Unit Trusts and OEICS

Unit Trusts and OEICs short for Open Ended Investment Companies) are pooled funds of investors’ money, which are used to buy a range of shares, gilts, bonds or cash deposits. Both Unit Trusts and OEICs are open ended funds meaning that the size of each fund can vary according to supply and demand. Unit Trusts and OEICs provide a mechanism of investing in a broad selection of shares, thus reducing the risks of investing in individual shares.

When you invest in a Unit Trust you buy a unit, which means a portion of the total fund. OEICs however issue shares. Each Unit Trust and OEIC has its own investment objective and the fund manager has to invest to achieve this objective. The fund manager will invest the money on behalf of the unit holders (or shareholders). The value of your investment may move down as well as up, usually affected by market fluctuations. The total value of the fund is also determined by the assets bought by the fund manager.

To cover the costs of running a fund you will usually have to pay an annual fee for ongoing costs such as administration. Some fees are declared as a percentage of your investment, others are built into the price. You can invest into a Unit Trust or OEIC through an ISA (Individual Savings Account). Usually, there are no additional charges for having an ISA, and you have the tax advantages that go with it.

Investment Trusts

Investment trusts, contrary to what their name implies, are not trusts in a legal sense. They are quoted limited liability companies subject to Stock Exchange requirements. Unlike a unit trust, an investment trust is subject to company law and FSA listing rules. “Approved” investment trusts, which, like unit trusts, are exempt from internal capital gains tax, have to meet criteria laid down by HMRC.

An investment trust is closed-ended which means that there are a fixed number of shares issued. Each investment trust has a board of directors, which is responsible for both looking after the shareholders’ interests and for choosing and approving the strategy and aims of the trust and making sure that these objectives are followed. It also makes sure that the running costs of the trust are not excessive. Thus the price of investment trust shares is influenced not only by changes in the net asset value of the company’s underlying investment portfolio but also by investors’ supply of and demand for shares.

Most investment trust shares trade at a discount to their net asset value. The level of the discount on any trust can, and does, vary through time, and sometimes trusts trade at a premium. Investment trusts can borrow monies to increase their investment levels, (unit trusts are limited to 10%). This is called “gearing” or “gearing up”. This can be advantageous in a rising market and disadvantageous if share prices drop, by magnifying gains and losses respectively.Generally speaking the risk/reward ratio for investment trusts is greater than that for unit trusts or OEICS because of the fact that an investment trust can trade at a discount and borrow.

Capital Gains Tax

You may be liable to Capital Gains Tax (CGT) when a gain is realised (for money or money’s worth) from collective investments.

Currently, the amount of the gain maybe reduced by three main factors:

• Every individual has an annual exemption whereby a certain level of capital gains each year may be made which is not subject to taxation. The exemption for the current tax year is £10,600 each.
• Losses can be used to offset against gains.

For individuals the rate of CGT is 18% where total taxable gains and income are less than the upper limit of the income tax basic rate band. A rate of 28% rate applies to gains (or any part gains) above this limit. For married couples it may be wise to spread the investments in order to try to mitigate (or potentially negate) any future CGT liability, by using more than one annual CGT exemption.

Income Tax

You should note that any dividend or interest distributions whether paid to you or not are liable to income tax in the year they arise.

Interest distributions are paid with an attaching 20% tax credit which satisfies the liability of basic rate taxpayers. Non taxpayers can reclaim the whole 20% deducted. Higher rate taxpayers will have a further 20% and additional rate taxpayers a further 30% of the gross distribution to pay.

Dividend distributions attract a 10% tax credit which again satisfies the liability of basic rate taxpayers. The tax credit is however not reclaimable by non-taxpayers. A higher rate taxpayer needs to pay an extra 22.5% and an additional rate taxpayer 32.5% bringing the total liability to 32.5% and 42.5% of the gross dividend distribution respectively.