I have recently been talking to some fellow investors about cost-effective diversification. The investment trust vs unit trust debate kicked in with differing opinions that are worth bringing forth here. It’s a bit confusing because both trusts have a similar function: they allow investors to put their money with other investors into a portfolio of diversified assets (shares, bonds, properties, etc.) through a single investment.
While these two types of pooled/collective investments help spread risk and generally look the same, they have important differences – differences you need to know if you want to make a choice that best fits your goals.
What is an investment trust?
An investment trust is basically a company in its own right that holds various financial assets (typically shares) in other listed companies. It’s run by a professional fund manager on behalf of investors and is backed by an independent board that acts in their best interest.
This is a closed-ended fund, meaning there is only a limited number of shares available. Whenever someone wants to buy them, they have to do so just like with any other listed company because new shares are not created.
The trust raises a finite amount of cash and invests it, which means the price of shares is determined by supply and demand as much as it is by their net asset value (NAV). Investment trust structure provides managers with a high level of flexibility as they aren’t forced to sell assets when investors sell their shares.
If shares in the trust are in high demand, they will trade at a price in excess of the NAV – this is called trading at a premium. By contrast, shares in low demand will trade at a price below the NAV, called trading at a discount. I’m sure you know which one is better.
What is a unit trust?
The more common type of collective investment for exposure to a portfolio of assets, a unit trust is a mutual fund that holds assets and provides profits that go directly to the individual investor (unit holder/owner) as opposed to reinvesting them into the fund. The investor is the trust’s beneficiary.
Unlike an investment fund, it’s “open-ended”, meaning the number of units or shares grows or shrinks in accordance with investor demand. The more people invest, the bigger the unit trust gets but if there are more sellers than buyers, it becomes smaller. Do note that unit trusts are set up differently across the globe.
The price of a unit fluctuates as it reflects the value of its underlying assets and is normally calculated on a daily basis to reflect the changes in the prices of those assets.
Why choose either one?
Collective investments can be convenient and beneficial solutions in more ways than one. I’ve already mentioned the principal benefit: diversified portfolio via both trusts means risks (market risks, liquidity risks, interest rate, etc.) can be better spread over assets in the trusts.
For instance, if you routinely struggle to find enough time to monitor a diversified portfolio, this way there’s an expert in charge of managing your money and decision-making when it comes to crucial ‘buy’ or ‘sell’ calls.
Also, getting the right balance of investments is a mission impossible for many investors as they need exorbitant amounts of money to build it on their own and manage – all of which both investment and unit trusts provide at scale.
Investment trust vs unit trust – which is better?
Right from the start – don’t expect a one-size-fits-all answer. Sometimes, an investment trust will be the way to go while other times, a unit trust may be the more favorable option. It all depends on your circumstances and willingness to risk.
That being said, there are some facts that can help you make your decision. For example, unit trusts are more flexible than their investment counterparts as they are able to make more units, offering more options for investors. On the other hand, it’s fairly common for investment trusts to borrow money (called gearing) to boost returns in times of market upsides and provide a cushion when markets fall.
Arguably the deciding factor will be the performance. Investment trust performance is generally considered to be better in the long run (a decade or so), while unit trusts fare better in shorter periods (between one to five years). This is something you have to research the hell out of as you push for a final decision. Some investment websites have free research tools or offer comparison tables like AIC.
Next up are fees/charges that will definitely put a strain on any returns you make. While these are one of the few things you can account for and control when opting to invest, fees can have a significant impact on returns over longer periods.
Here are some guidelines that may help you:
- If you are willing to risk more and seek a potentially higher return, go with an investment trust.
- Be prepared for volatility, particularly in the short term.
- Assess the total expense ratio (TER), which represents the fees charged by the fund such as management fees, trading fees, legal fees, etc.
- Check that your fund manager has some form of compensation coverage, like the UK’s FSCS, so that if they go belly up, you get some compensation.
- If you like what both options offer – go for both! Many investors combine the two as what matters most is the manager’s capacity to (out)perform, not the type of structure.
Final thoughts
Picking out the trust in which to invest your hard-earned money is as important and complex a decision as it can be. It’s imperative to spend some time combing through options in order to score the right investment that suits your investment objective and approach.
For example, unit trust risk factors are different than those for investment trusts. Some assets are riskier than others so the amount of risk and return will depend on the asset’s type the trust is willing to invest in. The right approach to building a diverse portfolio through collective investment demands you arm yourself with facts. If in doubt, don’t hesitate to reach out for independent financial advice – anything you can do to make sure your money is in good hands is worth it, literally.
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