Chapter 20

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Investment Vehicles

Platform and funds

‘If I had asked people what they wanted, they would have said faster horses.’

Henry Ford

Investment vehicles are the actual investment products that you buy for your portfolio. When choosing funds, the different acronyms are not always clear – OEIC, ICVC, CIS, NAV, ACD, UCITS, NURS, SICAV, ETF, CEF, KIID. It all sounds a perplexing gibberish. However, the choice of investment vehicle can impact results.

We will try to clarify it all.

Your platform

The universe of investment products from which you can select is part of the platform that you use. Your ISAs and pensions may be part of a platform.

A fund platform is an online service, allowing financial advisers to manage their customers’ investment portfolios. Customers can directly use some platforms. They often offer ISAs, SIPPs, life insurance products, funds, securities and financial instruments. You can manage your entire portfolio, including personal pension and ISAs, using a platform.

Some platforms offer tools for investment profiling and planning, as well as model portfolios or a guided architecture service. The latter directs advisers and customers to funds managed by chosen managers, allowing access to a limited, albeit sometimes large, number of funds, rather than the whole of the market.

Open architecture allows advisers and customers to buy funds managed by different fund managers on a single platform. It can give access to the entire range of funds on the market.

There are two types of platforms. Whole of market platforms (sometimes called wraps) offer access to a wide range of investments, potentially covering all the funds offered in the UK. Financial advisers commonly use them.

The second type of platform is a fund supermarket, offering a narrower range of products than a wrap. Fund supermarkets usually offer a simple, online access and are commonly used directly by customers.

Compare charges, features and choices of different platforms. Use a SIPP to actively manage your portfolio. If you are not active, a simpler, potentially cheaper choice, such as a stakeholder pension, can suffice. However, not all SIPPs are necessarily more expensive than stakeholder pensions.

Platform fee (often called service fee) is about 0.25% per year. Check switching charges levied on changing funds. Some platforms offer unlimited switching, others give you a free annual allowance (such as five switches) and charge you on switching funds above it.

The platform is your system to manage your portfolio. The look and feel of its website should fit your style and needs. Have a trial run before choosing. It is like test-driving a car before buying it.

Investment vehicles

OEICs

In plain English, an OEIC is a UK fund. You buy shares in the fund, which has many shareholders. It invests their money collectively in securities and investments. Your shares represent your proportional claim to the fund’s assets. When their value appreciates, share price rises accordingly. It falls when fund’s assets depreciate.

In not-so-plain English, an open-ended investment company (OEIC) or investment company with variable capital (ICVC) is an open-ended collective investment scheme (CIS) incorporated in the UK.

The fund is equitably divided into shares whose price varies in direct proportion with the value of the fund’s net asset value (NAV).¹ OEICs normally have one director (manager of the fund), which is an authorised company, referred to as the Authorised Corporate Director (ACD). The ACD appoints the investment manager.

An open-ended fund means the OEIC creates new shares when money is invested and redeems shares when money is divested. Investors buy shares from the fund and sell shares to it, rather than trading with other shareholders. The supply and demand of shares does not affect share price, which reflects the NAV. Open-ended funds are normally priced once a day.

OEICs have a single price for buying and selling shares (no bid-ask spread).

UCITS

UCITS stands for Undertakings for the Collective Investment of Transferable Securities. It’s a directive of the European Union, aiming to allow funds to operate freely throughout the EU on the basis of a single authorisation from one member state (passporting).

For example, a French authorised fund complying with UCITS regulations can be marketed to retail investors across member states in the EU, such as the UK and Germany, without full authorisation in each state.

UCITS restricts compliant funds on the types of permitted investments they can hold (such as no direct property and commodities), on concentrations (ensuring diversification) and on leverage and transparency.

NURS

Non-UCITS Retail Scheme (NURS) is a UK fund that is not compliant with UCITS regulations. NURS funds comply with FCA’s rules and regulations. NURS can invest in a wider range of eligible investments and has more flexibility than UCITS.

It should not matter to you whether you buy UCITS or NURS funds. Both are regulated.

Offshore funds (SICAV)

Offshore funds are incorporated outside the UK. One common type is a SICAV, which, in French, stands for an investment company with variable capital (similar to an OEIC). Often, offshore funds are incorporated in Luxembourg or Ireland.

ETFs

An exchange-traded fund (ETF) is traded on a stock exchange. Most ETFs aim to track the performance of an underlying index. ETFs use different methods to replicate the index’s performance, such as full replication, statistical stratified sampling replication and synthetic replication. Each technique has benefits and risks.

One risk of ETFs is tracking error with respect of the index. Full replication (holding all securities in the index) minimises tracking error, but might be costly. Statistical replication (holding a subset of securities in the index) balances tracking error and transaction cost reduction. Costs and fees are an important factor and one of the potential appeals of ETFs over other investments.²

ETFs come with a number of advantages since they are traded on the exchange. They are priced and traded throughout the day and you can short them. They behave like listed securities. However, this flexibility comes with a cost. Unless you are a day trader, you are unlikely to take advantage of these features.³

Index tracker funds (such as OEICs) price once a day and you cannot short them. However, if your investment horizon is longer than a few weeks, index-tracking funds may be cheaper than ETFs. Nevertheless, the fees of some core ETFs (such as those tracking the S&P 500 Index and FTSE 100 Index) have come down materially over recent years, making them more attractive.

Unit trusts

A unit trust is an open-ended fund constituted under a trust deed. Units in a unit trust have different purchase (ask) and sell (bid) price. This difference is called bid-ask spread. It varies depending on the liquidity of assets in which the unit trust invests.

The trend in recent years is to move from unit trusts to OEICs. OEICs are a simpler structure that can be sold across Europe when UCITS compliant.

Investment trusts

An investment trust is a closed-end fund, common mostly in the UK, incorporated as a company and normally listed on a stock exchange.

A closed-end fund (CEF) issues a fixed number of shares through an IPO. No new shares are created to meet investors’ demand. Rather, shares are traded in the market between buyers and sellers. Therefore, unlike open-ended funds, supply and demand impact share price, which can diverge from NAV.

When share price is above NAV, it is traded at a premium. When it is below NAV, it is traded at a discount. The premium and discount can be a source of volatility in share price.

Check the liquidity of investment trusts (average value of shares traded per day). Lacking demand for their shares, price can plunge, as a discount to NAV can be created or can widen. Buying an investment trust at discount may appear a bargain. However, poor demand can drive a discount to further expand.

Pay attention to the bid-ask spread. For example, when buying an investment trust, the bid price could be £105 – that is what you pay for every share. The ask price could be £100 – that is what you get when selling shares. In this case, when buying and selling, you lose 5%.

Be careful when buying CEFs. They can exhibit equity-like volatility as they are priced throughout the day and listed on the exchange. When they are traded at a premium, you can lose if the premium shrinks. Many investment trusts use leverage, augmenting volatility.

Investment trusts often have higher fees than OEICs and their fee structure is more opaque.

One advantage of investment trusts for their managers is that they can benefit from a long investment horizon. The money remains in the investment trust, as managers do not need to redeem shares. This could be advantageous when investing in illiquid assets, such as property, private equity and infrastructure.

Unit-linked funds

Unit-linked funds (insured funds) are linked to plans issued by insurance companies (such as investment bonds and endowment policies), allowing policyholders to invest in funds. Similar to OEICs, policyholders buy units in funds and their price depends on NAV.⁴

KIID

Key Investor Information Document (KIID) is a short document with key facts and figures about a fund. It has a standard layout describing what the fund does, its investment risks, charges and performance. Regulations require every investor to receive a KIID before investing in a fund in an ISA, for example, but not in a pension.⁵

Fees and costs

Welcome to the magnificent world of fees and costs. Often, fees and costs are misleading, due to jargon, inclusion and exclusion of some costs and hidden fees.

AMC

Annual Management Charge (AMC) is the management fee the fund manager charges. The AMC’s level depends on the asset class (higher for equities, lower for bonds), the management style (higher for active, lower for passive) and the asset management firm’s reputation. AMC normally ranges between 0.40% and 0.75%, but can be lower or higher.

AMC is an ongoing charge.⁶ It is an annual per cent deducted from the assets you invest in the fund. For example, an AMC of 0.50% means every year 0.50% is deducted from the fund’s performance. It is taken from income that the fund generates or from its capital (assets).

AMC compensates the manager for professional asset management services, including expertise, research and daily fund management. It is charged at the same rate, whether the fund performed well or poorly.

TER

Total Expense Ratio (TER) supposedly measures the fund’s total costs.⁷ It includes AMC and additional costs, such as custodian fees, legal fees, auditor fees and other operational expenses.

TER does not include transaction costs, due to trading securities and financial instruments. Transaction costs average about 0.40% per year for an active fund and 0.10% for an index tracker, depending on asset class and investment style.⁸ Transaction costs come out of performance.

When investing in funds, look at TER, not AMC. TER better represents how much you will pay for the fund each year. For example, a fund with an AMC of 0.55% and TER of 0.75% means your net performance will be lower by about 0.75% than gross performance.

When investing in an ETF with a 0.50% TER, for example, expect it to lag the index by 0.50% per year. This number can be higher or lower due to the ETF’s tracking error and potential benefits from securities lending.

OCF

Ongoing Charge Figure (OCF) is close to TER. Its name better describes what it represents than TER – recurring charges.

One-off charges

Initial charges (front load) are deducted when investing in a fund. The majority of an initial charge is paid to cover administrative and marketing costs, such as commission to the adviser who sells the fund. Your adviser may refund some or all of the initial charge as a rebate.

This means, for example, that when investing £1,000 in a fund with an initial charge of 5%, you are left with only £950 invested in the fund. You immediately ‘lost’ 5%. Avoid investing in funds with a high initial charge.

When shopping around for pensions and ISAs, check there are no front loads. It is silly to ‘lose’ 5% before you start investing.

Some funds have an exit charge (back load). Avoid investing in funds with back load. It is the same principle as front load – instead of ripping you off when entering; you are ripped off when exiting.

An exit penalty is a charge levied when redeeming a fund within a certain time since buying it. This could make sense to protect the interests of the fund manager and other investors when funds invest in illiquid investments or to deter short-term investors from buying and selling funds repeatedly, disrupting performance.

Dilution levy

Dilution levy (or the similar swing pricing) is an adjustment made to the fund’s share price, reflecting transaction costs resulting from inflows and outflows. It is intended to protect existing shareholders against the adverse performance impact of new or leaving investors. The dilution levy’s magnitude depends on the asset class, fund’s AUM and size of inflow or outflow.

For example, when buying shares in a fund investing in high yield bonds, the manager needs to spend the cash to buy securities. This involves transaction costs. The dilution levy reflects the transaction costs in the share price of the new investor, who is the only one bearing them, without unfairly affecting other shareholders.

As a relatively small investor, when investing in large funds (with AUM above £100 million), your dilution levy should be minor. This is one reason to invest in funds with decent AUM – size matters.

Performance fees

Performance fees reward fund managers for superior returns. They are normally charged on performance in excess of a benchmark or a hurdle.

For example, hedge funds historically followed a model of 2 and 20, meaning 2% ongoing charge on assets and 20% performance fee. Say the benchmark is Libor −4% and the fund returned 6% when Libor was 1%. Outperformance is 1%, so you pay 0.20% performance fee, leaving 0.80% net outperformance.⁹ Ongoing charge is 2%, leaving an overall net return of 3.8%.¹⁰ That is 2.2% below the 6% gross return. A 2.2% fee is expensive on a 6% return.

The performance fees’ objective is better aligning interests of managers with those of investors. With an ongoing charge on assets, managers are financially incentivised to accumulate assets. With a performance fee, managers are incentivised to maximise returns.

However, a performance fee might cause conflict of interest and managers to take excessive risks or low risks. This is known as a principal-agent problem.

When underperforming the benchmark, a performance fee is unlikely and managers might lose their job. They might take disproportionate risks. If materially enhancing returns, they may still be awarded a performance fee and save their job. If failing, they were doomed to fail anyway.

When having good performance before year-end, managers might de-risk the fund. With low risk they will lock in the performance fee. If taking risk and underperforming, they might lose the performance fee. Why risk it?

Managers (the agents) in these cases do not keep the interests of investors (the principals). The principal wants the agent to continue taking a risk level as per the mandate and market conditions, without changing it due to compensation. Agents exploit their information advantage as it is challenging for principals – especially small ones, to monitor the agents’ actions and motives.¹¹

High water mark is often used to ensure managers are not rewarded a performance fee for poor performance. They are paid a performance fee only if the fund’s value is above its highest peak. Some funds do not have a high water mark. Their managers can earn a performance fee even when not surpassing previous highs.

For example, say NAV is £120 at the beginning of the year. The fund lost £20 in the first year, reaching £100. In the second year, the fund gains £10, reaching £110. The manager does not get a performance fee for the second year, even though performance was positive. The fund is still below its peak. Only after the fund exceeds £120 again – the high water mark – can the performance fee kick in.

Stamp duty

When buying shares you pay a 0.50% stamp duty (called stamp duty reserve tax – SDRT). It applies to buying UK stocks, ETFs, REITs and investment trusts, as they are all traded on the stock exchange.

Buying OEICs and unit trusts is exempt from stamp duty.

Total costs and regulatory pressure on costs

On average, for an active fund you pay a 0.25% platform fee, 0.75% TER and 0.40% transaction costs. That is 1.40% in total. It means an active fund needs to generate a return of 1.40% just to perform in line with a passive index. This does not include switching fees, one-off charges and a performance fee.

And it used to be even worse.

The Retail Distribution Review (RDR) is a set of UK rules aimed at introducing more transparency and fairness to the investment industry. The most significant change is that financial advisers are no longer permitted to earn trail commissions and rebates from fund companies in return for selling or recommending their investment products. Instead, customers now have to agree fees with advisers upfront.

Some of these commissions used to be implicit costs, meaning they were not disclosed to customers. Post RDR, platform and adviser’s fees are explicit and must be disclosed.¹² Ask for a full breakdown of all charges when buying funds – everything including everything.

New regulations put a charge cap on default funds in DC schemes.¹³ Such regulations, the intense competition in the fund management industry and the scrutiny on costs continue to put downward pressure on charges. This is good news, as long as it does not compromise quality.

Take advantage of these developments; shop around, comparing platforms before opening ISAs and pensions. If you have a large portfolio, you can negotiate your fees. Save precious money.

Share classes

Funds typically come with a number of share classes. Different classes have different features, such as fees, currency and distribution of income.

Check fund factsheets for fees of each share class. Pay close attention to front load, back load and TER/OCF.

Two typical types of share classes are accumulation (Acc), where income is reinvested without a reinvesting charge, and income (Inc), where income is paid to shareholders. Choose Acc, unless you need income from your portfolio (such as after retirement).

Different share classes can be denominated in different currencies, where currency risk is not mitigated, or hedged to a currency (called hedged or currency-hedged) where currency risk is mitigated.¹⁴ When buying a fund investing in overseas assets, pay attention to whether the share class is hedged or unhedged.

Summary

• Investment vehicles are the actual investment products or funds that you buy in your portfolio.
• Understand what charges and costs include and exclude and try to avoid a pension and ISA platform charging entry and exit fees on funds.

Notes

¹ The fund’s assets or pool of investments are known as the scheme property.

² Counterparty risk is another risk of ETFs when synthetic replication uses OTC derivatives.

³ Shorting ETFs is not always easy since you need to borrow them to short them. Going short is much easier using futures contracts.

⁴ With-profits funds are a type of CIS offered by insurance companies. Whilst they were popular in the past, they fell out of favour due to poor performance, exit penalties and opaque charges.

⁵ Each regulated fund produces a prospectus that needs to be filed with the regulator. The prospectus contains information about the fund and is normally available online.

⁶ All regulated funds in states in the European Economic Area disclose ongoing charges, which include the Fund Management Fee (FMF). FMF covers investment management, accounting, valuation and management costs; trustee/depositary fees and expenses; audit, custodian, regulator and registrar fees; and payments to legal and professional advisers.

⁷ TER is calculated by dividing the total costs by the NAV. TER = Total fund costs ÷ NAV.

⁸ Simple average of funds in the UK All Companies sector of the Investment Association (IA). The precise averages are 0.39% for active funds and 0.09% for trackers. IA publishes papers on fund management charges, investment costs and performance. Check www.theinvestmentassociation.org.

⁹ 0.20% = 20% × 1%.

¹⁰ 3.8% = 6% − 2% ongoing charge − 0.20% performance fee.

¹¹ In contract law and economics, information asymmetry is when one party has more or better information than the other. This creates an imbalance of power in transactions.

¹² Bundled share classes include in their price fund manager rebates, supporting platform cost and adviser’s commission. Unbundled or clean share classes are designed to have a more transparent pricing. Their AMC is lower since they do not include platform cost and adviser’s commission.

¹³ The government introduced a cap on member charges of 0.75% on default funds available in DC pension schemes to comply with the automatic enrolment legislation.

¹⁴ Institutional share classes are labelled as I. They have larger minimums and lower fees compared to retail classes and they are designed for large investors. Retail share classes are labelled as R. They have lower minimums and higher fees than I shares.