Investment Versus Unit Trusts

Investment Trusts are a type of investment instrument. These differ from unit trusts in that they are closed-end or of finite size. There is a fixed number of shares on issue over any one period so when investors wish to buy or sell they must trade with existing holders - just like conventional stocks. With a unit trust however the purchase or sale of units is met by the issuance or redemption of stocks by the Trust itself.

Typically the management fees of investment trusts are lower than those of unit trusts because they do not have the overhead of issuing and redeeming units all the time. In addition, in New Zealand certain Investment Trusts tend to be favoured by the tax regime in that they do not have to pay income tax on realised capital gains. Those trusts are the UK-registered trusts.

Avoiding the tax sledgehammer of tax on realised capital gains is not the preserve of UK listed investment trusts. UK OEIC's (Open Ended Investment Companies) do the same. So do Australian unit trusts that derive their earnings outside of Australia and have compulsory reinvestment of realised gains, at least to non-Australian investors.

However it is not all plain advantage for listed Investment Trusts. Typically these instruments trade on the stockmarket at a discount to asset backing - reflecting the overhead of the manager over and above the costs of the underlying stocks invested in, and reflecting the costs involved in cashing up the portfolio should that be the best course for investors (for instance if the manager proved to be of no value).

What's worse the discount on listed trusts is highly volatile and can remain large for long periods of time. This has lead some advisors to continually recommend to clients buying trusts when discounts are large and exiting when they're low. Apart from the obvious tax implications of that strategy, more significantly the investment strategy in such cases is reduced to one that just "plays" discounts as opposed to focussing of the underlying business case for preferring that manager.

In summary for New Zealand investors, UK-listed investment trusts have tax advantages but have volatility over and above the volatility of the listed prices of the companies they often invest in. This additional volatility can be seen as an additional cost of having a professional fund manager as opposed to investing in the equities direct and needs to be weighed up against the tax disadvantage of a unit trust structure.

Finally unit trusts can face a significant additional disadvantage in the instance when there is a run on the whole market and redemptions force the manager to sell the underlying security in a weak market. This too has to be balanced against the reality that when a general market weakening occurs discounts on listed trusts are likely to blow out too.

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