Investment trusts usually outperform funds over the long term, but what are they and how do they differ from open-ended investment companies?
Investment trusts, savings vehicles that have been around since the Victorian era, are regarded as the City’s best-kept secret.
Statistically, over the long term, investment trusts tend to produce superior performance than their Oeic or unit trust (open ended investment companies) cousins. But they have historically been less popular and not as widely promoted by brokers.
However, in the aftermath of rules introduced by the Retail Distribution Review in 2013, financial advisers are warming to investment trusts.
Prior to the RDR, financial advisers pocketed commission payments when they bought investment funds for their clients. In contrast, investment trusts did not pay commission, so were therefore less popular among advisers.
The RDR levelled the playing field by abolishing commission. As a result investment trusts have experienced a rise in demand. Data from the Association of Investment Companies (AIC), which looked at sales of investment trusts via platforms, reported a 43 per cent increase in adviser purchases in 2015 versus 2014.
For many seasoned investors and regular readers of Money Observer, however, investment trusts have formed the bedrock of their portfolios for decades.
The investment trust industry is much smaller than its more mainstream open-ended rival. Money Observer tracks the performance of around 400 UK and overseas-domiciled trusts and investment companies, compared with around 2,300 investment funds.
HOW INVESTMENT TRUSTS WORK
Investment trusts, like unit trusts, invest in a 'basket' of underlying assets such as equities, bonds or property. But they are companies listed on the London Stock Exchange. Essentially, there are two 'layers' of activity. A fixed number of shares is issued (hence 'closed-ended'), raising a fixed amount of money for the manager to invest in a portfolio of assets.
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.
DISCOUNTS AND PREMIUMS
The two layers mean trusts have two values: how much 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, this is known as a 'discount'. When the share price rises above NAV, it's trading at a 'premium', as you're paying more than the assets are worth.
If you buy at a discount and that discount 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 holding loses 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 per cent or higher, because it tends not to be sustainable over the long term and can turn into a discount when conditions change.
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 per cent, 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 per cent 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.
Many trusts are ungeared or only modestly geared - the average gearing of the 35 trusts in the global sector was 6.5 per cent as at 1 June 2014 - but specialists such as private equity trusts may have gearing of about 40 per cent.
BOARD OF DIRECTORS
An investment trust typically has an independent board of directors overseeing it and ensuring it's 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.
By contrast, open-ended fund managers are answerable to the parent company, rather than investors. There's no independent overseer looking after investors' best interests.
Income-paying investment trusts have a particular attraction for investors who want a regular cash flow, because - unlike open-ended funds - they don't have to distribute all the income generated by their assets every year.
They can hold back up to 15 per cent each year, which means they can build up a reserve to bolster dividend payouts in leaner years. During the 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. In contrast the vast majority of UK equity income open-ended funds cut their dividends.
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 and are perfect for regular monthly investments.
Many global and UK trusts are also ideal for income-seekers, because of their ability to smooth dividend payouts over the years.
The closed-ended structure 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 in order to release money back to investors looking to liquidate their investments when markets dip.
We make every effort to ensure our beginner's guides are kept up-to-date. 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.