Almost every R02 paper contains a question that asks you to distinguish between collective investment structures. The topic is easy to underestimate because the vehicles all do the same basic job of pooling money, and the marks come from the structural differences rather than the investment strategy.
The four structures
Unit trust. A trust deed, a trustee holding the assets and a manager running them. Investors buy units, and the fund is open ended, so units are created and cancelled as money flows in and out.
Open ended investment company (OEIC). A company with a depositary and an authorised corporate director. Investors buy shares, and the fund is still open ended. In the UK it is the dominant structure and most former unit trusts have converted.
Investment trust. A listed closed ended company. It issues a fixed number of shares, and those shares trade on the stock exchange. The company invests in other assets.
Exchange traded fund (ETF). Usually an open ended fund listed on an exchange, most often tracking an index, with market makers and authorised participants keeping the price close to net asset value.
The comparison table
| Feature | Unit trust | OEIC | Investment trust | ETF |
|---|---|---|---|---|
| Legal form | Trust | Company | Company | Usually a company or fund, listed |
| Structure | Open ended | Open ended | Closed ended | Open ended, exchange traded |
| Investor holds | Units | Shares | Shares | Shares |
| Pricing | Bid and offer, or single | Single price | Market price, premium or discount | Market price, intraday |
| Dealing | Once daily at valuation point | Once daily | Continuous during market hours | Continuous during market hours |
| Gearing | Very limited | Very limited | Permitted, often 10% to 20% | Generally none, synthetic exposure possible |
| Governance | Trustee | Depositary | Independent board of directors | Depositary |
| Typical cost | Ongoing charge, no dealing spread | Ongoing charge | Ongoing charge plus dealing costs and spread | Very low ongoing charge plus spread |
Where the marks are
Discounts and premiums. Only closed ended vehicles have them, and this is the single most tested point. A trust trading at a 12% discount means the share price is 12% below net asset value per share. Buying at a discount that then narrows adds to return, and a widening discount subtracts from it, which is why investment trusts can be more volatile than the assets they hold. Boards use share buybacks and discount control mechanisms to manage the gap.
Gearing. An investment trust can borrow, which magnifies gains and losses. A trust with 20% gearing in a market that rises 10% should outperform an ungeared equivalent, and the same structure hurts in falling markets. Open ended funds are restricted to short term borrowing for liquidity.
Liquidity mismatch. Open ended property funds are the standard illustration. When investors want out faster than buildings can be sold, the manager suspends dealing or applies a fair value adjustment. A closed ended property trust never has to sell to meet redemptions, and instead the discount widens.
Tracking error and tracking difference. For an ETF, tracking difference is the actual gap in return against the index, and tracking error is the volatility of that gap. Causes include charges, cash drag, sampling, dividend timing and, for synthetic funds, swap costs.
Physical against synthetic replication. A physical ETF holds the constituents. A synthetic ETF uses a total return swap, which introduces counterparty risk and is common for hard to access markets.
Taxation
- Income from an equity based fund is a dividend, taxed at 8.75%, 33.75% or 39.35% after the £500 dividend allowance
- Where a fund holds more than 60% in interest bearing assets, distributions are treated as interest, taxed at the savings rates with the personal savings allowance available
- Gains on disposal are subject to CGT at 18% or 24% after the £3,000 annual exempt amount
- Switching between funds in the same fund family is a disposal for CGT, and switching between share classes of the same fund is generally not
- Equalisation on the first income payment after purchase is a return of capital and reduces the acquisition cost
- Accumulation units still produce taxable income even though nothing is paid out, and the notional income increases the base cost
- Stamp duty reserve tax does not apply to purchases of investment trust shares or ETFs listed outside the UK, and does apply at 0.5% on UK share purchases
Offshore funds add one more layer. A fund with UK reporting status gives capital gains treatment on disposal. A non reporting fund gain is an offshore income gain, taxed at income tax rates of up to 45%, which removes the annual exempt amount and the lower CGT rates. That single distinction is worth learning verbatim.
Choosing between them in an exam answer
| Client priority | Likely structure |
|---|---|
| Lowest cost index exposure | ETF or tracker OEIC |
| Access to illiquid assets such as infrastructure or property | Investment trust |
| Simplicity and daily pricing with no spread | OEIC |
| Intraday dealing and stop losses | ETF or investment trust |
| Smoothed dividend growth from reserves | Investment trust, which can hold back revenue reserves |
That last row is often missed. Investment trusts can retain up to 15% of income and use reserves to maintain dividends in weak years, which is why several have very long records of consecutive increases. Open ended funds must distribute substantially all income.
Regulation and protection
Authorised unit trusts and OEICs are UCITS or non UCITS retail schemes under the FCA rules, with investment and borrowing limits including the spread rules limiting exposure to any single holding. Investment trusts are governed by company law and the listing rules rather than the collective investment scheme rulebook, which is why they can hold concentrated or unquoted portfolios. Unregulated collective investment schemes cannot be promoted to ordinary retail clients.
Revision approach
Reproduce the comparison table from memory, then write three sentences explaining discounts, gearing and reporting status. Those three concepts account for the large majority of the marks this topic attracts.