New Star: Explanation of unit trust pricing

To understand what is going on with regards to the switch of pricing of many of the dual priced unit trust property funds, below is a quick refresher on how unit prices are set.
Switching from offer to bid and visa versa has been common practice since the first unit trust was launched in 1931 (M&G). Like equity and bond funds, property funds can switch pricing too – there is nothing uncommon about this.

“As Trustee of New Star Property Unit Trust we confirm that New Star's action in changing to pricing on a bid basis is normal practice within dual priced AUTs and OEICs, at times when redemptions exceed sales, and it is not caused by a lack of liquidity.” Royal Bank of Scotland

New Star has experienced short-term modest redemptions in the New Star Property Unit Trust and, as a result, has switched to a bid price basis over the past week.

At its simplest, any dual price unit trust fund can be valued on one of two bases:

Offer Valuation, which takes account of the costs of buying the underlying investments. An offer valuation is used when the fund is expanding and the cash inflow has to be invested.

Bid Valuation, which takes account of the costs of selling the underlying investments. A bid valuation is used when the fund is contracting. For unit trusts the term cancellation price is often used as an alternative way of describing the price derived from a bid valuation.

For equity and bond funds, the difference between a bid and offer valuation is usually quite small – under 2% – unless the underlying assets are relatively illiquid and themselves are subject to wide buy/sell spread, eg some small company shares.

For UK property funds, the spread between bid and offer valuations is around 5.8%, with 4% accounted for by stamp duty land tax (SDLT) which is payable on purchase of the properties. The balance is made up of agents’ fees, legal and survey costs. This gap has existed ever since stamp duty went up to 4% in March 2000. It has largely been unseen because investor demand has meant few property funds have moved to a bid valuation in recent years.

On Tuesday 10 July, the two oldest and largest unit trusts, New Star Property Unit Trust and Norwich Union Property Trust, announced that they were moving to a bid valuation, cutting prices by 4.1% and 4.7% respectively. The falls are smaller than some other funds because the unit trusts have less exposure to direct property investment: each has about 15% in property shares and New Star also holds a similar amount in cash.

The liquidity position of these two trusts underlines the fact that their move to a bid valuation is NOT a liquidity issue – in theory both trusts could meet substantial redemptions without selling a single property. For unit trusts, it is important to understand that, the trustees will only allow units to be liquidated at their cancellation price. If we have to cancel units when the fund is contracting we can not pay out more than we receive from the trustee. The fact that the fund can meet the redemptions from its liquidity is irrelevant.

“We expect this to be a short-term issue and we will move the fund to an offer basis when we see a trend of net inflows. Much has been written about this but the simple reality is that investors are only affected if they sell when the fund is on a bid basis. The fundamental long-term outlook for property is sound.”