Unit trusts vs investment trusts: who's the cheapest fund of all?

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Star managers often run almost identical 'mirror' funds with lower fees. But does this make them a more attractive option?

Can you get a star fund manager to run your money for a third of his or her normal fee? It's perfectly possible, although many financial advisers may not point out that you have this option.

Many big-name fund managers run smaller investment trusts alongside their larger, more popular funds. Typically the two funds will invest in a similar portfolio of shares, but the annual management charges on the investment trust can be far lower.

Take Neil Woodford, one of Britain's best-known and most successful fund managers. He runs the £8bn Invesco Perpetual Income fund, one of the bestselling funds in the country. Like most unit trusts it has a 1.5pc annual management fee, plus a 5pc initial charge, although investors can avoid this if they buy through a discount broker.

Less well known is the fact that Mr Woodford also runs the Edinburgh investment trust, which has a similar mandate. Here there is no initial charge, just an annual management fee of 0.6pc. The dividend yield on the investment trust is also higher, standing at 4.9pc at present, compared with just 4pc on the unit trust.

This is not a one-off example. Investors in Templeton's Emerging Markets offshore unit trust, run by the veteran manager Mark Mobius, pay a 1.6pc annual charge. But owners of Templeton's Emerging Markets investment trust, run by the same Mark Mobius and with an almost identical mandate, pay just a 1pc charge a year.

There is also the standard 1.5pc annual management charge on Investec (EUREX: INVF.EX - news) 's UK Special Situations fund, run by Alastair Mundy, but just a 0.35pc annual charge on the Temple Bar investment trust he runs. Other successful fund managers, including Harry Nimmo, who runs Standard Life (Other OTC: SLFPF.PK - news) 's UK Smaller Companies fund, and Evy Hambro, who runs BlackRock (NYSE: BLK - news) 's World Mining fund, run "mirror" investment trusts with far lower charges.

Assuming that the two portfolios deliver a similar performance, these lower fees can have a significant impact on returns over longer periods.

Jason Hollands, the managing director of Bestinvest, the advisory firm, said: "In the past five years those holding Harry Nimmo's unit trust have seen a £100 investment grow to £139. But those who invested £100 in his investment trust five years ago are sitting on shares worth £207."

The Invesco Perpetual Income unit trust has turned £100 into £116 over five years, while the "mirror" investment trust is now worth £139; Jupiter European's unit trust has turned £100 into £141 today, but its equivalent investment trust is worth £164.

Philippa Gee, who runs her own wealth management firm, said charges were higher on unit trusts because the annual management charge (AMC (Taiwan OTC: 3585.TWO - news) ) included commission and advice costs. But as this is bundled up within the product charges, investors will pay this in full even if they have bought the fund direct.

In contrast, investment trusts do not pay commission to advisers to sell their products. This perhaps explains why the charges are lower and why these products are not so widely sold. Ms Gee said: "For too long investment trusts have been completely avoided by certain types of adviser because they did not generate a commission remuneration for them."

She (SNP: ^SHEY - news) said new rules due to come into force in January "should drive an army tank through this biased approach". These rules will ban commission payments on investments and pensions, and require independent advisers to consider all type of investment, including investment trusts.

Of course, although "mirror" unit and investment trusts may invest your money in similar portfolios, they are fundamentally different. The main difference is that an investment trust issues a fixed number of shares, which are listed on the stock market in the same way as any other listed company. In contrast, a unit trust is "open-ended" and will simply cancel or create "units" in response to investor demand.

This can have a significant effect on pricing. The price you pay to buy or sell a holding in a unit trust will depend solely on the current value of the assets under management. However, demand for the limited number of investment trust shares can force prices up, so shares can trade at a premium to the underlying value of the assets. Of course, the reverse is also true, and shares can sell at a significant discount to the actual value of the assets in the trust.

This can make investment trusts riskier than unit trusts. For example, Standard Life's Smaller Companies trust, managed by Mr Nimmo, is currently trading at a 5.7pc premium. In other words, you are paying almost £1.06 for every £1 of assets held by the fund. However, Templeton's Emerging Markets trust stands at a 7pc discount, so you have to hand over only 93p to buy £1 of assets. This may look like a bargain, but don't forget that discounts can widen, as well as narrow, just as premiums can fall. When Anthony Bolton managed Fidelity's Special Situations investment trust it traded at a 14pc premium; today, after the loss of this star manager, it trades at a 10pc discount.

This isn't the only additional risk factor. Unlike unit trusts, investment trusts can borrow money to buy additional assets. This "gearing" can boost returns in a rising market, but can also magnify losses.

Such structural differences mean that investment strategy may vary, even if the mandates of the funds are the same. For example, a unit trust may hold a greater proportion of its assets in cash or highly liquid securities so that it can redeem investors' money when needed. This can lead to performance differences, which may or may not favour investment trusts, depending on market conditions.

However, Annabel Brodie-Smith of the Association of Investment Companies, the investment trust trade body, said: "Having a 'closed-ended' structure allows [investment trust] managers to take a long-term view without having to worry about inflows and outflows of money, giving them greater investment flexibility."

Damien Fahy of FundExpert.co.uk said: "While the headline AMCs may be attractive, don't forget that investors will still encounter other charges, such as dealing charges and bid-to-offer spreads. Some also charge performance fees."

Many advisers pointed out that when the new rules came into force next year, investment trusts might not retain their price advantage. Once fund managers are banned from bundling commission charges into their product fees, the AMC on a unit trust is expected to be between 0.75 and 1pc a year. Investors will pay additional fees, though, if they receive advice or buy through one of the "platforms" that many execution-only brokers operate. But those buying investment trusts through stockbrokers or advisers may face similar charges.

Juliet Schooling of Chelsea Financial Services said: "It isn't just annual fees that investors need to look at, it's the total cost of buying, selling and owning the fund." Performance can be as important as charges, she pointed out. The Fidelity Special Value investment trust has significantly lower charges, but the equivalent unit trust has performed better over both three and five years.

Mark Dampier of Hargreaves Lansdown said: "Investment trusts are niche products for more sophisticated investors who are comfortable with the discounts and premiums. But if everyone who bought Neil Woodford's fund piled into the investment trust, the premium would be so large that there would be no advantage."