In this week's millennial money episode, Damien and I tackle jargon terms for beginner investors. This week we discuss, what is a unit trust, investment trust or ETF?
There are different types of funds, unit trusts, investment trusts and ETFs (Exchange Traded Funds) and the difference between them is the way they are structured and how it works.
What is a unit trust?
A unit trust is an open-ended investment which means that the fund manager can create more units in the fund if demand requires it. So, when you buy a stake a fund manager's fund you get a number of units instead of individual shares.
Here's an example:
Assume there is a unit trust fund and I come along and want to invest my money. I invest £5 and I am given 1 unit (as that is how much each unit is worth). If I invested £10 I'd get 2 units and so on and so forth. When the unit price goes up so does the value of the units you own. For example if you own 1 unit at £5 and I own 2 units at £5 each, your share is worth £5 and mine is worth £10. If the unit price then goes up to £10 per unit, your share is now worth £10 and mine is worth £20.
What is important about a unit trust is the fact it is open-ended. This means that if you wanted to sell your units you can go back to the fund manager and ask for your money back and they have to give it back to you. Now, in a normal functioning market that is great, but if you get to a point, similar to a case we had recently (Google Neil Woodford), where a lot of people want their money back, it can be difficult. This is because all of the money is invested in shares and there is a limited amount available to give back immediately, therefore in order to give people their money back, the fund manager will have to start to liquidate some assets. If everyone did that, the price of the fund would go down and it turns into this vicious cycle.
The most common way of owning investments is in unit trusts. Another thing to bear in mind with unit trusts is that they are only priced daily and so therefore when it comes to selling your unit trust, you will only get the price it is that day, which is one of the drawbacks. One of the positives of a unit trust though is they are very easy to use.
What is an investment trust?
Investment trusts are slightly different as they're not open-ended, they're close-ended. If you imagine a company was created and all the company did was invest in other company shares. You are buying a stake of that company but as a share, via an investment trust. Then if you decide that you don't want your share anymore you can sell it to someone else, but you don't do it via a fund manager you have to do it yourself. Selling it this way means you avoid the rare issue that you sometimes get with unit trusts where fund managers have to sell down assets in order to give investors their money back. This is why investment trusts are quite good for illiquid assets such as property.
Investment trusts aren't as well researched as other funds due to the fact that they have only recently become readily available. A positive of investment trusts is that they are traded at all times throughout the day.
What is an exchange-traded fund (ETF)?
Finally ETF's have the best of both worlds in that they can be traded at all times throughout the day, they are cheap and they can sometimes be passive (which means there is no fund manager).
A downside to an ETF and an investment trust is that there may be additional charges when it comes to trading your share. In most cases with a unit trust, there are no fees which can make them more attractive.
What you must bear in mind when picking which fund to invest in is that they're all slightly different and structured in different ways. Fundamentally the most important thing is what you invest in.
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