The main benefit of devices such as unit or investment trusts is the reduction of risk: you get a spread of investments over a number of companies, which cuts the danger of any one of the companies performing badly or going under. Another advantage is administration by a market professional who may have a better feel for what is a good investment than the average layperson.
1. Investment trusts
Investment trusts are merely companies like any other quoted on the stock exchange, but their only function is to invest in other companies. They are called ‘closed-end funds’ because the number of shares on issue is fixed and does not fluctuate no matter how popular or otherwise the fund may be.
A small investor without enough spare cash to buy dozens of shares as a way of spreading risk can buy investment trusts to subcontract that work. A trust puts its money across dozens, possibly hundreds, of companies, so a problem with one can be compensated by boom at another. That does not make them foolproof or certain winners: investment managers after all are only human and can be wrong.
There are also pressures on them to which the private investor is immune. For instance, there is a continual monitoring of their performance so there is no chance to allow an investment prospect the time to mature for a number of years before reaching its full potential if that means in the meantime their figures are substantially below those of their rivals. A private investor on the other hand can afford to be patient and take a long-term view. Similarly, it is only brave managers who decide to stick their necks out and take their own maverick course different from the other funds. They will get praise if they are right and the sack if not. Stick with the same sort of policies as all the others however, and the bonuses will probably keep rolling in for not being notably worse than the industry average.
Some have given up the challenging and unrelenting task of outperforming the market and called themselves ‘trackers’ – they buy a large collection of the biggest companies’ shares and so move with the market as a whole.
Another disadvantage of going for collective investments is the cost. Since investment trusts are quoted on the stock exchange just like any other company, the set of costs is the same as with all share dealings: the cost of the broker (though that can be reduced through a regular savings scheme with the trust management company), the government tax in stamp duty, and the spread between the buying and the selling price, which in smaller trusts can be over 10 per cent. Some can be bought directly from the management company. There are obviously advantages or they would not still be around, much less in such large numbers.
Buying into investment trusts does not entail abandoning all choice. The investor has an enormously wide range of specialists to pick from: there are trusts specializing in the hairier stock markets like Istanbul, Budapest, Manila, Moscow and Caracas (some of them drift in and out of various ‘emerging markets’ labels such as the BRIC countries (Brazil, Russia, India and China)); there are some investing in the countries of the Pacific Rim with some of those concentrating on just Japan; some go for small companies; some gamble on ‘recovery’ companies (which tend to have a fluctuating success record); some specialize in Europe or the United States; some in an area of technology, and so on. Managers of investment trusts tend on the whole to be more adventurous in their investment policies than unit trusts.
Some are split capital trusts. These have a finite life during which one class of shares gets all the income, and when it is wound up the other class of shares gets the proceeds from selling off the holdings.
As the trusts’ shares are quoted, one can tell not only how the share price is doing, but check precisely how they are viewed. It is possible to calculate the value of the quoted company shares a trust owns, except of course for the ones specializing in private companies. Then one can compare asset value with the trust’s own share price, and this is published – see Chapter 7. Quite a few will then be seen to stand at a discount to assets (the value of a trust’s holdings per share is greater than the market is offering for its own shares), and some at a premium.
One reason many of them are priced lower than their real value is that the major investing institutions tend to avoid them. A huge pension fund or insurance company does not have to subcontract this way of spreading investments, nor does it have to buy the managerial expertise – it can get them in-house. This leaves investment trusts mainly to private investors who are steered more towards unit trusts by their accountants and bank managers. Fashion changes, however, and from time to time the investment trust sector becomes more popular. Buying into one at a hefty discount can provide a decent return – so long as the discount was not prompted by some more fundamental problem with the trust or its management.
2. Unit trusts
Unit trusts have the same advantage of spreading the individual’s risk over a large number of companies to reduce the dangers of picking a loser, and of having the portfolio managed by a full-time professional. As with investment trusts there are specialist unit trusts investing in a variety of sectors or types of company, so one can pick high-income, high capital growth, Pacific Rim, high-technology or other specialized areas.
Instead of the units being quoted on the stock market, as investment trusts are, investors deal directly with the management company. The paper issued has therefore only a very limited secondary market – the investor cannot sell it to anyone other than back to the unit trust. The market is viewed from the managers’ viewpoint: it sells units at the ‘offer’ price and buys them back at the lower ‘bid’ price, to give it a profit from the spread as well as from the management charge. Many of the prices are also published in the better newspapers.
As opposed to investment trusts, these are called ‘open-ended funds’ because they are merely the pooled resources of all the investors. If more people want to get into a unit trust, it simply issues more paper and invests the money, and so grows to accommodate them. Unlike the price of investment trusts shares, which is set by market demand and can get grossly out of line with the underlying value, the price of units is set strictly by the value of the shares the trust owns.
The EU and legislation have invented a new vocabulary. Unit trusts are now ‘collective investment schemes’ (CIS) as part of what the law calls pooled schemes managed by an independent fund manager. These are allowed to invest in quoted shares, bonds and gilts, but generally not in unquoted shares or property. Most of these ‘open ended investment companies’, unit trusts, and recognized offshore schemes are authorised and regulated by the Financial Conduct Authority.
The others are sometimes called non-mainstream pooled investments (NMPIs) because they have unusual, risky or complex assets, product structures, or investment strategies. These are unregulated collective investment schemes (UCIS); securities issued by special purpose vehicles (SPVs); units in qualified investor schemes (QIS); and traded life policy investments (TLPIs). These unregulated schemes are not bad or crooked but are reckoned generally to have more risky investment portfolios and so cannot be marketed to retail investors or members of the general public. They can sell only to people who have shown they know what they are doing, such as wealthy individuals (income over £100,000 and £250,000 to invest), sophisticated investors, existing investors in such schemes and financial institutions. Unregulated schemes are not subject to the FCA rules on investment powers, how they are run, what type of assets they can invest in, or the information they must disclose to investors. And investors do not have the safety net of the Financial Ombudsman Service or the Financial Services Compensation Scheme (FSCS) if things go wrong. They may however complain about a regulated firm if it advised an investor to put money into an unregulated scheme.
3. Tracker funds
Legend has it that blindfolded staff at one US business magazine threw darts at the prices pages of the Wall Street Journal and found their selection beat every one of the major fund managers. And indeed the task of having consistently to do better than the market average over long periods of time is so daunting that very few can manage it.
Some managers have given up the unequal struggle of trying to outguess the vagaries of the stock market and call themselves ‘tracker funds’ (or ‘index funds’ in the United States). That means they invest in all the big shares (in practice a large enough selection to be representative) and so move with the main stock market index – in the United Kingdom that is usually taken to be the FTSE100. This gives even greater comfort to nervous investors worried about falling behind the economy, and the policy provides correspondingly little excitement, so it is highly suitable for people looking for a home for their savings that in the medium term at least is fairly risk-free – it is still subject to the vagaries of the market as a whole in the short term but on any reasonable time frame should do pretty well.
In fact there are various ways of structuring such a fund. Full replication involves buying every share in the index or sector in appropriate proportions. Stratified sampling buys the biggest companies in the sector plus a sample of the rest, and optimization involves statistical analysis of the share prices in the sector. Just to complicate matters, there is a very large number of things to track. Even if you want to follow the US economy there is the choice of anything from the S&P500, through the Russell 3000 to the Wilshire 5000, which covers 98 per cent of US-based securities.
4. Open-ended investment companies
These are a sort of half-way house between unit and investment trusts. Like investment trusts they are incorporated companies that issue shares. Like unit trusts the number of shares on issue depends on how much money investors want to put into the fund. When they take their money out and sell the shares back, those shares are cancelled. The acronym OEIC is pronounced ‘oik’ by investment professionals.
The companies usually contain a number of funds segmented by specialism. This enables investors to pick the sort of area they prefer and to switch from one fund to another with a minimum of administration and cost.
5. Exchange traded funds
Very like tracker funds, ETFs are baskets of securities generally tracking an index, a market or an asset class. They are dealt on the stock exchange and have no entry or exit fees, but, as they trade like other shares, they incur commissions on transactions and do have annual fees of usually under 0.5 per cent. Also like tracker funds they may not buy every share in the index tracked (called ‘total replication’) but may use some sampling technique that can lead to ‘tracking error’, ie the performance of the fund does not follow its target completely and this can range from about 0.25 per cent to about 4 per cent, which can outweigh fees and price changes.
The low cost of ETFs has recently attracted a big rise in investment interest, which has in turn brought in a greater variety of products. So much so that the Financial Conduct Authority has been moved to publish a warning about growing complexity in the products producing higher risk. Another source of problem is the sloppy use of the ETF label – sometimes it is now applied to Exchange Traded Commodities and Exchange Traded Notes which are unsecured assets and hence of substantially greater risk.
Everything has a cost. Pooled investments are safer for small investors because they spread risks but, conversely, they cannot soar as a result of finding a spectacular performer. So you pay for the lack of risk by lack of sparkle. They are managed by professionals who must be paid, so the funds charge a fee.
Opting for safety does not mean investors can avoid thought, care or research. Some investment managers are not awfully clever and fail to buy shares that perform better than average. They can be found in the league tables of performance some newspapers and magazines reproduce, as can the funds with startlingly better performance than both the market and other trusts.
Those tables have to be used with caution. The performance statistics look only backwards and one cannot just draw a straight line and expect that level of performance to continue steadily into the future. One trust may have done awfully well, but it may just be the fluke of having been in a sector or area that suddenly became fashionable – retail, Japan, biotechnology, financials, emerging markets, etc. There is also the factor that somebody good at dealing with the financial circumstances of 10 years ago may not be as good at analysing the market of today, much less of tomorrow. On top of that, the chances are that whoever was in charge 10 years ago to take the fund to the top of the league tables will have been poached by a rival company.
The converse holds equally true. A fund may have been handicapped by being committed to investment in Japan at a time when Japan fell out of fashion or hit a rough patch, or in internet stocks when the net lost its glister. Such factors, whether prompted by economic circumstance or fashion, may reverse just as quickly and have the fund at the top of the table. It may also have had a clumsy investment manager who has since been replaced by a star recruited from the competition.
As a vehicle for recurrent investments, or as an additional safeguard against fluctuating markets, many of these organizations have regular savings arrangements. The investor puts in a set amount and the size of the holding bought depends on the prevailing price at the time. This is another version of what professionals call ‘pound cost averaging’. It also tends to level the risk of buying all the shares or units when the price is at the top.
One way of mitigating management charges is to get into a US mutual fund, which is much the same thing as a unit trust but has lower charges. The offsetting factor is the exposure to exchange rate risk.
Finally, there is the option of setting up your own pooled investment vehicle. Investment clubs, hugely popular in the United States, are growing up around the United Kingdom. A group of people get together to pool cash for putting into the market. The usual method is to put in a set amount, say £10 a month each, and jointly decide what the best home is for it. This has the advantage of being able to spread investments, to avoid management charges, to have the excitement of direct investment, to provide an excuse for a social occasion, and for the work of research to be spread among the members.
Source: Becket Michael (2014), How the Stock Market Works: A Beginner’s Guide to Investment, Kogan Page; Fifth edition.