What's inside the tax-free wrapper?

The great bulk of money placed in PEPs is actually invested in new or existing unit or investment trusts which are assigned to a PEP "wrapper". So the most frequent choice a PEP investor needs to make is between a unit trust and and investment trust to invest in.

The fundamental difference between the two vehicles is that investment trusts are closed ended and unit trusts open ended. At the beginning of an investment trust's life, the manager will have a specific amount of money to invest and the value of the entire fund - which is listed on the Stock Exchange like any other share - will fluctuate with market sentiment.

If the market believes the future is bright, the trust may trade at a premium to the actual net asset value (NAV) of the fund's underlying investments. At other times it may trade at a discount - a frustrating quirk which can result in the value of the shares falling despite the fund manager having performed well.

Unit trusts, on the other hand, issue units to buyers rather than shares. The fund is not listed on the Stock Exchange and if there are more buyers than sellers then the fund manager will have to invest that additional money. Conversely, if investors are net sellers of the fund, the manager will have to liquidate some of the investments in order to pay them back. The size of the fund will therefore expand and contract and the price of the units is adjusted each day to reflect the net asset value of the underlying portfolio; investors know they are buying at "fair value" and for this reason many people feel more comfortable with unit trusts.

"Asking whether you should be in investment trusts or unit trusts is the wrong question," said Jason Hollands, director of PEP analysts, Best Investment. "The real question is: which sector should you be in and which is the best fund within that sector?"

Most investors plump for unit trusts, although this is partly as a result of strong marketing by unit trust managers. Inevitably, these costs will impact on the initial management fee - 5 per cent is typical - and investors may ask whether they wish to pay for this - particularly as most investment and unit trust managers have underperformed the FT-SE AllShare over the past five years.

A perception persists that investment trusts are the reserve of more sophisticated investors. They tend to be more specialist and to some extent more risky vehicles since there are virtually no restrictions on what shares or securities an investment trust portfolio can hold; unit trusts are obliged to hold a minimum of 90 per cent of their portfolio in securities listed on recognised stock exchanges.

A more important legal difference between the two vehicles is that, unlike unit trusts, investment trusts are permitted to "gear" - to borrow additional funds to purchase investments. Gearing, as the name suggests, has the effect of exaggerating the returns of the fund.

Independent financial adviser Chase de Vere has undertaken research which shows that, because of the gearing effect, investment trusts will, to varying degrees, outperform unit trusts in bull runs but will underperform when markets are depressed. However, since most markets tend over the long term to be bull markets (the FT-SE 100, for example, now stands at around double what it was 10 years ago, despite the devastating crash of September 1987), surely this would imply that investment trusts offer better value?

Investment trust performance statistics are always based on the mid- price. With offer-to-offer calculations, unit trusts' initial and annual management fees are ignored. On an offer-to-bid basis they are included and their performance suddenly looks far less impressive.

Most advisers favour investment trusts above unit trusts under two circumstances: when they are trading at what seems to be an unnecessarily high discount to NAV and when markets are volatile.

Investors tend to move in herds and will buy or sell particular stocks or sectors en masse. Although some of the fund can be kept in cash, in a volatile environment unit trust managers are forced to buy near the top of the market and sell near the bottom - a complete contradiction to investment theory which could adversely affect the overall performance of the fund.

A pepable hybrid offering the best of both vehicles would seem to be the answer and that answer should arrive this July in the form of Open Ended Investment Companies (Oeics - pronounced "oiks" to the industry's dismay).

Like unit trusts, Oeics will be valued according to the underlying assets but investors will be issued with shares rather than units.

Another important difference is that Oeics will have a single price for both buyers and sellers rather than a bid-offer spread, which should make the job of comparing competing funds considerably easier. Expect increasing piles of Oeic promotional literature to land on your doormat as summer approaches.

Association of Unit Trusts and Investment Funds (AUTIF)0171-831 0898

Association of Investment Trust Companies (AITC)

0171-588 5347