By this point of this Grow It series you will have a greater understanding about investing your money and growing your wealth. The focus of this series has been on investing in a responsible way, that aims to grow your wealth over the long term while diversifying investment risks. As such I have focused on the use of funds to invest in a diversified range of assets and companies. If you decide to use an online robo-advice service that recommends a portfolio for you and manages the investments (as I discussed in the last episode) often they will build a low-cost diversified portfolio using a type of fund called an exchange traded fund, or ETF for short. Even though you may not be running your investments yourself it is still useful to understand how funds work, as most online investment services will invest via a range of ETFs or unit trusts.
If you are planning on running your own investments and picking a portfolio of funds then it’s crucial that you understand the difference between the types of fund structures out there. When researching funds on your investment platform you will come across unit trusts, investment trusts and ETFs.
In this video I am going to briefly explain the differences between each type of fund as well as their pros and cons.
Fund types explained - Active vs Passive Investing
Firstly unit trusts. Unit trusts are a type of collective investment, which means that investors pool their money together to invest in a diversified portfolio of assets. So rather than individual investors buying shares in individual companies, their money is pooled together into a unit trust, benefiting from the economics of scale meaning that they can invest in a wider range of companies and at much lower cost. You will often hear unit trusts referred to as ‘open-ended’ funds. This means the manager can create and destroy units as needed to accommodate money flowing into and out of the fund. That’s because Investors purchase units in a fund when they invest in it and the value of their investment will rise or fall in line with the performance of the underlying assets held by the fund. While this means investors will always be buying units at a price approximately equal to the value of the slice of assets the unit trust contains, it also means fund managers can be forced to sell assets at a loss if investors pull their money out of the fund en masses– or buy shares at an inflated price if investors start putting money into the unit trust.
Unit trusts are the common type of fund most investors will come across when investing. There is a wide choice covering all types of asset classes and it is usually free to buy and sell them on most investment platforms. Although of course don’t forget that as with all fund types the manager will charge a fee (expressed as an annual charge) usually between 0.5% and 2% to run the unit trust. On top of that your investment platform will usually charge a platform fee, somewhere in the region of 0.45% a year to administer your investments and facilitate your transactions. If you use a robo-advice proposition the costs quoted by the service will often include all these charges but they are wrapped up as a single annual fee of around 1% a year, but it can be less than that.
One of the main advantages of unit trusts is that they offer diversification and they are typically easy to buy and sell. However, unit trusts can have high fees, including management fees and performance fees, which can eat into your returns over time. Additionally, unit trusts are typically actively managed, which means that a fund manager will make decisions about which assets to buy and sell on your behalf, in line with the fund’s stated investment mandate. This is called active management or active investing. While this can lead to potentially higher returns, the opposite can also be true and research suggests over the long term most funds managers underperform the wider market or passive strategies that track key indices.
Investment trusts are similar to unit trusts in that they are collective investment schemes, but they are structured differently. When you invest in an investment trust, you buy shares in the trust, which are traded on a stock exchange. Investment trusts are described as closed-ended because there is a fixed number of shares available. However, as with any other traded company, their shares can go up and down in price according to supply and demand. It means that the value of an investment trust isn’t just determined by the value of the assets it invests in. Investment trust share prices can be affected by things like investor sentiment – for better or worse.
This means you could end up paying less than the value of assets the shares represent (known as a discount) or you could pay more than the underlying assets are worth (a premium) to buy shares in the investment trust. Whether a company trades at a discount or premium depends on several factors. Trusts can sometimes aim to maintain a discount. But just as often the discount or premium is determined by how confident investors feel in the management of the trust. If they have lost confidence in the management, they might sell their shares en masse and thus drive the price down. The reverse could happen if a manager or trust is particularly in demand. Trusts can swing from discount to premium. If you think of buying at a discount as buying shares (in the companies the trust has bought) at cheaper than market rate, it can look pretty appealing. But remember you also might not get market rate when it comes time to sell your shares again if the discount persists or widens.
It’s not a good idea to try and time markets or the movements of individual share prices, and the same applies here. Playing the discount/premium game is highly risky, and it’s very easy to fall into psychological traps that mean you end up selling low and buying high. Generally it isn't recommended to buy a trust simply because of its discount or premium.
The good thing about the structure of an investment is that trust managers aren’t forced to buy and sell assets to satisfy investor demand. The decision to buy and sell rests solely with them. This is a huge advantage over unit trusts. Should investors want their money back from a unit trust then the manager destroys units to enable this. If there is a large amount of investors wanting their money back at once the manager will have to sell some of the assets the fund holds. This isn’t necessarily a problem if the assets are liquid, such as shares traded on the stock exchange, but if they are illiquid, such as property (i.e. actual buildings) the manager can be forced to suspend withdrawals in the fund. That’s why it is generally best to avoid investing in illiquid assets such as property or shares not freely traded on the stock exchange via a unit trust. Investment trusts don’t have this problem. If someone wants to invest in an investment trust or sell out they have to simply trade their shares on the stock exchange via their investment platform, and this has no impact on the assets in the investment trust or the management of them.
As investment trusts can be bought and sold on a stock exchange, it means that they are more liquid than unit trusts. You can decide to sell your holding and the trade will be placed immediately assuming there is a buyer at the price stated. However unit trusts are priced and traded daily. So should you wish to sell out of a holding you won’t know the final price the transaction is settled at, which can be disconcerting in a volatile market and at worst lose you money if the market moves against you between the time the deal is placed and when it is actions, and the transaction can take days to clear.
Another advantage of investment trusts is that they can offer income investors a stable and growing income stream. Trusts can distribute profits to shareholders, just like any other listed company. Unlike with unit trust funds however, trusts have the right to withhold up to 15% of their annual dividends to keep for another year. This creates a smoothing effect on income generation– so in theory you won’t be quite as vulnerable to fluctuations in dividend payouts from one year to the next.
Another feature of investment trusts is that they can also borrow money (known as gearing) to invest in an attempt to boost returns. When a trust borrows money and makes good returns, it can share the difference with investors – meaning when things go well, gearing magnifies positive returns. However, the opposite is also true. If the value of the trust falls, the trust still has to repay the loan plus interest, thereby aggravating losses. In other words, gearing magnifies both gains and losses, so it’s important to look at how much gearing a trust uses before investing.
Given the ability to borrow or gear, the closed-ended structure, and the ability to invest with a longer time horizon, investment trusts can outperform their open-ended fund counterparts over the long term, if market conditions are right. However, for the same reasons they may outperform, investment trusts also tend to be more volatile, meaning their value can fluctuate more in a given period than their unit trust counterparts
This brings me onto ETFs. Exchange-traded funds (ETFs) are similar to investment trusts in that they are traded on a stock exchange, but they are structured differently. ETFs are usually open-ended, but they can be traded throughout the day, much like investment trusts. An ETF will generally replicate indices or specific parts of the market by physically holding the same assets. For example, if an ETF is aiming to track the FTSE 100 index, it will hold all 100 companies that make up the index. It does this by working with an institution like an investment bank, which works on the ETF provider's behalf to buy the underlying assets of the part of the market they are looking to replicate. This is known as a "physical" ETF.
Another option is a "synthetic" ETF, which uses "swaps", which are an instrument that pays the same returns as the underlying investments the ETF is tracking. These types of ETFs are usually associated with commodities or foreign exchanges that don't allow foreign investment. This is because they allow replication in situations where buying the actual physical assets would be difficult or impossible. Another type of ETF is known as a sampled ETF where the ETF won’t necessarily hold the assets in an index like the FTSE 100 but hold a representative selection.
This style of investing where you track the market or asset price is known as passive investing, when there is no human manager actively selecting assets to invest in. Instead a computer ensures the performance of the ETF mirrors the price of the index or asset it is tracking. One of the main advantages of ETFs is that they offer a low cost way to build a diversified portfolio, which is why many robo-advice services use them to build their portfolios.
There are technically now some active ETFs, which are run by managers who choose the assets included in the portfolio and the weightings to the individual holdings. Active ETFs generally have higher fees attached to them than their passive counterparts.Generally speaking passive ETFs cost around 0.15% to 0.2% per annum. Just like other fund types you still have to pay platform fees. One drawback is that, like investment trusts, most platforms charge fees to trade these types of funds, unlike with unit trusts, which can soon add up if you make a lot of trades.
So you can see that each type of fund has pros and cons. Most investors will hold unit trusts, from a legacy perspective, but more and more are exploring investment trusts and ETFs as they are more readily available now on mainstream investment platforms, and also cheaper to trade than they once were. Income investors will be particularly drawn to investment trusts and on 80-20 Investor we produce income heatmaps which quickly highlight those trusts that have a history (or multi-decade one in some instances) of growing the income they produce year on year. This is important if you want your investment to produce an income stream that keeps track with inflation or beats it. Whenever you invest keeping costs as low as possible is important as they eat into your long term returns which is why ETFs are gaining popularity, however cost is not the only reason to invest in a fund.
When investing it doesn’t have to be a choice between investment trusts, unit trusts or ETFs, there is no reason you can’t invest in all three types of funds if you choose. The key is to build a diversified portfolio that meets your investment goals and suits your attitude to risk, whichever type of funds you use. All three fund types will let you invest in most assets classes. However you need to ensure that your investment platforms offer the options you are interested in and that they are cost-effective. In the useful links below we provide a link to a comparison of investment platforms for Stocks and Shares ISA and pensions.
Useful links
- Best Buy Table (Robo-Adviser)
- Best Stocks and Shares ISA
- Best Pension in the UK
- 80-20 Investor (Take out a free trial)
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