Your choice of share class could affect your overall return.
Most open-ended investment companies (OEICs) and unit trusts are available in both income and accumulation share classes. The main difference between them is the treatment of income, but there are other less obvious factors that you need to recognise.
Each fund receives income throughout the year on its underlying holdings, be it dividends from shares, coupons from bonds or rent from property. If you invest in the accumulation shares your part of this income will be automatically reinvested and this will be reflected in the value of your holding.
Those who prefer the income shares will have their part of the income paid out over the course of each 12 month reporting period. Some funds only distribute it once or twice a year, whereas others pay quarterly or monthly.
An OEIC domiciled in the UK is required by law to distribute all of the income that accrues over the year. Many of them will smooth these payments so that investors receive roughly equal amounts with the balance swept up in the final distribution.
The price is right
Most OEICs and unit trusts have daily pricing, often at midday, based on the value of their underlying holdings at that point. The cut-off time for placing a deal with AJ Bell Youinvest depends on the fund but is normally 11am.
OEICs and unit trusts that are single priced will value the portfolio of assets using the latest mid-market prices available at the valuation point, whereas those that are dual priced (have a bid-offer spread) will use the last bid and offer market prices.
Subscriptions and redemptions placed prior to the dealing cut-off would be valued using a forward price.
For example, a fund might have a 12pm valuation and dealing cut-off time. If a subscription was placed before 12pm today, the deal would be valued using the published price released later this afternoon. The subscription would then be processed and included within tomorrow’s fund valuation.
One drawback to this process is that you don’t know the price that you will have to pay for the fund.
The longer the time lag between the time at which you place your order and the valuation the more scope there is for it to be affected by market volatility, but this shouldn’t normally be a major issue for long-term investors.
It is a very different situation for investment companies including investment trusts. These closed-ended funds are traded on the stock exchange like normal company shares and can be bought and sold at any time the market is open for business. Their share prices fluctuate according to investor sentiment and can trade at a premium or discount to the underlying net asset value (NAV), which is not the case with an OEIC or unit trust.
UK domiciled investment companies can transfer up to 15% of their annual income to their revenue reserves. This allows them to hold back some of the money so that they can smooth the dividend payments to help produce a steady or increasing stream of income for their shareholders.
Under the bonnet
Some countries deduct withholding taxes on dividend and coupon payments made by companies resident in those jurisdictions and where this is the case it will reduce the income received by a UK-based fund that holds those assets in its portfolio.
All the dividend income received by a UK OEIC is exempt from tax in the hands of the fund and the same is true of coupon income provided that the fund continuously holds 60% or more of its total assets in qualifying debt securities. This income, net of any costs, will roll up within the fund until the point of the next distribution.
The income that accrues to the accumulation share class is added to its capital value. On the date of the next income distribution the price of that share class will remain the same, all other things being equal, whereas the price of the income shares will drop as the income is stripped out of its net asset value for distribution to the shareholders.
This will affect the relative performance of the income and accumulation units in the same way that it does if you reinvest the dividends from your shareholdings.
For example, let’s say the accumulation units of a fund were valued at 117.73 pence. At the same point the income units were worth 111.08 pence and had paid out total dividends of 6.424 pence. This means that the accumulation units had marginally outperformed, although this will not always be the case.
The performance of the income and accumulation units will differ because of the compounding effect of reinvesting the income. If the fund steadily appreciates the profit on the reinvested income will mean that the growth of the accumulation units will outweigh the total return from the distribution units (growth plus distributed income).
The implications for investors
If you want to draw an income from your portfolio it would make sense to invest in income units as this would enable you to take out the natural yield of your holdings. Those who prefer capital growth can either reinvest the distributions manually or buy the accumulation units. The latter is the more cost efficient route.
When a fund is held in a tax-efficient account like an ISA or SIPP there would be no income tax or capital gains tax (CGT) issues to worry about, but outside of these shelters you need to be aware of the implications of your choice of units.
Income rolled up into your accumulation units is known as a “notional distribution” and is taxable in exactly the same way as the distributions from income units. Any dividends that are automatically reinvested can be used against your £2,000 dividend income tax-free allowance, which means that if total dividends received/reinvested surpass this you may have additional tax to pay.
The other point to consider is that any income that is automatically reinvested into a fund is not liable for capital gain tax (CGT). This means the holders of accumulation units would have to keep a record of all the notional distributions so that they can adjust the calculation when they sell their holding in order to work out their capital gain. There is an annual CGT allowance of £12,300 before any tax would be due.
These articles are for information purposes only and are not a personal recommendation or advice.