SELECTING INVESTMENT TRUSTS

Investment trusts (ITs) are companies whose business is buying, holding and selling shares in other companies, so they make the investment decisions for you. Investment trust shares can be bought and sold on the stock exchange and dividends are paid.

Some companies invest generally while others specialise, either in income or growth shares or in particular sectors, countries or world regions. Some specialise in fixed-interest investments.

A newly introduced category – global – recognises the trend towards a world-wide approach to investing, picking out what are thought to be the best companies world-wide, perhaps restricted to a sector (especially high-tech stocks). In any case, many large companies have significant operations extending beyond their national boundaries.

The share price is usually at a discount to the market value of the underlying investments (the net asset value or NAV) and the percentage discount varies from time to time as well as between individual ITs at any one time. In recent times discounts have been as high as 10% and as low as 2%. Occasionally the share price is at a premium to the NAV.

ITs can borrow money to invest. This is called gearing because the opportunity for growth and/or income increase is geared up. It does of course also increase the risk of loss.

The cost of managing the investments is a charge against profits.

Eighty-five per cent of income must be paid out.

Information about ITs can be obtained from the Association of Investment Trusts – ring (020) 7431 5222.

INVESTING IN UNIT TRUSTS

Unit trusts (UTs) are another form of pooled investment but are quite different from ITs.

They consist of a portfolio of shares managed by a professional company but owned separately by a trust.

The price of a unit is the total value of the underlying investments divided by the number of units. Units may be income (income is paid out) or accumulation (income is reinvested).

Units are bought and sold at varying prices, like shares, any margin between the two being an initial charge which may be as high as 5%. In some cases there is an exit charge instead, which reduces over a period, perhaps to nothing after five years.

There is also an annual charge in the form of a management fee, usually 1-2% of the fund value.

UTs have a similar variety of investing areas to ITs. Of particular interest may be corporate bond funds, especially those targeted at high-yield bonds.

It must be remembered that the capital value of corporate bond funds is affected by changes in market interest rates – a rise in rates means a fall in value and vice versa. High-yield bonds often include foreign company bonds and so are also subject to exchange rate fluctuations.

UTs do not have the facility for gearing and cannot be at a discount or premium to the underlying investments, so tend to be less volatile.

Many PEPs and ISAs (See Chapter 7) are set up by unit trust managers specifically for investing in their range of UTs and there is a lot to be said in favour of pooled investing in equities.

Advisers get an initial commission, so it is worth asking for a rebate, which some offer in their literature – they are called discount brokers. They also get a small annual commission (usually 0.5%). As these commissions cannot be avoided by investing direct it is worth using a discount broker, who may also provide annual or half-yearly statements, possibly with useful performance comparisons.

Information about UTs can be obtained from the Association of Unit Trusts – ring (020) 7831 0898.

Open-ended investment companies

Unit trusts are a singularly British institution and many are converting to the continental style open-ended investment company (OEIC), which have only one price for buying and selling, with separate charges. As they are companies, the ‘units’ are actually shares.

However, there is a proposal that single pricing should become compulsory for unit trusts.

Fund supermarkets

There are fund ‘supermarkets’ or ‘networks’, where the provider offers (usually over the Internet) a number of pooled investments to choose from, with easy (and cheap) transfers between the funds. They are frequently discount supermarkets, with lower initial charges.

Some providers offer a much wider choice than others, so again here it pays to shop around.

COMPARING INVESTMENT TRUSTS AND UNIT TRUSTS

One fundamental difference between the two is that a unit trust is open-ended, which means that new investors add to the total sum invested, whereas an investment trust is close-ended, the sum invested not changing during the life of the trust.

Investment trusts have more autonomy of choice of when to invest, i.e. can hold cash, whereas unit trusts must invest cash received within a limited period.

These differences plus the opportunity for gearing and the variable discount make investment trusts potentially more volatile than unit trusts. On the other hand, the charges for unit trusts have in the past been considered high.

Investment trusts can invest in a wider range of assets than unit trusts, i.e. including commodities and unquoted companies.

Investment trusts generally have a lower annual management charge, around 0.5%, compared with 1.5% for unit trusts. This saving of 1% can have a considerable effect over a long period.

CHOOSING INDEX TRACKERS

There is a category of unit trusts called index trackers, which are set up to match as far as possible a specific index, such as the FTSE 100, the FTSE all-share, the US, Europe or Japan indices.

Perfect linking cannot normally be achieved because no fund can invest in every share in the right proportions. Also indices take no account of the cost of buying and selling, which will depress the value of the tracker compared to the index.

Charges are lower than ordinary unit trusts because expert advisers are not needed. Initial charges are usually no more than 1%.

Some investment trusts offer index loan stocks, which are directly linked to the relevant index and so can achieve perfect linking. They usually have a set repayment date and pay dividends. As they are unsecured, there is a slight risk of a failure to repay, but they take preference over shares in the investment trust.

Index trackers are a relatively cheap and safe way of investing in the stock market.

Exchange-traded funds

Recently introduced in the UK, these index trackers (also called extraMARK or iShares) are different from an investment trust in that they are open-ended (like an OIEC) and different from a unit trust in that the price varies during the day with the movement of the underlying assets whereas unit trust prices are revised only once a day.

There is not a great deal of choice so far, but if they catch on there will be many more. In addition to the FTSE 100 and FTSE ex UK, there are iShares for specific categories, such as TMT (technology, media and telecom).

Dealing is through a stockbroker. There is no stamp duty to pay and annual charges are low (below 0.5%) They tend to be slightly cheaper than most index trackers.

From experience to date, exchange-traded funds seem to track better than traditional index funds, possibly because of the lower charges and reduced internal tax liabilities arising from the way they operate.

INVESTING IN FRIENDLY SOCIETY SAVINGS SCHEMES

A friendly society is a mutual insurance and savings organisation operating for the benefit of its members. Usually it has arrangements for sickness and death benefits as well as other forms of insurance and investment.

Friendly societies are authorised to offer a tax-free investment linked to their life assurance funds. The maximum investment is £25 a month or £270 a year and schemes run for a minimum of ten years.

There has to be a life-assurance element, the cost of which has a slight adverse impact on returns.

Income in the scheme is subject to a favourable rate of tax and capital gains are tax-free. After ten years no tax is payable on withdrawal. There are penalties for early withdrawal.

Watch out for proportionally high charges because the amounts invested are small.

These schemes are often promoted for children. They are a way of involving children’s savings in equities but most children are in a tax-free position anyway, so other alternatives should be considered (See Chapter 9).

BUYING INSURANCE BONDS

These are pooled investments in the funds of life assurance companies. As the investment is frequently unitised, they are in effect the life assurance equivalent of unit trusts. (Conventional or traditional insurance bonds are not unitised but have become increasingly unpopular with providers as they are less easily explained.)

There are usually separate funds for equities, fixed interest and property. Often some of these categories are divided into UK and international investments.

There is usually a minimum investment period (often five years) with penalties for earlier termination. However, there is usually no initial charge.

Income tax and capital gains tax is payable by the fund at the standard rate and no further tax is payable by higher-rate taxpayers until maturity. Tax deducted cannot be recovered, so they are not suitable for non-taxpayers.

Top-slicing relief

The tax payable by standard-rate taxpayers on maturity is calculated using top-slicing relief. The original purchase price is deducted from the final value plus any withdrawals. That amount is then divided by the number of years you have held the fund.

This gives the extra ‘slice’ of income, which is added to your other income in the final year. If any of it falls into the higher-rate band, then a further 18% is payable on that amount multiplied by the number of years.

Higher-rate taxpayers

These will have to pay the extra 18% tax, but not until maturity, the advantage of the deferred tax being that the fund grows with only standard-rate tax having been deducted.

If withdrawals are made before maturity, up to 5% a year is treated as a return of capital, so no additional tax is immediately payable unless the 5% limit is exceeded. The percentage is on a cumulative basis, so you can exceed 5% in a year if you withdrew less in earlier years. There is no need to include the withdrawal on your tax return if it does not exceed 5%.

On retirement, when your income generally falls, the marginal rate for some higher-rate taxpayers may no longer be above the standard rate band, so income can be taken without further income tax liability (unless it takes you back into the higher rate band).

Effect on income tax age allowances and tax credits

Another advantage of deferring income applies where otherwise the income would produce cutbacks to the extra income tax age allowances and to certain tax credits.

Guarantees

Sometimes there is a guarantee of performance (income and/or growth), but it may be subject to the performance of an index over the investment period, such as the UK all-share index or the European Eurostoxx index.

Another form of guarantee is that you will get back at least as much as you originally invested. This may or may not be subject to the performance of an index.

All guarantees need to be read carefully to see exactly what they mean, bearing in mind that there is an unknown cost from the use of derivatives (futures and options – See Chapter 6), resulting in slightly lower income and/or growth.

It is also worth noting that guarantees of this nature may not be worth much, since the average annual return over all recent five-year periods is 10% growth plus 5% in income, a total of 15%, and there is only a 1 in 78 chance of growth over five years falling below 30%.

Since life assurance is a requisite part of these funds, your heirs are guaranteed recovery of, probably, your original investment if you die during the investment period.

Managed funds

In this case the investments are in a mixture of the life company’s funds. Because of this, performance is less volatile.

You are in effect using the expertise of the life company’s managers to choose a mixture which achieves good returns at lower risk.

Some funds set off charges against annual bonuses, others do not, so it is necessary to take this into account when comparing. Some providers also charge by investing less than 100% of the amount put in; this is called the allocation rate.

Advisers get a commission – try for a rebate.

Market value adjustment

Most managed funds with an equity involvement carry a provision for a market value adjustment (MVA) in case the underlying assets of the fund are severely depressed at the time of an individual withdrawal due to a considerable fall in the stock market. This is in order to protect the interests of the remaining investors.

The application of an MVA is a rare event but to avoid it happening to you, it is wise to ensure that you can be flexible in the timing of your withdrawal so that you can defer it until the MVA is removed.

With-profits bonds

These are a more conservative form of managed fund. The difference is that the value of the fund is unlikely to fall because annual bonuses (also called reversionary bonuses) are declared but some growth is retained to smooth out returns and pay for terminal bonuses (payable on terminating the investment).

With-profits bonds have become a very popular form of investment, particularly with retired people, probably because of their steadiness in growth, despite the disadvantage of not knowing in advance what the terminal bonus will be.

On the negative side, in recent years there has been a downward trend in bonus rates.

Investment bonds

These are similar to with-profits bonds except that they are unit-linked, so there is no smoothing. This makes them more volatile.

As for with-profits bonds, the income is normally left in, as the objective is growth.

Some companies permit investment in a number of their funds, making the bond into a wrapper like an ISA. Transfers between funds within the bond do not create a necessity to pay any accumulated capital gains tax at that point as they would outside it – this is a deferral of tax.

Investment bonds are sometimes used as long-term investments for children and grandchildren.

Distribution bonds

These are similar to investment bonds except that the objective is income, so all the income from the underlying investments is paid out, while the capital value is maintained. They are popular with retired people.

Guaranteed equity bonds

Some bonds are set up to pay a guaranteed income over a period, perhaps five years, or achieve a guaranteed growth, dependent upon certain criteria being met. The comments above regarding guarantees are important and it should be remembered that higher interest can only be achieved by taking greater risk.

Endowments

These are usually associated with mortgages. They have recently come under criticism because returns are lower than were expected a few years ago and some holders are being notified that their policy is now unlikely to produce enough money to pay off the mortgage when it becomes due.

However, they are a suitable vehicle for lump sum investing and take the form of a one-off lump sum investment in a ten-year policy. There are with-profits and unit-linked varieties, the only difference being a terminal bonus in the case of with-profits, which should be substantial.

Second-hand endowments

There is a market in second-hand endowment policies and these can be a good investment. You buy the policy for a lump sum and unless it is paid-up you need to be able to continue paying the premiums till maturity.

As the life assurance element continues on the life of the original investor, you can get an earlier pay-out if that person dies but you need to keep in touch in order to find out if it happens.

To spread the risk, you can invest in second-hand endowments via a specialist investment trust.

Maximum investment plans

This is a fancy name for what is actually an endowment policy – do not be deceived into thinking it is something else. There are also maximum savings plans – identical except they are intended for regular monthly contributions instead of a lump sum.

Broker funds

Independent financial advisers and stockbrokers offer broker funds to their clients. These are investments in the funds of a life assurance company where the broker makes the allocation over the individual funds for you.

Originally investments were ‘fettered’ to the funds of the chosen life company, which meant they were akin to ‘fund of funds’ investments, except that there the life company makes the allocations.

However, many are now ‘unfettered’, i.e. they permit investment in other life companies’ funds, unit trusts and even individual shares.

The advantage claimed for broker funds is that the IFA/broker has extra expertise in the allocation decision, enough to more than compensate for the higher costs (but costs are not necessarily doubled because there will be some discounting of costs between the two parties).

CASE SCENARIOS

Amanda decides against pooled investments

Amanda prefers the idea of direct investment in equities because she considers she knows enough about business to be able to make her own decisions about which shares to buy and when to buy and sell. Also she hates the idea of paying someone else to choose for her.

Alistair and Jean like tracker funds

As they have no knowledge of the stock market, Alistair and Jean prefer pooled investments, at least to start with. They think that tracker funds are a good idea, as they are cheaper to invest in and should do well compared with selective funds.

They’ll give consideration to putting some of their money in trackers of indices outside the UK, to spread the risk.

Gwen and Hugh go for income

Some of the retirement cash will go into equities but they will need income. Gwen and Hugh therefore get advice from a discount broker about the performance of UK income unit trusts and pick out a couple of funds to invest in.

POINTS TO CONSIDER FURTHER

• 1.What are the relative advantages of investment trusts and unit trusts?
• 2.Do you think a with-profits bond would be a good investment for you? How risky do you think they are?
• 3.Regular savings are particularly suitable for pooled equity investment because of something called pound/cost averaging- when the stock market it low, you get more shares or units than when it is high, so that the average price you pay for each is lower than the average of the prices each time you invest. If you are saving to invest, would you invest in pooled equities in this way?