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> What are OEICs?
> The different types of OEICs
> How OEICs are Priced
> OEIC Charges
> How OEICs are Taxed
What are OEICs?
OEICs are collective investment vehicles, similar to unit trusts but structured as companies rather than trusts. OEICs came into being in the UK in 1997 with the Open-Ended Investment Companies (Investment Companies with Variable Capital) Regulations and the Financial Services (Open-Ended Companies) Regulations.
The main advantage of OEICs for fund managers is that they comply with the European Union's "Undertaking for Collective Investments in Transferable Securities" (UCITS) which allows regulated funds investing in "transferable securities" (i.e. securities that are traded on an open market) to be sold across national borders in the EU.
A number of UK fund managers have since converted their unit trust funds into OEICS in order to market them within the European Union.
Corporate structure of OEICs
The OEIC is structured and conducts itself like an investment company (rather than a trust), with the ability to issue different classes of "shares" (rather than units).
The OEIC is governed by its "Instrument of Incorporation" rather than by a trust deed. The Instrument of Incorporation and the scheme particulars are published in the prospectus.
An OEIC may be structured as a single fund or as an umbrella company for several sub-funds.
A board of directors or an Authorised Corporate Director (ACD) performs the same function as the unit trust manager and deals with the day to day running of the fund, including investment, share pricing and compliance with FSA regulations.
A depositary performs the same role for the OEIC as the trustee for the unit trust. The depositary can be an independent person or a financial institution such as a clearing bank whose role is to protect the interests of shareholders and to act as the custodian of the fund's assets.
"Shares"Each "share" represents an equal fraction of the assets of the OEIC fund. OEIC shares are not tradable on the stock exchange but are bought from and sold back to the managers.
As its title suggests, the managers can create or cancel shares. The managers may also issue different kinds of shares to cater for diverse investors, with different charging structures or denominated in different currencies.
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The different types of OEICs
Growth fundsMost growth funds fall into the higher-risk category and are likely to pay small dividends. Where a fund exhibits similar volatility to the index, it is said to have "market risk".
Income fundsCorporate bond and gilt funds can generate decent levels of income although capital growth is likely to be low and the funds are vulnerable to changes in interest rates. Some high yielding corporate bond funds contain debt instruments of lower quality and higher risk.
Growth and income fundsEquity funds provide a source of growing income which often outperforms fixed deposits over the long term, although it will start out lower.
The growth on balanced funds can be used to enhance income through simultaneous capital withdrawals, which can bring the total of income and capital up to a desired level. This can work very well over the longer term provided that the rate of capital withdrawal is not too high.
Active v passive fund managementActive fund management attempts to outperform a market index through stock picking. Passive fund managers create tracker portfolios that copy the content of a chosen market index (e.g. FTSE100, FTSE250, FTSE All Share) and their weightings in the index.
Supporters of passive fund management argue that most actively managed funds under-perform the market and that out-performing funds cannot be identified in advance.
Active fund managers argue that index tracker funds overpay for new entrants to the index and sell departing shares to cheaply. This is because new entrants to the index are bought only after the shares have risen in price while shares in departing companies are sold after their prices have fallen.
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How OEICs are priced
The pricing of OEIC shares is based on Net Asset Value (NAV), usually applied on a forward rather than on an historic basis (i.e. at the next valuation point rather than at the last valuation point).
The single OEIC share price represents NAV per share but is not the price actually paid or received by the investor:
The initial charge and the dilution levy (if applicable) must be added to reach the total price paid by the buyer.
Shares are sold back to the managers at NAV per share less the dilution levy and any exit charges.
Pricing of OEICS v unit trustsIn reality the OEIC pricing system is not very different from that for unit trusts. Despite the so-called "single pricing", a de facto "spread" exists when the initial charge and dilution levy are included. The practice of charging a dilution levy is similar to widening the spread on unit trusts to cover dealing costs.
It is arguable that OEIC pricing is more transparent and fairer than unit trust pricing because the initial charge and the dilution levy are both explicit and fall upon those who are creating expenses for the fund.
For fund management groups, the OEIC may hold advantages:
The single-priced OEIC is internationally marketable, whereas the dual-priced unit trust is unfamiliar to non-UK investors
The fund managers can issue different classes of shares for retail and institutional investors with different combinations of annual and initial charges.
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OEICS are characterised by a system of single-pricing. Buyers and sellers who transact at the same point in time do so at the same price. There are no bid and offer prices as with unit trusts.
Most of the charges are "explicit" which means that they are not incorporated in the single price but are added separately and itemised explicitly on the contract note.
Charging systemThere are three kinds of charges:
The initial charge to cover expenses and commissions. The initial charge is not contained in the price but shown as an explicit cost on the contract note.
exit charge: Some providers replace the initial charge with a sliding scale of exit charges over a number of years.
The dilution levy: When the fund managers have to enter the market to buy or sell securities, they can charge those investors who have caused the fund to incur dealing costs.
If there is heavy net buying of the OEIC shares by investors, then the managers may have to enter the markets to buy securities for the fund. In doing so they will incur dealing costs. Conversely, if there is heavy net selling of the OEIC shares by investors, the fund managers may have to sell securities to pay out investors and the fund will incur dealing costs.
The fund managers have the choice of charging these dealing costs to the fund (and ergo to existing shareholders who have nothing to do with these costs) or charging them to the actual buyers or sellers whose actions have created these costs.
The dilution levy is paid to the fund. The managers do not profit in any way. The levy is not reflected in the quoted price of the OEIC shares, but is displayed as a separate, explicit charge on the investor's contract note.
Annual management charge: OEICs normally levy an annual management charge to cover operating costs and renewal commissions to financial advisers. The annual management charge is not explicit.
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How OEICs are taxed
OEIC investors are liable for income tax on dividend and interest distributions, and for Capital Gains Tax on realised gains, as with unit trusts.
Taxation of equity income distributionsAn income distribution from an equity fund is called a dividend. A distribution from a gilt or corporate bond fund is known as a coupon.
Income is normally distributed on set dates in the year, usually 6 months apart. However, where the distribution is normally very small (e.g. on growth funds) it may be paid in one instalment. Other funds (e.g. specialist funds) may not make distributions at all.
The OEICs receive dividends from their underlying investments net of corporation tax. Investors receive the net dividend together with a tax credit of 10%. An £80 dividend corresponds to a gross dividend of £88.89 from which £8.89 (i.e.10%) has been deducted.
Non-taxpayers have no further liability to income tax but cannot reclaim the tax credit.
Lower rate taxpayers (10%) and basic rate taxpayers have no further income tax to pay.
Higher rate taxpayers are taxed at 32.5% of the grossed up dividend. In our example, higher rate taxpayers are liable for a further £20 (on top of the £8.89 already paid) leaving £60 net.
Taxation of non-equity income distributionsDistributions from non-equity funds are taxed as interest and taxed at 20% tax at source:
Non-taxpayers can reclaim the full 20% tax.
Lower rate taxpayers (10%) can claim back 10%.
Basic rate taxpayers have no further income tax liability.
Higher rate taxpayers must pay an additional 20%.
Equalisation paymentInvestors are entitled to dividends payable on holdings acquired before an ex-dividend (xd) cut-off date. Shares acquired after the xd date (which falls two months before the actual distribution date) do not qualify for the next distribution.
If an investor buys shares before the xd date (i.e. 'cum dividend'), then the offer price will reflect monies accumulated within the fund to pay the next distribution. When the shares go xd, the share price usually falls to reflect the impending cash outflow from the fund.
Investors who have acquired shares cum dividend will usually receive an equalisation payment with their first distribution, which is treated as return of capital and is not taxable.
Capital gains taxOEICs are not themselves liable for Capital Gains Tax on their internal realised gains. Investors are personally potentially liable for CGT on gains realised on disposal of their shares. A fund switch is treated as a disposal for CGT purposes.
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