What is a unit trust?
A unit trust is a shared investment fund that combines your money with other investors', then invests the total pot to try and give you the best return it can.
Each fund is divided into units, which represent a stake in the fund's total value. These units are created to reflect new investment in the fund and cancelled if you sell your units held in the trust. Consequently the total number of units that make up a unit trust fluctuates with demand.
A professional fund manager is responsible for choosing where to invest the unit trust's resources, with the aim of growing the fund's value while balancing its risk to investors' money. As a result the investment choices made by a fund manager tend to have a big impact on unit trust performance.
The best unit trusts are often seen as a relatively low-risk investment because they are professionally managed, but also because your money is pooled with other investors'.
This pooled investment structure enables a unit trust to spread risk across a large number of investments, this minimises risk to your money if one or more underlying investments doesn't perform as well as expected.
How do unit trusts work?
When you invest in a unit trust your money buys a number of units that represent your portion of the trust's overall value. The number of units you're able to purchase will be determined by the current unit trust fund prices.
Your money is then deposited into the trust's collective fund along with other investors' money, and used to buy assets in the markets or industries that the trust focuses its investment on - these are summarised by its 'investment objectives'.
If the investments perform well, the income earned through trading will grow the overall value of the fund, meaning your individual units rise in value too.
However, you can sometimes choose to receive your unit trust returns as direct payments. These are called 'distributions' and are paid to you based on how many units you hold. Distributions are essentially your 'portion' of the unit trust's dividend income received from certain types of shares and investments.
What do unit trusts invest in?
All unit trusts have an investment objective that dictates the types of investment unit trusts managers make, as well as the markets they invest in.
The type of investment can be split broadly into debt securities (government or corporate bonds), and equity securities (stocks and shares).
The market a unit trust invests in can also be defined by geography, by industry (for example, all construction companies) or by other specific criteria such as start-up or environmentally friendly companies only.
How are unit trusts prices set?
Although there are no restrictions on when you can buy or sell units, the latest unit trust prices are always fixed so that the cost to buy units is higher than the sell price at all times.
These prices, the 'offer' price and 'bid' price respectively, are based on the current value of each fund. As such, unit trust daily prices rise or fall based on the fund's growth, with the best performing unit trusts usually 'offering' higher prices.
The difference between unit trusts prices is used to cover the administration fees of issuing new units and is referred to as the 'spread'.
In practice, this means that you need to wait until the unit trust share prices climb higher than your initial outlay, before you could potentially sell your units for a profit (known as capital growth).
What is the risk?
As with all investments, even the top unit trusts share a certain amount of risk and you could end up losing your entire initial investment.
While unit trusts try to limit this risk by employing professional fund managers to balance their investments and by spreading the risk among a large number of investments, you should always check each fund's risk profile before investing.
Each unit trust will outline its investment strategy and the level of risk it will take in a bid to grow the value of its fund.
Remember, unit trusts can outperform even the best savings accounts over a substantial period of time, and if you treat them as a medium to long term investment you could see impressive growth from your money.
Plus, you can also make your returns tax efficient by investing up to £15,000 in a unit trust via an Investment ISA from July 1st 2014.