How Does an Investment Trust Differ from a Unit Trust?

Many investors confuse unit trusts and investment trusts, believing them to function and operate on the same basis. However, whilst they are both investment vehicles that work on the collective scheme basis – pooling investors’ money and buying shares and other securities for the benefit of those investors – there are a number of areas in which they differ quite dramatically.

Structure

The first of these is the ownership structure itself. Unit trusts are what are known as open ended investment vehicles. They can automatically create new units to satisfy investor demand, the money paid by the investor then buying more of the underlying investments held by the unit trust. During periods of excess selling, underlying investments are sold and units cancelled.

Investment trusts work entirely differently. First, the term investment trust is a little misleading, for the investment trust does not operate under a trust structure at all, but rather is a publicly traded company with its shares traded on the London Stock Exchange. When an investment trust company is first founded, a fixed number of shares will be sold. This number of shares in issue does not have the flexibility offered by the creation and cancellation of units of a unit trust. Where unit trusts are open ended, investment trusts are deemed to be closed ended.

Ability to invest

This also means that an investment trust has a finite amount of money to invest, that amount being the original sum raised through the sale of its shares. This is another area I which unit trusts and investment trusts show a marked difference. Unit trusts can only invest using the money paid to it by investors purchasing its units. An investment trust is able to borrow money to invest.

Just like any ordinary company, that is able to borrow money to buy bigger and better plant to enhance its business and grow its profits, for example, an investment trust is able to borrow money to enhance its business. It just so happens that its business is investing, and not, say, manufacturing widgets. This ability to borrow money allows an investment trust to leverage its investments (a process called gearing) which can produce higher returns, though with the caveat that risk rises.

Valuation

The price of the units of a unit trust is directly linked to the value of the underlying assets held by the unit trust. If the value of the underlying assets is, say, £10 for every unit held then it is this price which will be used to determine the price paid by unit buyers or received by unit sellers.

However, a unit trust will have both a bid and an offer price and this two-way quote will be biased according to pressure of buying and selling. For example, if the unit trust is in demand then the price quoted will be on a ‘bid basis’ with the bid price at the actual net asset value of the units and the offer price (the price at which investors can buy) a little way above it. If the weight of investment activity is biased toward selling, then the bid price (the price at which holders of units can sell) will be below the net asset value of the units, with the offer price at the net asset value.

The share price of investment trusts is more loosely based upon their underlying net asset value. Prices of investment trusts can be affected by a wide variety of factors, including general market sentiment, and can be some way below or above the underlying net asset value.

Buying and selling unit trusts and investment trusts

Unit trusts are traded with the provider. Most commonly this is through a financial advisor, though increasingly they are offered direct to the investors or through a fund platform. When investing, the financial adviser may receive a commission from the unit trust company or an up-front payment from the investor. This initial charge is deducted from the investment amount, and can be as high as 5% or 6%.

Shares of investment trusts are bought and sold through a stockbroker on the London Stock Exchange, with the investor paying the broker’s commission (usually around 0.5% but increasing a fixed flat fee in the region of £8 or £10).

In summary

Both unit trusts and investment trusts offer investors immediate diversification, and can be used to invest in the broad economy, different geographic regions, or more focussed business sectors.

However, they are structured very differently which impacts upon the way they invest. Unit trusts invest no more than the money invested in them, while investment trusts are able to borrow money to invest. Borrowed money inherently increases risk, though it provides greater potential upside.

The pricing methodology behind unit trusts makes them less volatile as to price swings, with underlying net asset value being the sole determinant of unit price. The share prices of investment trusts can be at a large premium or discount to underlying net asset value at any given time. However, as investment trusts are dealt on the stock exchange, they can be bought and sold throughout a trading day, while unit trusts will be valued and dealt on a once per day basis.

Perhaps one of the most pertinent factors for an investor to consider is the costs of ownership of investment trusts as against unit trusts. Investment trust management fees are usually lower than unit trust fees, and are counted within the cost of the running of the company. An investment trust also suffers no up-front charges (save for the broker’s commission). Unit trust fees include a sometimes sizeable up-front charge as well as the annual management charge.