4.3 Unit trusts

Box 4.3

Unit trust prices and yields

AXA Framlington (1200)F	(UK)
155 Bishopsgate, London EC2M 3FT	Dealing 0845 602 1952
Private Clients 0845 777 5511	www.framlington.co.uk

Authorised Inv Funds
	1
American Growth Acc............................	5–	168.8	178.8	+2.6	–
	4
	1
Biotech Acc...........................................	5–	33.57	35.8	+0.64	–
	4
	1
UK Select Opps Acc...............................	5–	1460.0	1533.0	+34.0	0.59
	4

FT

Source: Financial Times, 27/28 May 2006

The rate of growth of unit trusts has been erratic. The rst unit trust in the UK was

established in 1932 by the M & G management company. Growth was slow until

the early 1960s. Between 1960 and 1970, however, total assets grew sevenfold. In the

1970s, assets grew only fourfold and there was a sharp setback in 1973 and 1974.

From £5bn in 1980, assets have grown to £279.2bn by 2004. Their pattern of growth

suggests quite clearly, and quite reasonably, that the growth of unit trusts depends

on the performance of stock markets and on the public’s perception of the benets

of equity investment.

Figure 4.3 shows the distribution of unit trust assets at the end of 2004. At the

end of 2004, over 90 per cent of unit trust assets were company securities (UK and

Figure 4.3Unit trust assets at end 2004 (£bn)

Source: Adapted from ONS, Financial Statistics, April 2006, Table 5.2D

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overseas). After holdings of short-term assets (3.7 per cent and mainly cash and bank

deposits), only UK government securities formed a signicant category (3.5 per cent).

What the gure does not reveal is the shift in the balance that occurred during the

1980s towards overseas securities, prompted initially by the relaxation of exchange

controls in 1979 and encouraged subsequently by the strong performance of some

overseas economies and stock markets. Neither does it reveal the decline in holdings

of short-term assets, from over 10 per cent of the total in 1978. It will be interest-

ing to see whether the recent (2006) increased volatility of stock markets leads to a

reversion of liquidity levels to those seen in the late 1970s.

Total assets in 2004 amounted to £279.3bn. This was an increase over 2003 of

£24.2bn. This was in spite of a net inow of funds (and net acquisition of assets)

of only £16.2bn. The difference (£8bn) resulted from the increase in the value of

existing assets, as stock markets throughout the western world showed a rapid rise.

Remember though what we said about the ow of funds through insurance companies.

The purchase of assets with new funds is no reliable indication of the total scale

of buying and selling activity. Unit trust managements are continually rearranging

their portfolios with the aim of maximising performance and so turnover gures will

be much larger than net acquisitions.

In the UK a distinction is made between ‘authorised’ and ‘non-authorised’ unit

trusts. Since December 2001, authorisation has been in the hands of the Financial

Services Authority and depends upon a trust’s deed meeting at least the following

conditions:

l	there must be no investment in property or commodities;

l	the trust must not hold more than 10 per cent of the total capital of any one company;

l	the trust must not normally invest more than 5 per cent of its portfolio in any one company;

l	at least 75 per cent of the portfolio must be invested in shares quoted on a recognised stock exchange.

Responsibility for seeing that these conditions are complied with post-authorisation

lies in the rst instance with the trustee company. However, under the Financial

Services and Markets Act of 2000 complaints about any aspect of the conduct of a

unit trust can be referred to the FSA, as is the case with all regulated nancial services.

The Association of Unit Trusts and Investment Funds (AUTIF) is a professional body

to which most unit trusts belong and this also exercises a degree of supervision of

its members.

Those unit trusts which are ‘unauthorised’ normally owe their status to the fact

either that they invest in unauthorised assets such as property or commodities, or

that they are managed from an offshore location and therefore are not subject to UK

regulation. Unauthorised trusts are prevented from advertising units for sale to the

general public although they may write privately inviting subscriptions from a very

limited range of institutions.

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		4.4 Investment trusts
4.4	Investment trusts

Investment trusts differ from all the other institutions we have discussed in this

chapter in a number of signicant ways. The chief of these is that while all previous

intermediaries are ‘open ended’, investment trusts are ‘closed’. By open ended we

mean that any number of customers, savers or subscribers can lend any volume

of funds to the intermediary at any time. For example, people can increase their

aggregate building society deposits, or buy more life assurance or more unit trusts

without any limit, except that which they themselves choose, having regard to their

wealth, the return on saving and so on. Furthermore, any increase in this lending

will mean more funds are made available to ultimate users.

In the case of investment trusts, however, what savers buy is shares in a trust which

is in effect a company whose business happens to be holding stocks and shares. At

any moment, the total number of a trust’s shares in issue is xed. Thus new savers

can buy shares only from existing holders. When we hear of a sustained ow of funds

‘into’ investment trusts, we must recognise that extra funds do not go into the trust

at all (except in one case we shall come to in a moment). There is no increase in

lending by the trust to ultimate users; all that happens is that the market price of the

trust’s shares rises. Equally, if savers decided to ‘move out of’ investment trusts, this

would simply mean a fall in the market price of the trust’s shares. It would not mean

that the trust itself had to make payments to savers. As we shall see, this immunity

from savers’ redemptions is reected in the composition of trusts’ assets.

The fact that investment trusts do not continually take in new funds and channel

them to ultimate borrowers obviously raises the question of whether they should

be considered as nancial intermediaries at all. The reasons for doing so are twofold.

Firstly, there must at least once have been a ow of funds from savers to the trust

and on to borrowers, when the trust was rst established. Also, of course, a trust is

at liberty to raise new capital by an issue of additional ordinary or debenture shares.

When trusts are popular among investors and the market value of their shares is

‘high’, raising new capital is comparatively cheap (we look at the reasons for this

in Chapter 6). Thus a ow of funds into trusts’ shares, pushing up their price, may

result in new issues of shares in the trust and a ow of additional funds into the trust

itself. This is the case we anticipated in the last paragraph.

Secondly, even with only sporadic injections of new funds, investment trusts may

still be active traders in the markets for nancial assets. With all the previous inter-

mediaries we looked at, we warned that we cannot judge the volume of buying and

selling of assets which an intermediary carries out just from looking at the inow of

new funds. In the case of investment trusts, this warning needs repeating with force.

Even without an inow of funds from savers, trusts have income from dividends and

interest on their assets and from capital gains. After the deduction of operating costs

and payments to shareholders, this is put to reserve. From this reserve and from

the immediate disposal of existing assets, trusts can make acquisitions of new assets.

Investment trusts are in fact very active in the market for new issues of shares and

in this respect are channelling funds to ultimate borrowers. Although their business

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is not one of short-term speculation, they are, however, active traders in stocks and

shares. As we shall see in Chapter 6, trading in existing stocks helps to maintain their

liquidity, makes them attractive to savers and thereby lowers the cost to borrowers

of raising new capital in this way.

Their ‘closed’ nature is one feature which distinguishes investment trusts from

other types of intermediary. Their legal status and their regulatory framework are

others. They are not trusts at all in the sense that unit trusts are. There is no trust deed,

no trustee and the saver’s claim upon the assets of the trust is only the very general

claim that any shareholder has upon a company. Indeed, being a limited company

makes an investment trust subject to the relevant Companies Acts and it is these

which principally constrain the trusts’ conduct of business. In addition, the Stock

Exchange imposes conditions on companies wanting a listing. These extend to very

broad guidelines on the nature of investments and would also affect trusts considering

merger. Lastly, the Inland Revenue ‘approves’ investment trusts for purposes of tax

treatment (principally their exemption from capital gains tax on disposal) and this

approval is conditional upon very limited portfolio requirements being met.

Investment trusts, therefore, are not regulated by the Financial Services Authority

as are unit trusts. This became an issue in a recent nancial markets scandal – that

of split capital investment trusts (see Box 13.2).

The rst trust was established in 1868. By comparison with other intermediaries,

growth has been slow, at least until the 1980s when the value of investment trusts’

assets almost doubled (1981–86). A feature throughout their history has been a very

high level of investment in overseas securities. The reason for this seems to have been

that until 1914, the return on UK securities was very low, rarely more than 3 per

cent, and better returns could almost always be obtained abroad. However, these

were generally riskier and since many savers lacked the necessary information and

condence to invest overseas, it seemed a natural role for investment trusts that

they should provide an indirect route into overseas markets for small investors who

would benet from the trust’s professional management. The overseas weighting

fell from the end of the First World War until the early 1950s, since when it has

grown steadily, increasing sharply again in the 1980s after the removal of exchange

control in 1979.

At the end of 1997, aggregate investment trust assets amounted to £60.4bn and the

number of trusts to about 150. The number of trusts has been falling, though only

slowly, mainly as a result of mergers. As a company, each trust has a board of directors

responsible for the broad outline of investment policy. The day-to-day administration,

however, is often left to professional management companies. Some of these com-

panies manage several trusts. As Figure 4.4 shows, the assets of investment trusts

are overwhelmingly company securities; there are very few government securities.

Overseas company securities take almost as large a share as UK company securities.

The small holdings of government debt and of net short-term assets (mainly bank

deposits) are a reection of the point we observed earlier, namely that investment

trusts are not subject to savers’ redemptions.

We noted earlier that the immediate effect of increased investment in investment

trusts would be to push up the price of their shares without resulting in any extra

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				4.4 Investment trusts

Figure 4.4Investment trust assets at end 2004 (£bn)

Source: Adapted from ONS, Financial Statistics, April 2006, Table 5.2C

ow of funds from savers to borrowers. This obviously amounts to saying that the

market value of investment trust shares is determined by the demand for them and

not (as with units in a unit trust) by the performance of the underlying assets. Even

so, we would expect the resulting market valuation to pay some attention to the

underlying assets since the reason for buying investment trust shares is to participate

in the income and capital gains resulting from the managers’ investment performance.

Nonetheless, it is a general and interesting phenomenon of investment trust shares

that they stand ‘at a discount’ to the net asset value of the trust. On the face of it, this

offers a potential bidder the opportunity to acquire a complete portfolio of assets

at a discount to their value by taking over the trust by buying up all its shares. To

understand how such a discount can persist we have to consider the value of a trust’s

shares from a buyer’s point of view.

Consider rstly the ordinary investor who wants shares in a trust so as to have

a claim on a much wider portfolio of shares than she could afford by investing

directly. She has this advantage, but set against it she has to accept that management

charges and corporation tax will be charged against trust income. This obviously

reduces the income below what it would have been had she been able to hold the

assets directly. Now consider the shares as seen by a potential bidder for the whole

trust; most likely this would itself be a nancial institution. If it held the shares

intact it would suffer the same disadvantage that our ordinary investor encountered.

If it liquidated the trust, however, in order to hold the underlying assets directly, it

would face liquidation costs including compensation to the existing management.

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