10 things you need to know about investment trusts
For many years now, investment trusts have been portrayed by a lot of investment professionals as the eccentric cousins of the big happy family that includes unit trusts and open-ended investment companies (OEICs).
They can be highly entertaining company at a family do - but you never quite know when they're going to overdo the sherry and pass out in their soup.
But are investment trusts really so unpredictable and complicated, as we've been led to believe?
Here we examine some of the main ways in which they differ from unit trusts, consider the real reasons why advisers are so reluctant to recommend them, and ask whether in fact you should welcome them into your portfolio.
1 SIZE AND PERFORMANCE
The investment trust industry is much smaller than its more mainstream open-ended rival. According to fund research group Morningstar, there are almost 2,100 UK-domiciled unit trusts and OEICs aimed at the retail market, compared with around 300 UK-domiciled investment trusts (excluding venture capital trusts).
Yet investment trusts tend to outperform significantly over the long term. Independent financial advisory group Collins Stewart found that over the past 10 years, investment trusts have done better than unit trusts in eight out of the nine biggest sectors, in terms of share prices.
For example, if you had bought a global growth investment trust 10 years ago, on average the share price would have risen by 93%, compared with a rise in the average global growth unit trust price of 24%.
2 WHAT ARE THEY?
There are many similarities between investment trusts and their more popular cousins, unit trusts. Both are collective investments where investors' money is pooled and used to buy a portfolio of stocks or shares, which is professionally managed on their behalf.
There might be anything from 30 to 100-plus holdings - more than most investors could afford if they bought the shares individually.
A broader range of holdings obviously means there would be less damage to the overall portfolio if trouble should hit any individual company.
3 WILL INVESTMENT TRUSTS SUIT ME?
Trusts are long-term investments, so they won't be right for anyone wanting either to access their cash in the next few years or to make a quick buck.
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), so they're not ideal for those of a particularly nervous disposition either.
But remember, if you're invested for the long term, it's not worth worrying too much about short-term swings.
However, trusts are a good bet if you want a big, steady, internationally diversified fund at the heart of your portfolio - perfect for regular monthly investments. The global growth sector includes such leviathans as Witan, Foreign & Colonial investment trust, RIT Capital Partners and Scottish Mortgage.
Many of the global and UK funds are also good for income-seekers.
Finally, the closed-end structure is particularly suitable for more specialist funds holding assets that cannot be easily or swiftly bought and sold (such as property or start-up companies). This is because managers don't have to sell in order to release money back to investors when markets dip.
There's a wide choice of specialist funds too.
4 HOW THEY WORK
Unit trusts are simple: they are structured as open-ended funds, so investors' money goes into the fund manager's investment cash. As more people invest, the fund gets bigger and more units are created; conversely, as people pull out, it shrinks.
The value of your units will move up and down according to how well the underlying holdings are doing, so if investors get nervous and there's a run on the fund, the manager will have to sell holdings to free up enough cash to return to investors.
That can mean he's selling when prices are falling and no one wants to buy.
Investment trusts work differently. They're actually companies listed on the London Stock Exchange, and like any other listed company they issue a fixed number of shares (hence 'closed-end'), which are then traded on the open market.
As a consequence, there are two 'layers' of activity. At the trust level, the manager issues a fixed number of shares and raises a set amount to invest.
But the shares themselves are then resold and bought on the stockmarket. The share price goes up and down according to investor demand and supply, but the fund manager's investment plans are not affected.
5 DISCOUNTS AND PREMIUMS
Because of these two layers, these 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, 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 less than the NAV per share, this is known as a 'discount', because you're buying the trust's assets at less than their actual value. 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 it narrows, your holding gains in value even if there's no movement in the underlying NAV.
Say you buy a trust trading at a 10% discount to NAV; you invest £1,000 but the discount means the underlying holdings are worth £1,111. Over the next six months, the share price rises and the discount narrows to 5%. Even if there's no movement in the underlying asset values, your shares will rise in value from £1,000 to £1,055.
Even if the discount remains the same, you won't lose out.
If the NAV doubles from £1,111 to £2,222, but the discount holds fast at 10%, your shares will double in price to £2,000.
Of course there's a risk that the discount will widen, although over time they tend to stabilise and many trust managers also control them artificially through share buybacks.
In addition, it's generally not a good idea to buy a trust on a premium, because the discount is likely to widen.
6 WHAT IS GEARING?
Investment trusts are companies, so they're allowed to gear, or borrow, to invest. This can improve their performance, but it also means they tend to be more volatile than their open-ended peers.
The effect of gearing in a rising market is to magnify the gains for each shareholder; but if the market falls, investors in a geared trust will suffer greater losses per share.
Many trusts are ungeared or only very modestly geared - the global growth sector average potential gearing is 8% - although some specialist investments such as private equity trusts have much higher potential gearing of around 40%.
7 FEES AND CHARGES
Another important reason why investment trusts tend to outperform unit trusts and OEICs is that their charges are lower.
According to data from Lipper, the average total expense ratio (TER), including performance fees, for an investment trust in the global sectors is 1.14%, compared with 1.66% for global unit trust sectors.
For UK sectors, the TER is 1.29%, compared with the equivalent unit trust TER of 1.63%. These may appear to be small savings, but they can add up to significant sums over time.
The big difference - as far as charges are concerned - is that investment trusts don't have to pay any commission to financial advisers, which will typically save around 0.5% a year in trail payouts.
Alan Brierley, head of investment companies research at Collins Stewart and author of the Collins Stewart report, says this is also why unit trusts have grown so much more dramatically than investment trusts over the past 10 years.
"While it's impossible to quantify the impact [on open-ended fund sales] of the commission paid to so-called 'independent' advisers, it's fair to say superior net asset value performance has certainly not been the key driver," he says.
But what about the purchasing costs? The good news is there's no front-end fee involved with trusts if you make a lump-sum payment, but you'll have to pay the broker's dealing charges.
A cheap alternative is to go for one of the regular saving schemes that many trusts run.
8 BOARD OF
Like other listed companies, investment trusts are overseen by an independent board of directors. Its job is to ensure the trust is managed in the interests of the shareholders.
In most cases, the directors will appoint an external fund management team to run the trust on a day-to-day basis, and if it doesn't do a good enough job, it risks being sacked and replaced with another.
By contrast, unit trust fund managers are answerable to the parent company and its shareholders, rather than the investors in their funds. There's no independent overseer breathing down their necks, looking after investors' best interests.
9 DIVIDEND PAYOUTS
Income-paying investment trusts have a particular attraction for investors who want a regular cash flow, because - unlike unit trusts - they don't have to distribute all the income generated by their assets every year.
They can hold back up to 15%, which means they can build up a reserve that can be used to bolster dividend payouts in leaner years.
10 JARGON BUSTER
Gearing: Investment trusts can 'gear' or borrow money to invest. This can magnify the return, but makes the trust riskier, as each share gives more exposure to the market.
Net asset value (NAV): The net worth of an investment trust's equity capital, usually expressed in pence per share.
Closed-end funds: An investment vehicle, such as an investment trust, with a fixed capital structure. Variation in demand for shares is shown through movements in the share price rather than in the supply of shares.
Open-ended funds: Investment funds, such as unit trusts and OEICs, where the number of units in issue varies daily, according to demand.
Discount: If the share price of an investment trust is lower than the NAV per share, the trust trades at a discount, shown as a percentage of NAV.
Premium: If the share price is higher than the NAV per share, it trades at a premium.
Usually charged as a percentage of returns for performance above a specified benchmark, such as an index. The fee can range from 10% to 20% of total investment returns on a low starting benchmark such as Libor and investors could find themselves paying extra fees for merely average performance. Note that these funds do not compensate investors when the manager underperforms the benchmark.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
Net asset value
A company’s net asset value (NAV) is the total value of its assets minus the total value of its liabilities. NAV is most closely associated with investment trusts and is useful for valuing shares in investment trust companies where the value of the company comes from the assets it holds rather than the profit stream generated by the business. Frequently, the NAV is divided by the number of shares in issue to give the net asset value per share.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
Investors who borrow money they use for investment and use the securities they buy as collateral for the loan are said to be “gearing up” the portfolio (in the US, gearing is referred to as “leveraging”) and widely used by investment trusts. The greater the gearing as a proportion of the overall portfolio, the greater the potential for profit or loss. If markets rise in value, the investor can pay back the loan and retain the profit but if markets fall, the investor may not be able to cover the borrowing and interest costs, and will make a loss. Also used to describe the ratio of a company’s borrowing in relation to its market capitalisation and the gearing ratio measures the extent to which a company is funded by debt. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).