003b Unit Trusts
Chapter 3b of 'There are no grown ups'
Unit Trusts are also known as Mutual Funds, or Open Ended Investment Companies
What is it?
A vehicle, run & marketed by a fund management company, that receives investors cash, and then invests it.
Leverage (Gearing)
Traditionally unit trusts were not allowed to borrow money. Now some are able to borrow up to 33%.
This is a limit imposed by regulators so, if a unit trust was close to the leverage limit, and investments declined, the fund would be forced to sell assets to bring borrowing below the 33% limit.
How do you buy / sell the investment
Either: By dealing with a Financial Advisor
Or: Using an online ‘funds supermarket’ style platform.
How is the price you pay/receive determined?
By the investment manager. Each trading day the manager (management company) assesses the value of the portfolio & comes to a view on the value represented by each unit in the fund. Some managers quote a single price, at which people can sell, or buy. Others have two prices: one at which they will buy units in from you, and anther (higher) price at which they will sell to you (where this occurs, the spread may include the c5% ‘front load fee’, or may be purely about the bid-offer spreads of underlying not-that-liquid investments).
Setting a fair price requires two things for each underlying investment
a) A reasonable basis for valuing it
b) The ability of the fund to receive the estimated value should the investment (or part of it) need to be sold.
c) If a share, or a bond, is publicly listed, (a) is easy (the market price may be an under or an over valuation, but it is an objective fact that can be used), (b) is also easy, for the shares of large companies, for government bonds, and other securities that are highly liquid. Small companies, such as those listed on AIM, may be rather less liquid: The spread between the market bid and offer may be 5%, or more. And, if you want to buy or sell more shares than are traded on a typical day, you face the prospect of ‘the market running away from you’.
If a fund invests in unquoted companies, or property, valuation is difficult, and should it be necessary to sell (or buy more) of the investment, there are likely to be high dealing costs, a need to ‘cross the spread’, and, very likely, delays (possibly significant), in the transaction if the manager wants to avoid selling at ‘fire sale’ prices, or paying a huge premium.
Most of the time, most managers do not find it difficult to quote a daily price. Unfortunately, the times when they do find it difficult, may coincide with when you want to sell. See the ‘restrictions on selling’ section for more details
What happens to the investment vehicle when you buy or sell?
When you buy, the investment vehicle receives cash, and the manager deploys that cash
When you sell, the investment vehicle must pay cash out to you. If they don't have enough cash pay you, the manager must sell investments to realise cash. If the fund is leveraged, it may have to sell more than £1 of investments for every £1 you redeem.
Much of the time, the cash needed to pay those selling units in the fund, can be found from new investors. If one Wednesday new investors want to put £500,000 into the fund, and existing investors want to withdraw £500,000, then the manager does not need to buy or sell any underlying securities. The new money from new investors, is simply paid to the existing investors, and the fund has to do nothing other than to register that £500,000 worth of the fund has different owners.
When there are more people buying units than selling them, the fund manager gets new cash to invest. Where investments are in minority stakes in large quoted companies, the manager can easily scale up each holding pro rata (ie if new money makes a fund 5% larger than it was last week, the fund manager can just by 5% more BP shares, 5% more Berkshire Hathaway B shares, 5% more Amazon shares, etc). If the investments are in unquoted companies, such scaling up is likely to be difficult at best (and, potentially, involve transaction fees that, in fairness, should not be funded by long term investors in the fund who have already paid the transaction costs when the fund bought its initial holding in the unquoted company), and potentially impossible to execute at a reasonable price. And, if the fund owns property directly, it cant increase its holdings of the property already owned (eg if there is only one building at 100 Park Avenue, and the fund owns it, then there is no more property at 100 Park Avenue to buy), and so will, at best, buy similar property. For all but the largest funds, property, which may be a very good long term investment, comes with the complication that it comes in much larger ‘chunks’ than shares. Even if 101 Park Avenue is available to buy, the purchase might fundamentally re-balance the portfolio.
Lets say that we have a £200m fund, with 15% (ie £30m) invested in office property in the form of 2 office blocks, each worth £15m. This fund is successful, and new investors mean that the managers have a further £20m to invest. To keep the existing allocation ratios of the (successful so far) portfolio, would suggest 15% of £20m ie £3m going into new property. But, without c£15m, the fund can’t buy another office block similar to the existing ones that have proved to be successful investments.
For a fund manager, having to deploy new capital is ‘a good problem to have’, even if it comes with a few complications. Less good is what happens when there are more people selling units than buying them. When this happens, the fund manager needs to sell assets to raise cash to return to investors leaving the fund. If they have to sell some blue chip shares, that's easy, as such shares have 3 great virtues
- They can be turned into cash very quickly
- The fund’s act of selling is unlikely to cause the price to deteriorate (If cUSD 3+ Billion worth of Apple shares are traded each day, then even a USD 100 million disposal would hardly be noticed)
- The cost of disposal (dealing cost / crossing the spread) is unlikely to be large
If they have to sell shares in a smaller company, then, at best, they will be likely to have to cross the spread. The well regarded micro cap Smart (J) & Co Contractors, symbol SMJ, has a bid at 110 and an offer at 120, a spread of more than 8%): a month can go by with less than GBP100k of shares traded, so getting out of a large position quickly would necessitate a price cut.
When one gets to unlisted assets, whether property, or shares in private companies: selling at anything like the usual willing buyer-willing seller price takes time, and costs money. If you had to sell your house, you would pay fees to an estate agent, and would also expect to give them weeks if not months to find a buyer willing to pay what you think the house is worth. Even if your next door neighbour with an identical house had just sold at £500,000, if you called an estate agent on Wednesday, asking them to sell your house by Friday, you would probably be lucky to get £375,000: few people looking to live in the house would be able to act that quickly, so the only buyers would be vultures planning to flip the house. It would be the same for a £10m or £100m office block. Privately held companies are no more liquid: it takes time for any fresh investor to do due diligence, and time/brokerage fees to find that investor.
For funds that are not mostly invested in large-cap equities (or highly liquid government securities such as Gilts, US Treasuries, JGBs etc), the moment the fund has to start making large disposals of illiquid assets, the wheels are likely to come off, and the regulatory requirement that the fund manager posts a daily price at which they are prepared to buy/sell becomes a vast burden beset with conflicts of interest. Consider a USD250m fund that lists a fair price based on underlying Net Asset Value, and then is hit by a USD 50m redemption. To fund that USD50m, it may have to sell assets that it has valued at USD75m. So the remaining investors, who yesterday owned USD200m of the funds assets, now own USD175m. And, if the fund has just disposed of is more liquid holdings, the remaining USD175m of assets might require fire-sale pricing to liquidate quickly. Lets say that the fund manager really believes in the underlying investments, and that USD175m is a conservative (pessimistic) valuation in normal times, but that, in a fire-sale, they would raise only USD125m. If the manager quotes a price based on the USD125m, then investors who 36 hours earlier owned USD200m, are now looking at a 37.5% loss if they need to get out and, even if they don't want to get out, they face the possibility of dilution by new investors coming in and, in effect, getting the fire sale prices by buying the fund at a discount. If the manager tries to avoid this, and quotes a price based on the underlying USD175m ‘fair value’, switched on investors who have just seen what has happened with the USD50m redemption, will have a big incentive to get out fast, just as, if you fear a run on your bank, you need to get your money out first. Your incentive is threefold
- The USD175m price is based on ‘fair value’, while if you wait, and there is a rush of withdrawals, you will end up getting the fire-sale value
- If the fund’s initial investment choices were well chosen and resulted in a balanced, diversified, set of holdings, the rush to fund the USD50m redemption, would not have resulted in an across-the-board sale of 1/5th of the holdings. The least liquid would have been kept, and the most liquid sold. The remaining holdings would have an illiquidity bias
- Fund managers, who are paid a fee based on the notional value of assets under management, would be facing a big fee cut. If the fund is part of a big organization, ‘star traders’ would be likely to be focused elsewhere. The fund may even be merged with another fund. If you initially invested because you believed in the strategy and the manager
Being an Open Ended investment vehicle is a structure that only works well when the fund is growing, or going sideways.
Restrictions on selling
Because the open ended structure works badly during times of heavy selling, the normal rules are often suspended if investors start wanting to withdraw lots of money. If you really want to sell, at a time when lots of other people also want to sell, you may be faced with a ‘redemption gate’: literally the gate is closed to withdrawals to prevent a run on a fund and/or to allow the fund time to dispose of assets in an orderly way (giving the estate agent a month or two to sell that house at a fair price, rather than having to accept a fire-sale price from a vulture), or a ‘liquidity fee’: if not banned from selling entirely, the fund manager may say ‘if you sell, we will have to offer a 20% fire sale discount to liquidate quickly, so we are passing that 20% on to you as a fee’.
Who gains / loses when you buy it?
If you are paying an entry fee (typically up to 5%, and sometimes incorporated into a bid-offer spread), then your advisor / broker / platform will benefit from this. The fund management company does not necessarily share in that fee although, funds that use a 3rd party (eg advisor-broker etc) sales channel may have agreed with the channel that they will not undercut the 3rd parties (so people don't get a recommendation from their advisor, and find that by going online and buying direct they save 5%: such a structure would not have advisors queuing up to recommend the fund to their clients). The ‘not undercutting the channel’ strategy means that, where you buy the fund online directly from the fund manager, the manager can pocket the 5% as extra profit. Because different advisors & platforms compete with each other, they may offer discounts / rebates on the c5% usual fee, in which case it can be cheaper to buy via the intermediary than to buy direct
Once the purchase has been made, the fund management company will gain ongoing management fees for as long as you hold the fund.
Who gains / loses when you sell it?
If you sell, the fund will have less capital under management, and so the fund manager will receive less in management fees going forward.
Where a fund quotes a bid and an offer separately (rather than publishing a single daily dealing price), then to the extent that you have to cross this spread to sell your holding, the person/business on the other side (eg the fund management company or, possibly, the platform) will gain, especially of they benefit from a large trading volume and are offsetting your sell order against a buy order from another investor.
If your decision to sell triggers, or helps to trigger, the sort of large scale liquidation & fire sale described in the ‘ What happens to the investment vehicle when you buy or sell’ section, then the fund manager may face a significant impairment to their business. Staff there may loose their jobs, almost certainly they will get smaller bonuses. And, if the liquidation involves fire-sale disposals, the vultures buying assets cheaply are likely to gain (unless the market is about to head south and, what the vulture thought was a bargain, ends up being valueless. See the brilliant Film Margin Call with Jeremy Irons & Kevin Spacey)
Who makes the investment management decisions?
The investment management company
How can the investment management company be fired if they are doing a bad job?
Hmm. Usually, for all practical purposes, they can’t.
How does the investment manager make more money for themselves out of the fund?
By making the fund bigger: they get paid a fee that is a percentage of the funds value each year.
Some mutual funds may have a performance fee on top of the basic ‘assets under management’ fee, but, even where this is the case, most fund management companies would rather have twice the assets under management, rather than achieve twice the annual return for their investors.
Typical cost of buying
Up to 5%
Typical annual management costs
Management fees of: 0.75-1% in the UK (1.5% used to be typical, not least because perhaps 0.25% p was being given as a kickback ‘trail commission’ to the advisor who sold the fund)
Plus trustee, auditor, etc fees running to another 0.1-0.2%
Potentially plus performance fees of up to 20% of performance above inflation/the index/other benchmark
Typical ‘Total Expense Ratio’ (not including crossing the spread)
1.25%- 2.75%
Typical cost of selling
With an online broker, the transaction costs may be minimal.
The fund manager may impose an ‘exit fee’ (aka ‘repurchase charge’ or redemption charge). Before buying a fund, check to see if the manager imposes an exist fee, and be very careful to check the wording: promotional materials that say ‘We currently do not have an exit charge on any of our funds’ are no help if the small print gives the manager the power to impose such a fee later.