Investment trusts fight for their future
The Association of Investment Companies (AIC) and its members are fighting for their future. The threat is from the Alternative Investment Fund Managers Directive, which is working its way through the European Union institutions.
Intended to curb the power of hedge funds and private equity funds in its current unamended form, it will prevent investment trusts from issuing new shares or marketing existing shares to retail investors, limit gearing, undermine the authority of trust boards, and could even force trusts to redeem shares on request.
Such changes would be a blow to almost every trust, from the global growth giants such as Foreign & Colonial Investment Trust and Scottish Mortgage - which have offered investors low-cost, well diversified, long-term core portfolios for 100 years or more - to the newer smaller specialists such as BlackRock New Energy or Jupiter Green Investment Trust.
The average investment trust has served investors much better than similarly oriented open-ended investment companies (OEICs) over the past 30 years and more. It would be a big loss to investors if trusts were forced to adopt a similar business model to OEICs.
It would also be a blow to the nooks and crannies of the investment trust world, which offers individual investors opportunities that are not available through OEICs and are impractical as direct investments.
In some cases this is because trusts invest in assets that are too illiquid to be suitable for open-ended vehicles, where investor withdrawals can require the managers to make speedy sales.
In others, it is because they use the investment trust structure to slice and dice returns to suit shareholders with different needs.
Split capital investment trusts exemplify the latter approach. They have been widely reviled because of the difficulties that arose in the 2000-2003 bear market.
However, split capital trusts have been around in various formats for more than 30 years. Many have served investors well through difficult periods.
Warrants and subscription shares can also capitalise on a trust's corporate structure and can be very rewarding for those prepared to accept above-average risks.
Family-controlled trusts use the trust's closed-end structure in an entirely different way, and their bias towards generating positive (or absolute) returns means they are arguably less risky than most of their peers.
Asia-oriented income trusts exploit yet another aspect of the trust structure, namely the ability to smooth dividends by under-distributing dividends in good years so as to be able to draw on reserves in tougher times.
Asset classes that are better suited to trusts than funds range from the ultra-small, such as fledgling shares, to the ultra-long term, such as forestry. Private equity is a different story, as this asset class tends to exaggerate the ups and downs of the quoted equity market.
It will be a great loss to private investors if the EU directive ends up throwing the baby out with the bath water.
This article was originally published in Money Observer - Moneywise's sister publication - in January 2010
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).
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.
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.
This refers to a market situation in which the prices of securities are falling and widespread pessimism causes the negative sentiment to be self-perpetuating. As investors anticipate losses in a bear market and selling continues, pessimism grows. A bear market should not be confused with a correction, which is a short-term trend of less than two months. A bear market is the opposite of a bull market.
A sophisticated absolute return fund that seeks to make money for its investors regardless of how global markets are performing. To that end, they invest in shares, bonds, currencies and commodities using a raft of investment techniques such as gearing, short selling, derivatives, futures, options and interest rate swaps. Most are based “offshore” and are not regulated by the financial authorities. Although ordinary investors can gain exposure to hedge funds through certain types of investment funds, direct investment is for the wealthy as most funds require potential investors to have liquid assets greater than £150,000m.