Investment trusts vs unit trusts and OEICs

An investment trust and a unit trust or OEIC are both collective investments: ways to pool your money with other people's and have a professional manager run it. The difference is in how they are built. A unit trust or OEIC is open-ended, so it issues new units or shares as people put money in and cancels them as people take money out. An investment trust is closed-ended, with a fixed number of shares that trade on the stock market, most of them on the London Stock Exchange for UK investors¹.

That single structural difference drives almost everything else a buyer cares about. Because an investment trust's shares are traded rather than created on demand, its price is set by supply and demand and almost always differs from the value of the assets it holds. More often than not the shares trade at a discount to that value, so you can sometimes buy a trust for less than its underlying portfolio is worth³. A unit trust's price, by contrast, directly reflects the value of the assets held⁴.

On cost, investment trust fees tend to be lower than those for a unit trust or OEIC, and most annual management charges fall somewhere between 0.5% and 1.5%⁵. But the advantage has narrowed in recent years, and because trusts are dealt like shares you may pay one-off fees to buy and sell even where fund trading is free⁴.

Unit trusts and OEICs are professionally managed collective funds

A unit trust or OEIC pools money from many investors, and a fund manager uses it to buy shares, bonds, property or cash assets and other investments⁸. Unit trusts, offshore funds and OEICs can all be referred to generically as funds, and funds are usually structured as one or the other⁹. The two are close cousins: a unit trust is similar to an OEIC but issues units rather than shares¹¹.

The legal difference matters more than it sounds. A unit trust is structured as a trust, and investors in it are not owners of the underlying assets. An OEIC is a company, and its investors are shareholders in it². In both cases a trustee or depositary holds the legal title to the underlying stocks in the fund, which keeps those investments separate from the provider's own money and away from its creditors¹². UK law defines a collective scheme investment as a share in an authorised OEIC, a unit in an authorised unit trust scheme, or a unit in an authorised contractual scheme¹³.

Because they are open-ended, unit trusts and OEICs grow and shrink with demand: they issue new units or shares when money comes in and cancel them when it goes out². That keeps the price closely tied to the net asset value of the fund's investments⁹. It also means the fund can become very large, and that the manager has to buy and sell assets as investors move in and out. Each unit trust and OEIC fund carries its own specific risks, set out in its Key Investor Information Document¹⁴.

How an investment trust differs from a unit trust or OEIC

An investment trust is a public limited company, and it is closed-ended because the fund managers cannot redeem or create shares¹¹. When you invest you become a shareholder in that company⁴. It is a single investment that gives you a share in a much larger portfolio, and investment trusts are sometimes called investment companies¹⁵.

The closed-ended structure has three consequences a buyer should understand.

• The share price is set by the market. With investment trusts the price of shares is determined by supply and demand in the stock market, so the price paid almost invariably differs from the net asset value⁴. More often than not, investment trust shares trade at a discount³. You can sometimes buy a trust for less than the value of its underlying portfolio, and sometimes you have to pay more than it is worth if the trust is in demand¹⁸.
• The trust can borrow. Investment trusts can usually borrow at lower rates of interest than you would get as an individual, through bank loans or special kinds of shares that work like IOUs³. Unit trusts are not permitted to gear, which makes borrowing an advantage investment trusts have over other kinds of fund¹.
• The trust can hold things a fund cannot easily hold. Investment trusts can invest in a much wider range of investments than other types of fund, including global companies, smaller companies, sectors, property and infrastructure¹.

Most investment trusts are managed by an external management group, which may run several trusts, and the board of directors selects the fund manager¹. The Association of Investment Companies classifies all investment trusts into sectors, usually based on regional focus, industry focus, or the trust's own investment objective¹⁹.

Fees and charges: investment trusts tend to cost less

Investment trust fees tend to be lower than those for a unit trust or OEIC⁷. Most annual management charges fall somewhere between 0.5% and 1.5%⁵. One independent review puts the range at 0.8% to 1.8% in most investment trusts, so the two figures do not agree exactly and the true range depends on which trusts you look at⁶.

Size is one driver. Large investment trusts often have lower costs than smaller ones because of economies of scale, which are often passed on to shareholders as trusts grow¹⁹. What the trust invests in is another. Investment trusts that invest in more specialist assets such as property, private equity or infrastructure are likely to have higher charges than those that invest in more conventional assets such as shares or bonds¹⁹. Venture capital trusts generally have higher running costs than other investment trusts, and most charge performance fees as well²¹.

The effect of charges compounds. On £10,000 invested for ten years with markets returning 6% a year, charges of 0.5% a year would leave a return of £17,081, while charges of 1% a year would leave £16,289, a difference of £792⁵.

Two caveats sit alongside the headline. Investment trusts will incur management charges, which can be high as most investment trusts are actively managed, and as most are actively managed they tend to have higher charges than tracker and index funds²². And because platforms treat investment trusts in a similar way to shares, you will likely have to pay one-off fees when you buy and sell trusts, even if fund trading is free⁴. The lower-cost advantage over open-ended funds has narrowed in the last few years⁴.

Spreading risk: trusts, funds or running your own portfolio

Both investment trusts and funds spread your money. Investing in a collective investment fund such as an investment trust gives you access to a broad portfolio of shares, which spreads risk and minimises the impact of any one company going bust or performing badly²³. An investment trust can invest in lots of different companies' shares, providing instant risk diversification²⁴. Investment trusts let you spread your risk and access investment opportunities you would not find on your own¹⁷.

The trade-off is that investment trusts are likely to be more volatile than equivalent funds, because of the combined effect of gearing and the discount⁴. They can be a little more risky than other collective investments such as funds and ETFs²⁵, and they are considered slightly riskier than other types of funds such as unit trusts⁷. Venture capital trusts are higher risk than most other investment trusts because of the companies they invest in, and are generally more suitable for experienced investors²¹.

Running your own portfolio is the third option, and it changes the risk picture. Investing in individual shares tends to be riskier than investing in funds, though not always, and investing in funds is usually less risky than investing in individual company shares²⁶. A side-by-side comparison of the three routes makes the differences plain.

²⁸

The table is one provider's summary of the three routes, and the "low charges" line reflects the annual charge rather than the total cost of dealing. The independent point stands: a fund gives you diversification and a manager, while a self-built portfolio gives you control and the full weight of any mistake.

Where you can hold investment trusts, unit trusts and OEICs

You can hold investment trusts, unit trusts and OEICs inside an ISA to shelter your money from tax up to a certain limit⁷. A stocks and shares ISA can hold several different types of fund, including equity funds, tracker funds, unit trusts and OEICs²⁹.

Platforms and providers vary in what they accept. One general investment account offers over 3,000 unit trust and OEIC funds to choose from³⁰. Another lets you invest in collective investment funds such as unit trusts and OEICs and in investment trusts³¹. A third offers unit trusts, investment trusts, OEICs and cash deposits in the same account³². A pension or bond wrapper may go wider still: one Section 32 buy-out bond lists OEICs, unit trusts, investment trusts, exchange traded funds, structured products, stocks and shares, venture capital trusts, government securities and term deposits³⁴.

There are limits to watch. One share dealing service's price improvement does not apply to investment funds, meaning unit trusts and OEICs³⁵. And a Bed & ISA, which moves investments into an ISA, is available across shares, investment trusts, trackers and bonds but not unit trusts and OEIC funds³⁶. If you plan to move holdings into an ISA, check whether the platform treats funds and trusts the same way.

Investment trust or unit trust: which suits which investor?

Neither structure is better in the abstract; each fits a different set of circumstances. What follows is what the evidence says about each, not a recommendation.

A unit trust or OEIC suits an investor who wants the price they pay to track the value of the underlying assets closely, who wants to deal in and out without a share price moving away from net asset value, and who prefers a fund that cannot borrow. Most investment funds are unit trusts, though some are exchange-traded funds, so this is the more common structure⁴.

An investment trust suits an investor who is comfortable with a share price that moves independently of the portfolio, who wants exposure to assets a fund cannot easily hold such as property or infrastructure, and who can accept the extra volatility that gearing and the discount bring¹. Investment trusts are complex and are not suitable for everyone³⁷. They have frequently out-performed open-ended rivals in the past, which can sometimes be explained by a combination of lower costs, the closed-ended structure and gearing, but past performance is not a guide to what happens next⁴.

A self-built portfolio suits an investor who wants to choose and monitor every holding, accepts that individual shares tend to be riskier than funds, and does not want to pay for professional management²⁶.

What protects you, and where protection stops

Unit trusts and OEICs have a specific safeguard: a trustee or depositary holds the legal title to the underlying stocks in the fund, so those investments are protected from the provider's creditors¹². That is a custody protection, not a guarantee of performance.

Neither structure protects you against investment loss. If the market falls, the value of your units, shares or trust holdings falls with it. What you can do if something goes wrong depends on the nature of the problem. Complaints about unit trusts and OEICs cover poor service, mistakes made or instructions not followed, payments not processed, investments mis-sold, and being unable to withdraw funds⁸. If a firm has treated you badly, the Financial Ombudsman Service can look at a complaint once you have been through the firm's own complaints process.

Before buying, read the fund's own risk disclosure. Each unit trust and OEIC fund has its own fund specific risks detailed in its Key Investor Information Document¹⁴. For investment trusts, the equivalent detail sits in the trust's own documents and its annual reports.