Ins and outs of unit trust funds:

Unit trust funds are the investment of choice for thousands of South Africans. In the first of a threepart series on collective investment schemes, Martin Hesse explains what unit trusts are, how they are regulated, and the cost and tax implications for y

UNIT trust funds are a popular way of investing, and it is likely that you have money in one or more of them, either directly or indirectly through an investment such as a retirement annuity (RA) fund or tax-free savings account.

So popular are they, that about 1 500 locally managed unit trust funds are available to South African investors – more than the number of shares listed on the JSE – and about R2 trillion is invested in them, according to the Association for Savings & Investment SA.

But do you know how unit trusts work, how they are governed, whether they are safe, and what you pay to invest in them?

LEGAL STRUCTURE

Unit trust funds are collective investment schemes and are governed by the Collective Investment Schemes Control Act.

When you invest, your money is pooled in a trust with that of the other investors. The trust has a trustee and is subject to a trust deed that sets out, among other things, the investment criteria for the fund.

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.

The trustee (a separate institution, usually a bank) has a fiduciary duty to the trust to protect its assets and can act against mismanagement by the management company. 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 Services Board (FSB), and they are subject to ongoing monitoring by the FSB.

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.

All 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. The price at which you buy a unit is the same as the price at which you sell it.

Funds are “open-ended”, which means 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 equities. In the third article in this series, Personal Finance will look at the different categories of collective investment schemes and their associated levels of investment risk.

INCOME

There are two main sources of income for unit trust funds: interest from interest-bearing investments, such as money-market instruments and bonds, and dividends from shares. This income is factored into the NAV. Periodically (typically twice a year), income is distributed to investors, and when this happens the unit price drops slightly and the price becomes what is known as “ex div”.

If you are investing for the long term, you are likely to be reinvesting your distributions, which the fund manager does on your behalf by buying units to the value of the distribution at the “ex div” price (the lower price will buy you more units). On the other hand, these distributions will be paid out to you if you depend on your investment for an income.

TAXES

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

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

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

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

Note that these taxes don’t apply to unit trusts held in a tax-free savings account and underlying unit trust investments in an RA.

COSTS

You can incur initial fees and annual fees on unit trust investments.

• Initial fees, which comprise an adviser’s fee of up to 3.42% (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 the financial adviser and does not apply if you invest with the asset manager directly.

martin.hesse@inl.co.za NEXT WEEK: EXCHANGE TRADED FUNDS