4.3Unit trusts

The purpose of a unit trust is to accept funds from individuals or companies and to

invest those funds in a wide variety of assets. Contributors to the trust then have

a share in the income and capital appreciation of the underlying assets. To under-

stand the mechanism whereby contributors share in the benets of belonging to the

trust we need to understand the concept of a unit. Imagine that a newly formed trust

advertises units for sale to savers. It must advertise those units at a price. The price

is not important except in so far as it determines the number of units to be created

after subscriptions have been received. Prices of 50p and £1 are common for units in

a newly established trust; we will choose 50p for our illustration. The advertisement

will give some indication of the objectives of the trust. These might be capital growth

or income or ‘general’ – a combination of both. It will also give some indication

of the range of assets in which it expects to invest: ‘health’, ‘technology’, ‘recovery

situations’, ‘European’ are examples. Suppose now that the trust receives £5m of

subscriptions. Ignoring the question of expenses for the time being, it will create

10 million 50p units which will be distributed to savers in proportion to the funds

they subscribed and it will buy £5m of appropriate assets.

As the price of the underlying assets changes, the value of the units will change

and will be calculated (again ignoring expenses) by dividing the current value of

the assets by the number of units in existence. Such calculations are normally done

daily and are published in nancial and other quality newspapers. The income

generated by the assets is accumulated and paid out at intervals, the amount paid on

each unit again roughly corresponding to total income divided by the number of

units in existence.

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4.3 Unit trusts

However, the number of units need not remain xed. Unit trusts are one example

of what is known as an open-ended mutual fund. This means that new savers can

join the trust at any time, and that existing savers can increase their holdings of units.

Indeed, many trusts encourage regular saving through xed monthly contributions.

If, as is usual, the inow of funds exceeds the rate at which people wish to relinquish

their units, the trust creates new units at the going price. If the value of existing

units has risen to 75p for example, new subscribers will ‘buy’ newly created units at

75p and the number they purchase will be equal to the amount they wish to invest

divided by 75p. The new funds will be used by the trust to buy additional assets. In

this crucial respect, ‘open ended investments companies’ (OEICs) are similar to unit

trusts. Although they have a different legal structure, OEICs share the characteristic

that when there is a net ow of savings into the fund, the fund expands; when there

are net withdrawals, the fund contracts.

The attractions to savers are several. Firstly, a small saver is able to minimise risk

by investing quite cheaply in a much wider range of assets than would be possible

by direct investment. Suppose, for example, that one wished to hold company shares.

If you look at Figure A1.3 in Appendix I you will see that most of the benets that

diversication offers in the reduction of risk can be achieved with a portfolio of

‘only’ fteen to twenty different shares. However, brokerage fees make the purchase

of less than, say, £5,000 worth of a share very expensive. The minimum cost of a

fteen-share portfolio is likely therefore to be nearly £75,000. The minimum invest-

ment in a unit trust is commonly £500 as a lump sum and £20 as a regular monthly

contribution. And for this, a saver can have a very small share in the performance

of over 100 companies.

Open-ended fund:A fund which will expand in response to new contributions and

contract in response to withdrawals. The value of shares in the fund corresponds to the

value of the underlying assets.

Closed-ended fund:A fund with a xed number of shares. The value (not the number)

of the shares responds to inows and withdrawals and thus may differ from the value of

the underlying assets.

Secondly, holdings of units can be liquidated quite quickly. After purchasing

units, the owner receives a certicate stating the number of units purchased. This

certicate normally carries on the reverse side a form of renunciation. The sale of

units merely requires the completion of this form and its return to the trust. A

seller would normally expect to receive the current market value of the units within

fourteen days. Notice that the buying and selling of units can take place only between

the trust and the original purchaser. They cannot be transferred by the purchaser and

thus there is no secondary market and the market value of the units is determined

solely by the performance of the underlying assets themselves. Since new units are

created in response to an inow of funds (and existing units cancelled in response to

an outow), there can be no excess demand or supply and so demand for the units

has no effect upon their price.

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Chapter 4 • Non-deposit-taking institutions

Each individual trust is always the responsibility of two companies. Firstly, there

is the company responsible for the day-to-day management of the trust. This may

be a specialist unit trust company or it may be part of some other large nancial

grouping, a subsidiary of a retail or merchant bank for example. The management

company will make the detailed investment decisions, accept funds from investors,

issue certicates of unit ownership and pay income to investors as appropriate.

In addition to its managing company, each trust has a trustee. These are mainly

specialist subsidiaries of major banks. The job of the trustee is to see that the fund

is managed within the terms of its ‘trustee deed’. This deed species the objectives

of the trust and lays down broad conditions governing the management of the

funds. There is an obvious sense, therefore, in which the trustee company is acting

as guardian of the unit holders’ interests.

For simplicity we have so far ignored the expenses of running a unit trust. How-

ever, both the management and the trustee companies will expect a reward for their

services. For the management company, this comes from two sources. Firstly, there is

the ‘spread’, the difference between the bid (the trust’s buying) and offer (the trust’s

selling) prices. Unit trusts are permitted to operate a spread as wide as 15 per cent

of the net asset value of the fund. Thus in our example above, where we calculated

the unit price at 75p, the bid price could be as low as 64p while the offer price could

be 86p. However, competition between management companies normally keeps the

spread to within 5–6 per cent. In addition, the management company may charge

an annual fee of 0.5–1 per cent of net asset value. This would normally be deducted

from dividend income before calculating the income available for distribution to unit

holders. The trustee company will also be paid an annual fee, normally calculated as

a very small percentage on the net asset value of the trust.

Details of unit trust prices are published every day in the Financial Times. Box 4.3

shows details of the rst three unit trust funds in the list operated by AXA Framlington,

and illustrates all the points we have been making. The rst column tells us that

among the funds operated by the company are one concentrating on capital growth

amongst US shares, one on biotechnology companies, and another focused on rms

showing some ‘special’ features – usually suggesting high growth prospects. The next

column tells us that the managers make an initial charge of 5.25 per cent to buyers

of units. This is reected in the fact that savers could buy the US growth units, for

example, for 178.8p but would be able to sell them for 5.25 per cent less (168.8p).

The fth column tells us that the value of the underlying assets (and thus of the units)

increased (+) by 2.6p during the last valuation period. Information at the top of the

table tells us that the units are revalued at 12 noon (1200) every day and that the

managers will deal with clients at the price that is xed at the rst valuation after

the receipt of instructions to buy or sell (‘F’ or ‘forward’ pricing). The nal column

shows the yield on the units, calculated from the dividend yield being paid by the

underlying shares. For the US units, this is zero, which is often the case where shares

are being selected solely for their growth prospects. (They may be shares in very

young companies which are using every penny of prot to nance new investment.)

If we look a bit further down we can see that the UK Select Opps pay a very small

dividend yield of 0.59 per cent.

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