How do Unit Trusts work?

As anyone who was invested in Steinhoff International when its shares went into freefall in December will know only too well, investing in a single stock is risky. Holders of Steinhoff stock have by now lost about 97% of their investment since early December.

Had you held Steinhoff in a unit trust or another collective investment scheme, the impact would hopefully have been cushioned by gains in some of the other shares in your portfolio. That’s the benefit of pooled investments such as unit trusts and exchange-traded funds; you spread the risk. In South Africa, these are increasingly being referred to as collective investment schemes.

Here’s how unit trusts work:

A unit trust is a portfolio of stocks, bonds, property, cash or other asset classes, chosen by professional fund managers according to themes and styles of investing.

The manager buys these securities on behalf of the fund, which is then split into equal units which are sold to investors. In an open-ended fund, the number of units is unlimited so more investors can pile into the fund. The fund is priced daily according to the net asset value of the underlying investments. Dividends and interest from the underlying investments are either reinvested or paid out. Investors share in the gains of the unit trust – and the losses.

Some unit trusts, like exchange-traded funds, follow a passive strategy, i.e. they track a prescribed index or stock market. However, many unit trusts are actively managed, with fund managers making decisions they believe will either beat the market or, in the case of conservative funds, preserve your capital during volatile periods.

Actively-managed funds typically have higher fees due to the cost of the fund managers involved in the decision-making process. While the fund manager ensures that the fund invests according to its mandate, the administration of the fund is undertaken by a management committee, which notifies the manager of any breaches in compliance with the fund rules.

Apart from an initial fee, there is also an annual management fee, as well as administration, legal and custodian fees. These are usually grouped together to give you a total expense ratio, or TER. TER’s vary so you should consider the fees you are likely to incur and weigh them up against the fund’s historical performance – bearing in mind that many fund managers include the caveat that historical performance is no guarantee of future returns. A fund’s performance relative to its benchmark is usually illustrated net of costs. Active funds aim to beat their benchmark, which is usually a broad market index.

Apart from spreading the risk across asset classes, managers also reduce the risk of you incurring losses by spreading the investment across different asset classes, regions and sectors.

It’s important for you to decide which style of investing suits you. If you can’t afford to lose the money you’re investing you should probably veer towards a low-risk or balanced unit trust portfolio. These usually include a higher proportion of cash and bonds, which are deemed safer than equities. However, the returns may not be as good.

Portfolio managers also invest according to themes. These could include value, where the manager invests your funds in companies that appear cheap relative compared to the market, or geographical, such as emerging markets. There have been a growing number of unit trusts focused on technology given the rise of big-tech companies globally such as Amazon, Alphabet (Google) and Tencent.

Unit trusts are regulated by the Financial Sector Conduct Authority, which should provide some peace of mind that your investment is in safe hands.

 

Source: InceConnect – Stephen Gunnion