THE INS AND OUTS OF UNIT TRUSTS

Unit trust funds have been around for half a century. MARTIN HESSE explains how this popular form of investment works.

UNIT trust funds are a popular vehicle for investing, and it is likely that you have money in one or more of them, either directly, or indirectly, through a retirement fund or tax-free savings account.

They are a type of collective investment, and are governed by the Collective Investment Schemes Control Act. In other countries, they are known as mutual funds. There are about 1 300 locally managed funds to choose from. When you invest, your money is pooled in a trust with that of the other investors. A unit trust management company invests the money on behalf of the trust in assets such as shares, bonds and money-market investments, which form the portfolio of the fund.

You, the investor, are protected, because the trust fund and the company that manages it are separate entities. If the management company goes into liquidation, the assets in the trust fund are safe. All unit trust funds marketed to South African investors must be approved by the Financial Sector Conduct Authority (FSCA).

BUYING AND SELLING UNITS

The fund is divided into units of equal value, and it is these units that are bought and sold by investors. The price of each unit, known as the net asset value (NAV), is calculated by taking the overall value of the portfolio (which includes income that has not been reinvested or distributed), deducting expenses (taxes and investment costs), and dividing that amount by the total number of units in the fund.

Example:

R1 million (total value) – R50 000 (expenses) = R950 000 R950 000 ÷ 500 000 (number of units) = R1.90 (NAV) So if you invest R500, you will receive 263.16 units (R500 ÷ R1.90) If the NAV rises to R2, the value of your investment will be R2 x 263.16 = R526.32. If you sell at that price, you will have made a profit of R26.32 (or just over 5%). If the NAV drops to R1.80, the value of your investment will be R1.80 x 263.16 = R473.68. If you sell at that price, you will have made a loss of R26.32.

The investments in the fund are valued at a set time each business day (typically, 3pm, Mondays to Fridays), and this determines the daily NAV. There is no gap between the buying price and the selling price: the price at which you buy a unit is the same as the price at which you sell it. There does not have to be a seller for you to buy a unit (or vice versa): you buy and sell units directly from the management company at the NAV.

The NAV fluctuates according to the value of the underlying investments, which may be relatively volatile in the case of shares.

INCOME

There are two main sources of income: interest from interest-bearing investments, such as money-market instruments and bonds, and dividends from shares. Periodically (typically twice a year), income is distributed to investors.

If you are investing for the long term, you should be reinvesting your distributions, which the fund manager does on your behalf by giving you units to the value of the distribution. On the other hand, if you depend on your investment for an income, these distributions may be paid out to you.

TAXES

Three taxes apply to returns and gains in a collective investment scheme:

1. Dividend withholding tax of 20%, which is withheld by the manager on the dividend portion of your distributions.

2. Tax on interest, which is income tax you pay on the interest portion of your returns, subject to your annual exemption. You have to declare this interest on your tax return.

3. Capital gains tax on the capital gain when you sell units, subject to exclusions. This is also declarable on your tax return.

These taxes don’t apply to unit trusts held in a tax-free savings account and to underlying unit trusts in a retirement fund.

COSTS

You can incur once-off initial fees as well as annual fees on unit trust investments.

• Initial fees. These comprise an adviser’s fee of up to 3.45% (negotiable with your adviser) and an initial investment fee. Most unit trust management companies have scrapped the initial fee, and you do not pay an adviser’s fee if you invest directly.

• Annual fees. The overall annual cost is expressed as the total expense ratio (TER).

This includes management fees, bank and audit charges, value-added tax, and trustee fees, and it may also include a performance fee, paid to the manager if the fund outperforms a benchmark.

The TER is between about 0.5% and 2.5%, depending largely on the complexity of the underlying investments. You may also incur an annual advice fee, but this is negotiable with your financial adviser and does not apply if you invest directly.

PROS AND CONS OF UNIT TRUSTS

Advantages

• Unit trust funds don’t require large up-front amounts; you can make a once-off lump-sum investment (of as little as R1 000 in some instances, although some investments require a minimum of R10 000), or you can invest a small amount (as little as R500) monthly.

• They are extremely flexible: units are easy to buy and sell. You are not tied into a fixed investment term, and there are no penalties or fees on disinvesting.

• They are well regulated.

• They enable your money to be managed by an investment expert.

Disadvantages

• Choosing a unit trust can be overwhelming when faced with so much choice.

• Not all unit trusts are created equal: fund managers’ ability to make good investment decisions varies.

• Some funds’ annual management fees are relatively high.

• There are no guarantees associated with these investments, such as a guaranteed return or a guarantee that you will not lose money.