Investment trusts usually outperform funds over the long term, but what are they and how do they differ from funds? We delve into the detail.
Investment trusts, savings vehicles that have been around since the Victorian era, like funds (open-ended investment companies) are a type of pooled investment that invest in a 'basket' of underlying assets such as equities, bonds or property, but unlike funds are listed on the London Stock Exchange.
Essentially, there are two 'layers' of activity: the performance of the underlying investments held in the investment trust and its share price.
The shares are then traded on the stock market. The share price goes up and down according to investor demand and supply, but the fund manager's investment plans are not affected.
There are other structural differences that set investment trusts apart from funds, which investors can use to their advantage. We outline each below in detail.
Why are funds more popular than investment trusts?
But before we delve into the technical details, the first thing to explain is why funds have historically been more popular than investment trusts. Figures from the Investment Association (the trade body for funds) shows total fund assets under management is in the trillions of pounds, while total assets under management for investment trusts stands at just under £200 billion.
One key reason is the way funds used to be sold by financial advisers, prior to a rule change that was enforced in 2013. Under the old rules financial advisers pocketed commission payments from the fund management company when they bought investment funds for their clients. In contrast, investment trusts did not pay commission, so were therefore less popular among advisers.
The rule change in 2013, under the Retail Distribution Review, levelled the playing field by abolishing commission payments for fund sales. As a result, investment trusts have experienced a rise in demand among advisers, with figures showing purchases by advisers reached a record £985 million in 2018, almost five times what they were in 2012.
There are other factors at play as to why investment trusts are less popular, including the fact that the investment trust universe is smaller than funds. There are only around 400 investment trusts versus over 3,000 funds.
A third key reason is the perception that investment trusts are more complex and difficult to understand, so as a result financial advisers and DIY investors stick to funds, which are more straightforward to get to grips with.
But for many seasoned investors and regular readers of Money Observer, investment trusts have formed the bedrock of their portfolios for decades. A key reason why this is the case is because the various structural elements of investment trusts can work to the advantage of long-term investors.
Structural advantages explained: Fixed pool of assets
As mentioned above, there are two 'layers' of activity. A fixed number of shares is issued, raising a fixed amount of money for the manager to invest in a portfolio of assets.
Those shares are traded on stock exchange and their price fluctuates according to demand and supply. But the fund manager does not have to sell or buy shares depending on whether they are attracting or losing investors. This allows the fund manager to take more of a long-term view in running the portfolio.
In contrast, problems arise for open-ended funds when there’s a dramatic increase either in inflows of cash (which then has to be invested) or in investors wanting to take money out of the fund. Under the latter scenario, in order to raise the cash to give investors their money back the fund manager has have to sell investments held in the fund. This can create a vicious circle and can create a ‘firesale’ scenario whereby investments are being sold at knockdown prices.
Having a fixed pool of assets (one that won’t fluctuate with investor demand) is particularly suitable for specialist trusts holding assets that cannot be easily or swiftly bought and sold, such as property, private equity or very small companies. This is because managers don't have to sell their holdings to release money back to investors looking to liquidate their investments when markets dip; instead investors sell their shares on the stock market and the share price takes the strain.
Discounts and premiums
The two layers of pricing mean trusts have two values: the amount the trust itself is worth (the net asset value or NAV), and its share price.
If the trust is popular (perhaps because the wider industry or geographical sector in which it invests is attracting a lot of interest), the share price will be boosted by extra demand, but this doesn't necessarily mean the underlying NAV has changed.
When the share price is lower than the NAV per share, the trust trades at a 'discount'. When the share price rises above NAV, it is trading at a 'premium', as you're paying more than the assets are worth.
If you buy at a discount and that discount then reduces or narrows (due to increased shareholder demand, say), your holding could gain in value, even if there's no movement in the underlying NAV.
Conversely, the discount could widen, so your shares lose more value than the underlying assets do. Many trusts therefore control discounts artificially through share buybacks.
It's generally not a good idea to buy a trust on a high premium, of say 5% or higher, because it tends not to be sustainable over the long term and can turn into a discount when conditions change. Although it is worth pointing out that certain income investment trusts typically trade on high premiums in excess of 10%, such as infrastructure trusts, due to their inflation-linked income streams.
What is gearing?
Investment trusts are allowed to gear, or borrow to invest. This can improve their performance, but it means they tend to be more volatile than their open-ended peers. Gearing in a rising market magnifies gains for each shareholder; but if the market falls, investors in a geared trust will suffer greater losses per share.
Simply put, if the manager borrows X to invest and the trust grows, the manager has to repay X plus interest but retains the investment growth as part of the trust's NAV. So if you have £1,000 invested (let's assume a constant share price for now) and the manager gears by 10%, then there is effectively £1,100 working for you.
Now, if that doubles in value to £2,200, the manager pays back the £100 plus, let's say, 1% interest. That leaves you - the investor - with £2,099. If the manager had not geared, you'd only have £2,000.
Conversely, if the same investment halves in value to £550, the manager still has to pay back £101. This magnifies the losses, leaving you with only £449 instead of the £500 you'd have without gearing.
Board of directors
An investment trust typically has an independent board of directors overseeing it and ensuring it is managed according to shareholders' interests. In most cases, the directors will appoint an external fund manager to run the trust. If the manager doesn't do a good job, the board can fire and replace them.
Income-paying investment trusts have a particular attraction for investors who want a regular cash flow, because they don't have to distribute all the income generated by their assets every year.
Investment trusts can hold back up to 15% each year, which means they can build up a ‘rainy day’ reserve to bolster dividend payouts in leaner years. In contrast, open-ended funds have to return all of the income generated each year back to investors.
During the global financial crisis the majority of UK equity income investment trusts were able to either maintain or increase their dividends, as they dipped into their reserves; the vast majority of UK equity income open-ended funds cut their dividends.
At the time of writing, in early May 2020, the ‘rainy day’ reserves will be tested again, as a dividend drought has emerged following moves by various companies to cut or cancel dividends in response to the coronavirus pandemic.
While no one can pre-empt the decisions that will be made by investment trust boards as to whether to cut, maintain or increase their dividend payments, the good news is that UK equity income trusts are in a healthy position to continue to satisfy income-hungry shareholders.
Analysis by the investment companies team at Investec Securities (at the end of March) found that all 17 UK equity income investment trusts that it analysed (although there are 24 in the sector as a whole) would be able to endure a 30% fall in dividend income from their underlying holdings over the next year, and still pay a progressive dividend (it modelled a 3% rise). The 30% figure was used because this is the dividend decline that is being priced in by the futures market.
Will investment trusts suit me?
Investment trust performance can involve rather more ups and downs than the unit trust equivalent (because of gearing and the effect of movements in the discount). But if you're invested for the long term, it's not worth worrying too much about short-term swings.
Big, steady, internationally diversified trusts, for instance - of which there are many examples in the global sector - can form an ideal portfolio core.
Many global and UK trusts are also ideal for income-seekers, because of their ability to smooth dividend payouts over the years.
. This beginner guide was updated on 5 May 2020. However, in the constantly shifting environment of investment and financial services, occasions may arise where elements of a guide become out-of-date. Please double-check the facts before taking any important financial decisions.