Unit 11

Investment Funds

Both mutual funds, or open-ended investment companies (the American name) and unit trusts (the British name) are legal constructions which permit the pooling of a large number of small unequal amounts of money belonging to different individuals in a common fund to be invested by skilled managers. Pooled investments can take a variety of forms, exemplified in the confusion which continues to arise in British discussion between unit trusts and investment trusts. The latter involve an investment vehicle with share capital fixed in amount and are referred to in the US as a «closed-ended investment company». British unit trusts are the equivalent of the American «open-ended mutual funds» and issue new units or shares every time they receive additional money from subscribers.

The most common form of closed-ended fund is a company which uses the funds provided by shareholders to «invest» in the shares (stocks) of other companies. Despite a fixed share capital, «gearing up» of ordinary shares by borrowing is possible, thereby making the risk - expected return combination facing shareholders different from that of the asset portfolio. Consequently, because of gearing and the forces of supply and demand for the closed-ended investment companies’ fixed stock of shares, the market price of closed-ended funds’ shares can be greatly above or below the market value of the underlying share portfolio. This cannot happen with open-ended funds, because gearing is prohibited by charter and the number of units or shares is not fixed. Being open-ended, the supply of units, i.e. capital, can be increased or decreased according to demand. If unitholders wish to dispose of all or some of their units, the manager of the fund can simply cancel the units and sell off the corresponding assets. Accordingly, the market value or price of the units will, within set limits, vary directly with the market value of the securities represented by those units.

By allowing individuals to purchase a share of a managed portfolio, mutual funds perform a number of functions which we group under three headings. First, there is what we have called the «brokerage» function, in which information is processed and collected for resale. Left to their own devices, people would need to gather information about the various securities, assess the inherent risks, devote time to monitor and evaluate new information on an ongoing basis, and then undertake all the administration involved in making alterations to the composition of their portfolio. The fund arrangement centralizes the collection and the processing of the information and the administration. Subscribers acquire the information and professional investment management at a price - the management fee - but are left to assess the ability of the managers of the various funds.

Second, diversification is made possible by the size of the fund. This is the factor which prompted the formation of the first British pooled fund in 1868, its prospectus making clear that the purpose was «to secure for the investor a degree of diversification in his investment portfolio which a single individual is unable to obtain unless he is extremely wealthy».

Third, units can be readily encashed, and open-ended funds are more liquid than direct shareholdings. This comes about partly from the lower variability of the market value of a well-diversified portfolio, but mainly from the nature of fund arrangements. All pooled funds are, of course, owned by the unit-holders, but they are held in trust and invested in the name of the trustee (normally a bank or insurance company), such investment being performed, for a fee, by the management company. Under the trustees’ supervision, the job of the manager is to invest and administer the funds, advertise and promote the units and conduct a market in the units. This market is a distinctive feature of mutual funds.

The main differences between unit trusts any investment trusts are:

- Unit holders in authorized unit trusts have an extra measure of protection arising from Department of Trade and Industry supervision and the fact that most trustees are major banks or insurance companies. It is possible to buy units with regular savings of very small amounts; units can be acquired through a unit-linked insurance policy; unit trusts distribute their income on regular (normally half-yearly) dates, dividend payment dates for investment trusts are less predictable; authorized unit trusts cannot invest in assets such as property, investment trusts are not so limited.

- Units may be bought from and sold to the managers without going through The Stock Exchange. The managers must buy units back if an investor wishes to sell. Shares in investment trusts are sold through The Stock Exchange. With some smaller investment trusts, the market in the shares is very small and it may be difficult to find a purchaser.

- Unit prices are calculated according to the rates laid down in the trust deed (as approved by the Department of Trade and Industry) and are directly related to the value of the underlying assets. The price of the investment trust shares is determined by supply and demand and it is usual to find prices below net asset value.