Understanding Unit Trusts

Unit trusts are a very popular investment used as an underlying in many financial products in the South African market. Let us take a closer look at what a unit trust is and how the costs work in a unit trust.

Investing into a unit trust means that the investor does not directly buy a share trading on the stock market, but that they literally buy a unit (or units) of the pooled investment. This pooled investment is actively managed by an investment manager and this manager takes all the money received from the investors that bought units, to buy shares on the stock market. Any profits and losses made from the underlying investment of the unit trust will then either increase or decrease the value of the units investors hold.

Most unit trusts are daily priced, meaning that they will calculate the new value of the units at the end of each day, based on additional investments, withdrawals, profits, losses and the value of the underlying shares in the unit trust.

Investors can request withdrawals from or top-ups into a daily trading fund every day. Some unit trusts are monthly priced and, in such cases, the price of a unit is only calculated monthly and withdrawals and top-ups can also only be made monthly, which limits their liquidity.

Let us consider an example. You as an investor want to invest in Unit trust ABC, a daily dealing fund. As at today, a unit in Unit Trusts ABC is worth R110 and the total pool of invested funds is worth R660,000, meaning there are 6000 units held by investors (R660,000/R110). You have R550 that you would like to invest, therefore you can buy 5 units (R550/110).

The pool of investments is now worth R660,550 at the end of the day, assuming the market value of the shares already held did not change during that day and there are therefore 6005 units held by investors, that are all still worth R110 each. The investment manager will then use the R550 invested in the unit trust by you, to buy new shares, or alternatively this will be held in cash and all other investment percentages are slightly adjusted considering that the total has been adjusted.

Consider now that the underlying investment in shares that the unit trust is invested in, has increased over a period of two months to R700,000 and that the number of units in issue has not changed (meaning that no new units were bought and none of the investors sold units either). This means that each unit is now worth R116.57 (R700,000/6005). If you now sell all 5 of your units, you will withdraw a total of R585.85 (5 x R116.57), meaning you made a profit of R32.85 (R585.85 minus R550) by investing in Unit Trust ABC during these two months.

The above examples do however not consider costs. When talking about a unit trust’s fees, we usually refer to the Total Investment Charges (TIC), which is a sum of the Total Expense Ratio (TER) and the Transaction Cost (TC). The TER measures the direct total costs involved in managing a unit trust. It includes costs like management fees, trustee fees, legal and audit fees and other operating expenses. The TER is expressed as a percentage of the average value of the portfolio. The TC is a measure of the costs associated with the buying and selling of the underlying shares in the unit trust.

Every unit trust management company in South Africa is required to publish the TER, TC and TIC numbers regularly, and can usually be found on the Minimum Disclosure Document (MDD) that is usually published monthly, often commonly referred to as a “fact sheet”. It is important to note that the return published on the MDD is always net of the costs considered in the TIC. For this reason, the costs must not be considered in an absolute manner, but must rather be seen relative to the return of the unit trusts. Say for example you consider two unit trusts: A has a TIC of 3.5% and a return of 6% as shown on the MDD (or 9.5% return before fees were deducted), while B’s TIC is 2% but the return is only 4% as shown on its MDD (or 6% return before fees were deducted). Because the costs are considered in the return, unit trust A might have higher costs, but also has higher performance. Although past performance cannot be the only consideration for future performance, it might indicate that the fund manager in unit trust A can create better performance despite the higher costs accrued.

Except for the TIC, there might also be some other costs involved in investing in a unit trust. The first is initial fees, which are sometimes levied on new investments when an investor purchases new units. Initial fees are deducted from the amount invested upfront, before units are bought, meaning less money is available to buy units and the investment is therefore made a little bit less. Usually, this initial fee is not levied by the investment manager, but rather by financial advisers that advise the investor in which unit trust to invest. This fee is negotiable but capped at a maximum of 3% of the total investment amount.

Performance fees are also sometimes charged if the performance of the unit trust exceeds the benchmark. This fee must explicitly be stated to the investor upfront, and it must be clear how this is calculated. If performance fees are levied by the investment manager, it must be stated clearly on the MDD. This fee is used as an incentive for the investment manager to increase returns and ultimately benefit the investors.

A unit trust is usually considered an underlying investment, because although the investor does not buy the shares, they do buy units which are their investment. Underlying investments must be held within a product, which can be thought of as the shell that keeps track of the returns, losses and other movements for fee and tax purposes.

Although unit trusts can be the underlying investment in many products (aka investment vehicles) such as endowments, tax free savings accounts, and sinking funds, they are usually held in what is known as an investment plan, which usually doesn’t have complicated tax and liquidity structures and usually the investor has access to a wide variety of different unit trusts within such an investment plan.

If the investor switches from different unit trusts (for example from a unit trust predominantly invested in financial stocks to another unit trust that invests in commodities), a fee can also apply which will be levied by the product provider for the administration involved in accommodating the investor making such a switch.

In the following article we will consider the benefits and drawbacks of unit trusts to gain a better understanding of when it might be a suitable solution for investors.