Spreading the risk to maximise your investment

Putting your eggs in different baskets is the principle behind the collective investments known as unit trusts and investment trusts. But which to choose? Simon Read introduces a special report

Investing in shares is a risky business, but it's a safer bet putting your cash in a number of different companies' shares, rather than just one. This is the principle behind the collective investments known as unit trusts and investment trusts. By pooling funds from many investors these funds have large sums which can easily be spread among different shares, so that if one share drops in price, the overall value of the fund remains pretty solid.

But despite their ostensible similarity, there's a world of difference between unit trusts and investment trusts. To decide which to invest in you need to understand how both trusts work.

Unit trusts are by far the more popular of the two: more than pounds 109bn is invested in them, according to the Association of Unit Trust and Investment Funds (AUTIF). A unit trust is a fund split into equal units which can be bought and sold. The price fluctuates, as it is directly linked to the value of the fund; if the fund is performing well, the unit price will be high, and vice versa.

To simplify comparisons, unit trusts are divided into 22 different categories and these in turn are grouped into four main sectors, of which the main one is UK funds. This sector includes six categories of trust, known as balanced, equity income, general, gilt and fixed interest, growth, and smaller companies. Each of these categories has different objectives, investment strategies and levels of risk.

There are more than 1,600 unit trusts to choose from, so novice investors are faced with a huge range of funds and, often, very little guidance. Ultimately the decision-making process depends on individual investment criteria and attitude to risk. Getting information about the fund manager and the trust's objectives can help give a clear idea whether an individual trust is in sympathy with your investment needs.

At the lower end of the risk spectrum there are fixed interest trusts and balanced trusts, which hold a mixture of fixed interest investments and shares.

If you have some capital - for example, from an inheritance - and want it to provide you with an income, there is a large number of income-producing trusts, but bear in mind that taking income from a unit trust can reduce the value of the capital.

A growth fund, on the other hand, would be the best bet for those seeking to increase their capital. It pays out little or no income, because it reinvests the money it makes. In this way, when you come to sell your units in a few years' time they should be worth a lot more than you paid for them.

There are even investment trust unit trusts. These are unit trusts which invest in an investment trust - a company in which anyone can buy and sell shares. The cash raised from the sale of shares is effectively used to invest in other companies. There are 335 investment trust companies in the UK with pounds 45bn worth of assets, according to the Association of Investment Trust Companies (AITC) .

There is a range of investment trust companies, from broad international trusts, to small specialist trusts, currently grouped in 24 different sectors.

The criteria for choosing which investment trust is similar to that for unit trusts. However, unlike unit trusts, investment trust shares are not directly linked to performance. As with any shares, supply and demand can have a major influence on the price - as can the general sentiment of the stock market. If the investment trust is performing well, that will obviously be reflected in the popularity of its shares.

In simple terms, just buying investment trust shares could help the price, as the supply of shares will have reduced, therefore pushing up the price as long as the demand remains.

But that's the major difference between the two types of trusts. If a unit trust manager performs well, the value of units will rise, so investors get the full benefits of choosing the right trust. Investment trusts may be more of a lottery, as market sentiment can be fickle.

But both types of trust offer small investors access to the kind of professional investment management they would not be able to afford individually. Be aware of the fund manager's charges - detailed in brochures and other marketing literature - since they can have a major effect on returns.

You can offset the costs and at the same time protect your trusts from the tax man by holding them in a Personal Equity Plan (PEP). This is a package which can hold shares or unit trust units worth up to pounds 6,000 free of income and capital gains tax.

However not all trusts are "PEPable". If you want to hold the maximum pounds 6,000 in a unit or investment trust, it must be invested in what are known as qualifying trusts.

To qualify, trusts must hold at least 50 per cent of their portfolios in UK or EU shares. If you choose non-qualifying trusts you will be allowed to hold only up to pounds 1,500 within a PEP. Even non-qualifying trusts have restrictions: 50 per cent of their assets must be invested on stock exchanges recognised by the Inland Revenue, which rules out some of the more exotic investment opportunities n