Tax efficient OEICs carry currency risk

About three years ago most of the UK unit trusts promoted in New Zealand changed into OEICs and were promoted as tax efficient investment vehicles.

FundSource takes a look at the pros and cons of this type of investment.

Q: What are OEICs?

A: OEIC (pronounced oik) stands for open-ended investment company. They have operated out of the UK since 1997 and have been promoted to New Zealanders since late 1999. OEICs fall under the New Zealand Securities Commission exemptions (of late 1999) and consequentially most UK unit trusts offered in New Zealand (NZ) switched to this legal structure, as it was less complex and less costly. The exemption means that OEICs do not need to have an investment statement or prospectus in NZ as long as other conditions are met, including the presentation of a 'Key Features" document to individuals prior to investing. OEICs have an authorised corporate director (equivalent to the unit trust manager) and an independent depositary instead of an independent trustee.

Q: How does investing into OEICs work?

A: OEICs fall somewhere between unit trusts and investment trusts. Investors' money is pooled and invested across a diverse range of products including shares, bonds and cash. Unlike unit trusts however, OEICs are limited liability companies and investors hold shares rather than units. Because OEICs are open-ended this means they can issue and cancel shares depending on applications and redemptions and, with the shares fully backed by net assets, the share price reflects the true appreciation and depreciation of the underlying assets. This is in contrast to investment trusts (which are closed-ended) that have a predetermined number of shares on issue. For an investor to sell their shares there must be a buyer, leading to the share price to be influenced by market sentiment (supply and demand).

Q: Why would I invest into an OEIC?

A: One of the advantages of OEICs is that they act as 'umbrella funds' and can create 'sub-funds' without seeking individual authorisation for each (as a unit trust must). This reduces the administration costs of the fund and investors can switch between sub funds more easily. Sub funds range from emerging markets to technology, Latin American and bond funds. Investors can own shares in one OEIC and gain exposure to different asset classes and sectors by their choice of sub funds. From an investor's point of view OEICs can be simpler as they receive one report outlining the entire investment instead of one for every individual fund.

The single report presented to an investor not only summarises the individual's entire investment, but it also reports all fees and charges separately, making them easier to identify. This is also true for the pricing of OEICs as they single-price rather than dual-price like unit trusts. The application price for a unit in a unit trust is usually higher than the redemption price due to the costs of buying and selling the underlying assets. Having one price removes the 'price differential' or 'spread' (difference between the entry and exit prices) and the entry fee is reported as a separate commission.

Q: What is the nature of OEICs?

A: Many of the UK OEICs promoted in NZ tend to be growth oriented and therefore have few dividends to reduce the tax paid on the investment. The dividends that they do receive are taxed at the UK company rate of 20 per cent and automatically reinvested. The growth focus is an advantage because capital gains are generally tax-free to NZ tax residents and thus can reduce their tax liability. In addition, because the UK falls under foreign investment fund (FIF) 'grey list' exemption investors on a 33 per cent or 39 per cent marginal tax rate are not liable for the extra tax on the reinvested dividends above 20 per cent.

Q: Who offers OEICs in New Zealand?

A: The fund managers in New Zealand offering OEICs include ING NZ, Royal & SunAlliance (R&SA) and Challenger NZ. ING NZ and Challenger NZ have formed alliances with Edinburgh Investment Company and Global Asset Management (GAM) respectively to manage their product offerings, whereas the OEICs promoted by Royal & SunAlliance NZ are managed by Royal & SunAlliance Investments in the UK. The sub funds available across the three managers range from the single Australasian fund from Challenger, to the 20 sub funds offered by R&SA. ING falls in the middle with 12 sub funds on offer, tending to exclude the lower risk, lower return products, such as a bond sub fund.

Q: What are the risks?

A: As OEICs are funds managed from the UK and domiciled in pounds sterling, investing into them exposes an individual to currency risk, specifically the volatility of the cross rate between the NZ dollar and the pound. Although the NZ fund manager promoting the funds usually handles the currency conversion on application and redemption, the movement of the exchange rate over the period an individual is invested can affect the return to the NZ investor. A number of factors, including the exchange rate, can cause the value of an investor's portfolio to fall as well as rise, and different sub funds have varying levels of volatility. When the investor chooses to redeem their shares they may be worth less than what they paid for them, especially if they have invested for a short time. In addition, changes to legislation can adversely affect an investment and because of this, investors should not invest into any fund based on the tax breaks alone.

Summary…

OEICs operate slightly differently to a unit trust and it is important that investors understand what they are investing into and the resulting implications. This article is designed as an overview only and individuals should consult their financial planner for advice before investing. OEICs are a tax efficient investment vehicle for many New Zealanders but this alone is not a good reason to invest. Legislation is constantly changing and evolving and investors need to be sure that they would want to be invested in the product if the tax break was not there.

- FundSource