share, and the fund invests in one of company A’s share, alongside another 99 shares in another 99 companies, the impact of one company going bankrupt or losing money would be negligible.

In fact, if 100 people have each invested £1000 in the fund, then each person will have invested an average of £10 per share. As a result, if company A’s shares go to £0 each investor will only have lost £10.

Diversification and not needing to worry about selecting your own stocks are great reasons to invest in a fund. However, you still have a decision to make because there are many different types of funds to choose from:

Types of funds available in the UK

• Unit Trusts
• Open Ended Investment Companies (OEICS)
• Investment Trusts
• Index Funds
• Exchange Traded Funds

Some of these different kinds of funds are similar.  As a result they can generally be grouped as follows:

• Unit Trusts & Open-Ended Investment Companies (OEICS)
• Investment Trusts
• Index Funds and Exchange Traded Funds (ETFs)

Unit Trusts and Open-Ended Investment Companies (OEICS)

When people talk about investment funds in the UK, they tend to be referring to either Unit Trusts or Open-Ended Investment Companies (OEICS). These are called mutual funds in the US.

These two kinds of investment are very similar. Unit trusts are the older of the two. In fact many Unit Trusts have changed in to OEICS in recent years.

The only real difference between Unit Trusts and OEICS is in the price you pay. Unit Trusts tend to have two prices, a “bid” price and an “offer” price. If you want to buy, you pay the “offer” price and if you want to sell, you receive the “bid” price.

The difference between the two prices is the initial charge. With OEICS the initial charge is taken separately, so the price is the same no matter whether you buy or sell.

As well as this initial charge, both of these two different types of funds charge a management fee every year. The initial charge can often be 5% and the Money Advice Service suggests annual fees range from 0.8%-1.25%.

The initial charge can sometimes be sidestepped at some brokers. However, such brokers tend to have their own fees and it is important to note that there are hidden fees associated with this type of fund, namely turnover fees associated with the buying and selling that takes place within the fund.

Jack Bogle in the Little Book of Common Sense Investing estimates an average of 1% per year for the hidden costs of portfolio turnover.

One of the biggest characteristics of these funds is that they are open ended. That means whenever new money comes into the fund more shares need to be bought. Similarly, if money flows out shares need to be sold.

This system can have a negative impact because it can mean these funds need to trade whenever money leaves or comes into the fund. That’s bad because trading costs money, which in turn eats into investment returns.

Furthermore, it can mean the funds really suffer in downturns when people start panicking and pulling their money from the fund. At a time when shares in the fund are devaluing, fund managers will have to spend money selling shares!.

Investment Trusts

Investment trusts are actually companies that trade on the stock market. If you want to invest in an investment trust you need to buy shares in the company.

They are generally less well known than Unit Trusts and OEICS because they don’t pay commissions. This means less people write about them or advertise them because they can’t earn any money doing it.

Unlike Unit Trusts and OEICS, Investment Trusts are closed-ended. This means the number of shares the trust is divided into is limited.

If investors want to invest in an investment trust, they simply buy that investment trusts shares. If investors want to pull their investments, they simply sell their shares in the investment trust.

Close-ended has its advantages and disadvantages. I’ll get the bad stuff out of the way first. To start with, a trust’s shares can trade at a discount or premium to the value of the actual company shares they have.

Let’s assume the Investment Trust BEM just contains a single share in Apple. That Apple share is worth £1000, so it figures that Investment Trust BEM’s shares should also be worth £1000.

If there were two investors in Investment Trust BEM that would mean the shares of Investment Trust BEM should be worth £500 each.

However, it doesn’t work quite like that. If Investment Trust BEM is popular the shares are likely to cost more than £500. Similarly, if it is unpopular the shares are likely to cost less than £500.

Reasons for over and undervalue tend to follow the funds performance, but there are many reasons why a fund could be over or undervalued.

A superstar fund manager leaving the company could push the price of shares down. Similarly, the shares of the fund this superstar fund manager joins could rise.

Sharp eyed readers may already be seeing the potential for increased returns by purchasing a funds shares at a discount and that’s right.

It is possible to use this method to increase returns. However, the very fact that these shares can trade at a premium or discount means Investment Trusts are often considered riskier than Unit Trusts or OEICS.

That said, Investment Trusts are considered to have a number of advantages over Unit Trusts and OEICS. The fist one is that because they are closed-ended they don’t need to buy or sell assets when they don’t want to.

This is important because investors tend to panic in market crashes and corrections and pull their money out at just the wrong time. Unit Trusts and OEICS would be forced to sell their assets at the wrong time, whereas Investment Trusts don’t need to do this.

Consequently, at such times Unit Trusts and OEICS are likely to lose a lot of money, but Investment Trusts can just wait patiently for the share prices to recover.

The second advantage of investment trusts is that they can hold cash on the side. Maybe they can use this cash to take advantage of opportunities that present themselves, but most importantly it means they can continue to pay a dividend through thick and thin.

The third advantage of Investment Trusts is that they don’t have initial charges. There are some costs for Investment Trusts, though. Firstly, in the UK you need to pay stamp duty when you buy shares. As Investment Trusts are classed as companies, you will usually have to pay 0.5% stamp duty at purchase.

There will also be some additional buying and selling costs associated with the broker you use. The Money Advice Service suggests annual feels may range from 0.8%-1.8%.

However, as with Unit Trusts and OEICS there are hidden costs associated with this type of fund. Portfolio turnover costs is estimated to be an additional 1% on average.

The last and perhaps the most important advantage is that research tends to show that Investment Trusts outperform Unit Trusts and OEICS. This may or may not have something to do with the fact that they can use gearing.

Gearing, sometimes called leverage means borrowing money. Whether this is an advantage is debatable.

The crux of the matter is Investment Trusts can borrow money to improve results. If used carefully this can be a straight forward way to increase the return on investment for investors.

If you have £100 invested and it goes up by 10% you’ll have £110. You’ll have made £10. However, if you borrowed £100 from the bank at a 2% interest rate to go with your £100 pounds and your investment goes up 10% you’ll have £220.

Taking away the £100 you borrowed from the bank and the 2% interest of £2 you’ll have made £18. You’ve almost doubled your return by simply borrowing money.

Gearing isn’t always considered to be a good thing, though. Magnifying returns is all very well in the good times, when your profits are increased. However, it might not be so good in the bad times when your losses are magnified.

Index Funds and Exchange Traded Funds

We can’t talk about Index Funds without first mentioning the active vs passive debate.

Active funds have an active manager, tasked with providing higher returns than their competitors when the market is going up, and lower losses when the market is going down.

Passive funds on the other hand do not have an active manager. Though, there are more and more passive strategies emerging all the time, they traditionally follow an index.

These days there are a multitude of indexes, but perhaps the most famous one in the UK is the FTSE 100. A list of the UK’s top 100 companies by Market Capitalization. Passive funds following this index simply mimic the stock sizes of the index in proportion.

If the FSTE100 has 2% of its investment in Shell then so will the passive fund. If HSBC grows to 2% from 1% then the fund will buy more HSBC shares to make sure it has the same proportions as the index.

Passive funds typically have two forms: Index Funds (trackers), and; Exchange Traded Funds (ETFs). Trackers are bought like Unit Trusts and OEICS and ETFs are bought through a stock exchange like Investment Trusts.

The key advantage of trackers and ETFs is cost. They are usually considerably cheaper than Unit Trusts, OEICS, and even Investment Trusts. The Money Advice Services estimates fees of between 0.25% and 0.85%.

Those who don’t believe in active management will argue that not having a fund manager is a second advantage.

That’s because there are many studies that show that fund managers often underperform their benchmark (usually an index).

In fact, research by Standard and Poor in the US showed that over the last 15 years only about 1 in 20 actively managed domestic funds beat index funds.

You can read more about the active vs passive debate here.

The Bottom Line

There are so many different types of funds out there that choosing one over another isn’t going to be straight forward as it should be. In the end, tt will come down to an individuals goals and preferences.

However, generally investors who don’t want to pay large annual fees or who aren’t convinced by active management should probably chose Index Funds or ETFs.

Which one you chose of the two won’t really matter. Instead, it will probably be decided by which one is available to you. Many expats don’t have access to Index Funds but do have access to ETFs for example.

Those who believe in active management and aren’t concerned with the higher fees need to weigh up the trade off between risk and reward.

The rewards with Investment Trusts may be greater because they can use leverage, shares can trade at a discount and they are cheaper. However, leverage and shares trading at a discount or premium add risk.

If you are happy with that risk, then Investment Trusts are likely to be a suitable option for you. Those who aren’t comfortable with such risk, but want active management and are willing to pay more are probably going to be better off investing in Unit Trusts or OEICS.

Again, which one you chose will probably come down to which one is available.