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Tools of the Trade

Updated: May 16, 2022

In this post I set out a classification scheme for publicly available investment funds. It is hoped this can provide those readers who do not have a firm grasp of the fund landscape with the tools necessary for further enquiry.

"Active funds generally state the period over which they seek to beat their benchmark"

The approach of this piece is to present a list of features by which all publicly available funds can be classified. I have numbered each characteristic for ease of reference but there is no right or wrong order. It does however seek to flow as logically as possible, eg from fund structure-related to investment-related.

1. Availability. Funds in general are fully available, restricted to experienced investors, or private. The scheme presented here pertains to funds that are fully available to the public so does not cover alternatives such as hedge funds.

2. Open-/closed-ended. This is ultimately about whether a fund’s price closely tracks its net asset value (NAV), is loosely tethered to it or untethered. Open-ended funds such as open-ended investment companies (Oeics), unit trusts and exchange-traded funds (ETFs) are designed such that the price at which one buys or sells units is the same as or practically the same as the NAV. Investment trusts are closed- ended funds whose price can be higher or lower than NAV depending on market supply and demand. Some trusts have mechanisms that seek to keep the price closer to NAV than would otherwise be the case, ie loosely tethered.

3. Price denomination. If non-sterling, be aware of uncompetitive exchange rates you may incur upon on purchase and sale.

4. Listed? ETFs and investment trusts are listed on a stock exchange, other types are not.

5. NAV pricing frequency. Since ETFs are listed but also designed to track NAV, their NAVs are calculated continuously throughout market hours.

6. Single/dual pricing. Oeics have single pricing while with unit trusts there is a bid-offer spread. Listed funds tend also to have bid-offer spreads, sometimes wide ones.

7. Number of unit/share classes. Oeics and unit trusts can have multiple unit classes relating to management fees. An investment trust can have share classes with different voting rights.

8. Domicile/place of incorporation. A Luxembourg-domiciled (offshore) open-ended fund, for example, is known as a Sicav. Investment trusts are companies that can be incorporated outside the UK.

9. Regulatory structure. Onshore open-ended funds can have Ucits (an EU standard) or NURS (non-Ucits retail scheme) structures. NURS structures have more flexibility and therefore offer less investor protection.

10. Where listed? ETFs and investment trusts can be listed on the London Stock Exchange or on an overseas exchange such as the New York Stock Exchange.

11. Currency hedging. Funds can be fully or partially hedged, or unhedged with respect to foreign currency risk. Actively managed funds may vary the amount of hedging depending on forex views.

12. Leverage/derivatives. Funds may borrow or invest in derivatives up to a certain percentage of fund NAV to enhance returns or for other reasons such as ‘efficient portfolio management’.

13. Active/passive. A passive fund is one that seeks to track an index. An active fund seeks to beat an index, by employing a fund manager to make (active) decisions. All fund types (investment trusts, unit trusts, Oeics, ETFs) can be either active or passive. A smart beta fund is a type of passive fund that seeks to track a factor index (see below). Passive funds employ different tracking mechanisms, eg full index replication, proxy basket or derivative simulation.

14. Index/benchmark. Whether equity, bond or multi-asset, passive funds have an index (geographic, sector, theme, factor, composite, long-short) they seek to track. Similarly, active funds have a benchmark they aim to beat – or state they do not employ a benchmark. Benchmarks can be indices (as above), a peer group percentile, or an absolute benchmark such as 5% nominal or 6% real/inflation-adjusted.

15. Performance objective. Active funds generally state the period over which they seek to beat their benchmark, eg one or three years, or simply ‘over the longer term’.

16. Investment style. Active funds are either ‘quant’ or ‘fundamental’ depending on whether they look only at prices of investments (the so-called ‘technicals’) or also at, for example, the state of the balance sheets of companies (the so-called ‘fundamentals’).

17. Tracking error/volatility. Passive funds have zero tracking error, practically speaking. Active funds can either have high or low volatility in relation to their peers.

18. Liquidity of investments. Strictly closed-ended funds can own illiquid investments. Others do not or are strictly limited.

19. Listing of investments. While listing is often associated with liquidity, some listed investments are illiquid (micro-caps) while some unlisted ones are liquid (Oeics).

20. Disclosure. ETFs in general are required to disclose all their investments (names and percentage holdings). However, such a level of disclosure would be detrimental to active ETFs, particularly those that own illiquid investments, as other investors could ‘front run’. In such cases, only partial disclosure is required.

If you have any suggestions as to how this scheme can be improved, please let me know.

Published in What Investment

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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