Malcolm Wheatley looks at a commonly asked question -- should you buy income or accumulation units when purchasing an investment fund?
A question that regularly crops up on the Fool's Index Tracker and Unit Trust discussion boards is "Should I buy Income units (whatever they are), or should I buy Accumulation units?"
It's a good question. For over ten years -- as regular readers will know -- The Motley Fool has been a big fan of index trackers. Yet when one goes to actually buy an index tracker, whether for a SIPP, ISA or as a direct purchase, the Income versus Accumulation issue is often a stumbling block, serving to confuse and -- worse -- deter potential investors.
Two flavours of funds
Put simply, index trackers and funds are often sold in two 'flavours'. In other words, one can buy the Income flavour, or the Accumulation flavour. The name of the index tracker or trust will otherwise be identical (as will the underlying shares and assets held within it), but some units will be classed as 'Income', and some as 'Accumulation'.
Legal & General's best-selling UK Index tracker, for instance, is just such a fund. At the time of writing, the Income units are 79.34 pence, while Accumulation units are 105.9 pence.
So what's the difference? And which should you buy? The answer boils down to the treatments of the dividends paid out by the underlying shares held within the tracker.
Where do the dividends go?
Hang on, I hear some of you say "Dividends? I thought trackers didn't pay dividends!" Not so. In fact, there's something of a misconception around index trackers and dividends, with many people assuming that index trackers' sole source of growth as an investment is through capital gain.
In fact, just as the shares which go to make up an index pay dividends, so do index trackers themselves -- totalling up the dividends that they have received, and dividing them up the investors in the tracker in proportion to their holding.
While the dividend yield on a broadly diversified index such as the FTSE All-Share isn't massive -- in normal times around 3% or so but now around 5% -- it's from those dividends that the index tracker's management fees are deducted, with the balance being paid to you, the investor. This is one reason why the Fool has always argued in favour of low-cost trackers: the lower the management fee, the more of those lovely dividends get passed to you, their rightful owner.
Which takes us back to Income and Accumulation units.
With Income units, those dividends are paid out -- directly to you. Once or twice a year, the tracker manager will declare a distribution (indeed, Income units are sometimes called 'Distribution' units), and your share of the dividends that the tracker manager has received is credited to your brokerage or ISA account, or arrives as a cheque on the doorstep.
With Accumulation units, the dividends aren't paid out -- at least, not directly. Instead, they are used by the tracker manager to buy more shares, thus adding to the number of shares represented by each unit that you hold. Those units logically become more valuable than the Income units (because they are backed by more shares), and so their price goes up.
Either way, then, you receive the dividend. So does it matter if you buy Income or Accumulation units? After all, the end result is the same.
What's your favourite?
The answer depends on what you want to do with the dividends. If you're quite happy to reinvest the dividends in the same tracker, then that's exactly what Accumulation units deliver. On the other hand, if you want to reinvest the dividends elsewhere, then Income units are the way to go: the money will either be credited to your brokerage account, for shares or funds to bought within that, or mailed out as a cheque, or credited to your bank account. And of course, if you're relying on the dividends to live on, then Income units are most certainly the way to go.
Note that there is not a difference from a tax perspective, with the rise in value of Accumulation units being classed as a 'notional distribution', and taxed accordingly. And of course, for trackers and unit trusts held within an ISA or SIPP, the tax question doesn't apply at all.
Also the Income and Accumulation issue is only important if you're looking to buy a fund that is a unit trust or open ended investment company (OEIC). They are other types of funds, such as investment trusts and exchange traded funds (ETF), which don't have these two types of unit and just pay out dividends to all their shareholders.
As the Fool's Maynard Paton argued earlier this week, regularly buying a cheap index tracker through good times and bad is a solid way to build wealth. So if confusion over Income and Accumulation units has been holding you back, don't delay. While stock markets may or may not have bottomed out, one thing is certain: compared to 2007 values, today's tracker prices appear unbelievable bargains.
Malcolm Wheatley's delightful wife Mandy has Legal & General's UK Index tracker in both her ISA and SIPP.
