How Unit Trusts and Open-Ended Investment Companies (OEICs) Make Money

Unit trusts and open-ended investment companies (OEICs) are two popular forms of collective investment funds that invest yours and others’ money in a carefully selected portfolio of investments. Both are commonly referred to more simply as a type of fund.

What are unit trusts and OEICs?

Unit trusts and OEICs pool money from lots of different people and invest it on their behalf in a variety of investments.

Unit trusts, whose origins date back to 1931, are set up under trust law. This means that there is a manager responsible for investing and a trustee responsible for securing the assets and ensuring the manager is investing responsibly and according to the fund’s objectives.

The fund is divided into units, which can be bought and sold by investors. Unlike an investment trust, which operates with a fixed number of shares, a unit trust can create and cancel units. Since the size of the fund can shrink and grow, unit trusts offer an unlimited number of units for investors to buy.

OEICs behave similarly to unit trusts, but they are operated by a company and sell shares instead of units.

Both unit trusts and OEICs will either be managed actively or passively. With active management, an experienced fund manager tries to outperform the market by selecting the investments with the best potential to grow. With passive management, the fund seeks to replicate the market by tracking the performance of a specific index, such as the Financial Times Stock Exchange 100 index, also known as the FTSE 100.

How unit trusts and OEICs work

There are thousands of these funds to choose from, each with their own mandate. Funds may invest exclusively in one asset class, such as company shares, bonds or property. This is done either across the entire globe, a specific continent, country or even industry.

To offer investors greater diversification, some funds invest in more than one asset type and are known as mixed or multi asset funds.

Some also embark on a particular strategy, the main ones being:

• Growth: Investments poised to grow quicker in value
• Income: Investments that generate lots of cash and share it with investors
• Value: Investments judged to be undervalued

Each fund’s basic area of focus is often evident in its name and then expanded on in its prospectus and other literature it distributes, such as a monthly manager report which offers a quick and useful snapshot. Within those reports, you will find information about the fund’s largest investments, how much it charges, and its objectives, including which relevant segment of the market, or index, it aims to outperform.

For example, Lindsell Train UK Equity, a popular fund targeting British businesses, lists the FTSE All-Share index as its benchmark. This means the fund manager has set a minimum goal of beating the average performance of all companies listed on the London Stock Exchange.

How do unit trusts and OEICs differ?

Unit trusts and OEICs are frequently grouped together because they have a lot in common. Both are open-ended, meaning there is no limit to how much can be invested in them, and are normally priced once a day based on the total value of all their holdings, otherwise known as net asset value (NAV).

Traditionally, unit trusts quote different prices, namely a higher one to buy, and a lower one to sell. OEICs, on other hand, keep things simpler by listing one price for all transactions.

Nowadays, it is increasingly common for unit trusts to dispose of their controversial dual pricing structures, or completely convert to the more modern, flexible, and internationally friendly OEIC structure.

How do unit trusts and OEICs distribute money?

Like other investments, investors make money from unit trusts and OEICs in two ways:

• Through profit, by selling shares, or units, for a higher price than they were bought
• Through distributed returns from the held investment, which are received as dividend payments

Returns are distributed by the company or fund in the form of dividends, which are derived from underlying shares, interest generated from bonds and rent earned by property. A fund typically delivers these dividends to its investors once every three months or twice a year.

When investing in a unit trust or OEIC, you will usually be given two payment options:

• Income units or shares, which allow you to pocket these proceeds
• Accumulation, which automatically reinvests all dividend payments back into the fund, which increases the overall value of your investment

How to invest in unit trusts and OEICs

If you are happy to invest alone, without the guidance of a financial adviser, the best way to proceed is through an investment platform. These online fund supermarkets are easy to use, offer plenty of choice, enable you to use your tax-free ISA allowance, and begin your unit trust or OEIC adventure with a reasonably small sum.

» MORE: What is an investment platform?

Pros and cons of investing in unit trusts and OEICs

Investing in these types of funds comes with several benefits, including:

• Spreading risk: Pooling money together with others boosts buying power, making it possible to diversify and invest in dozens of different investments at a fraction of the cost of buying them individually.
• In trusted hands: An expert manager is looking after your money and, in the case of actively managed funds, will make all the difficult decisions around what to buy and when to sell.

As nice as that sounds, there are some caveats. For actively managed funds, consistently selecting the cream of the crop is easier said than done. In fact, the majority of fund managers repeatedly fail to deliver on their minimum objective of bettering the combined returns of the market they are picking from, especially after factoring in fees.

Investors are expected to foot the bill for any expenses incurred from the everyday running of a fund. These costs, packaged together as an ongoing charges figure, can add up and significantly eat into your potential returns.

Active and passively managed funds

The high costs of traditional active funds has led many investors to go ‘passive’. Rather than try to pick the winners, passive vehicles, such as index funds and exchange-traded funds (ETFs), play it safe by buying everything within their chosen field.

This approach requires minimal intervention and can largely be executed by a computer. As a result, they are much cheaper to run, meaning investors get to keep more of the money the fund generates. Often, these savings make the difference in securing better returns overall.

Passive investing isn’t perfect, though. Adopting an ‘autopilot’ technique means there is nobody to intervene and plug losses when markets are falling. It can also lead to more of your money being tied up in over-valued investments that have already reached their peak.

Knowing there is a dedicated team of professionals managing investments every day on your behalf is comforting. It is just important to ascertain that they are good at their jobs, have been doing so consistently for a number of years, and are not charging you a fortune for their services.

» MORE: Learn about active and passive investing

WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.

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