Investment trusts: The natural choice for specialist investors
Investment trusts are popular choices among investors looking to expand their portfolios into more 'niche' areas of investment or asset classes through a collective fund.
The Association of Investment Companies' (AIC) classification of trusts by sector features a very mixed bag of 'sector specialists', including environmental, biotechnology, forestry, infrastructure, private equity and property trusts, as well as a clutch of single-country and frontier-market funds.
Specialist funds of various descriptions are readily available as open-ended investments (which include unit trusts and open-ended investment companies) too, of course. However, it's a widely held view that closed-end arrangements work better for these types of investment. But why is this?
Access to liquidity
The key issue is liquidity - basically how easy it is for fund managers to buy and sell the assets they're investing in. The size of open-ended funds fluctuates all the time, according to how much demand there is from prospective investors.
Managers therefore either have to hold cash in reserve against a run on the fund by investors, or else be sure they'll be able to sell some of their holdings without difficulty if the worst happens.
By contrast, investment trusts are closed-end listed companies with a fixed number of shares issued, and those shares then change hands on the stockmarket, independently of the trust. That means when shareholders are rushing to sell and the share price nosedives, there's no effect on the day-to-day running of the trust.
Property trusts directly invested in bricks and mortar; private equity trusts invested in small unlisted businesses; infrastructure trusts holding stakes in assets ranging from railways to schools; and forestry trusts, where the cycle for producing timber amounts to decades - all are examples of asset classes that aren't easy or quick to buy or to dispose of.
Such assets only work as investments on a long timeframe. The trust structure enables managers to take the necessary long-term view on such investments in a way that could be quite difficult for unit trust managers.
Other sectors may also benefit from a longer timescale, says Dennis Hall, managing director of Yellowtail Financial Planning. "Esoteric or specialist investment areas, such as biotechnology, often need incubation time. Trusts are better suited for this type of investment, because the manager isn't forced to buy or sell assets throughout the life of the trust."
Single-country and other high-risk regional funds are another area where the structure of investment trusts works to their advantage, says James Brown, investment trust analyst at Winterflood Securities.
In these cases, it's not the illiquid nature of the holdings so much as the risk that markets may be crippled by political or economic upheaval. "The last thing you want as a manager is to have to sell shares when everyone else is also running for the door," he explains.
One interesting example is the BlackRock Frontiers trust, which launched last December. The trust invests in companies worth more than $50 million across a spectrum of 'frontier economy' countries, including Nigeria, Saudia Arabia, Qatar, Iraq, Ukraine and Kazakhstan.
There's plenty of potential for tremendous growth as these countries' economies gain momentum, but there are also very real risks of political upheaval or economic turbulence.
Brown says: "The manager of the trust, Sam Veitch, believes there are great opportunities in these areas, but only a closed-end structure is suitable for investing in them, because the markets can be so volatile."
Even in more mainstream sectors, such as global emerging markets or Asia, where a number of management companies run both unit trust/OEIC and investment trust versions of the same fund, the latter's closed-end structure tends to work in its favour.
"Invariably, fund managers say they prefer to run the investment trust version, because there's no need to worry about liquidity. It means they can choose smaller, less liquid but more interesting and potentially rewarding holdings," Brown says.
In addition, investment trusts are able to use gearing (invest borrowed money) to enhance returns. Take JP Morgan Emerging Markets, which is sold both as a unit trust and as an investment trust.
The investment trust net asset value (NAV) - the value of the underlying portfolio of shares - has performed better over one, three and five years than the unit trust; over five years the investment trust is 8% ahead, and the gap widens over longer timeframes.
So which are the specialist areas financial advisers are most inclined to use investment trusts in? Hall uses HgCapital and RAB Capital for exposure to private equity. He also likes trusts for infrastructure.
Meanwhile, Anna Sofat, managing director of Addidi Wealth Management, uses trusts mainly for specialist exposure rather than as a core portfolio holding. Among her choices are Polar Capital Technology and Ecofin Water & Power, as well as HgCapital for private equity.
She argues that the kind of investors who want such specialist portfolios are likely to be comfortable with any potential volatility. Also, she says, there's not necessarily a comparable mainstream unit trust available in some of these niche areas - for example, private equity.
"You get a different style of management in these investment trusts," Sofat adds. "Managers can have a wider choice of holdings, as liquidity is not an issue, and as a consequence they tend to create more bespoke, unique portfolios."
Specialist trust pitfalls
Although trusts are in many ways well suited for 'niche' investments, they come with various warnings attached: if you're not comfortable with the risks involved, steer clear.
Even if you're comfortable with them, they should only be used as small parts of a broad, balanced portfolio. So what do you need to consider?
• Focused funds invested in smaller, riskier companies or less well-known markets are more volatile than mainstream funds. You need to be able to stomach the inevitable ups and downs.
• They must also be long-term investments. If you need to get out at a time of poor performance, you may have to sell at a very low share price - probably much lower than the NAV of the portfolio itself.
• Conversely, if you're keen to get into a sought-after area with little choice of trusts, you risk buying on a premium to the NAV. And from there the usual way is down, as demand drops off again and the share price discount to NAV returns. So you have to be wary.
• Gearing is another risk factor. "If we get a perfect storm - high interest rates, falling markets and so on - gearing will push a trust's discount even wider," warns Dennis Hall, managing director of Yellowtail Financial Planning.
That's what happened to many seriously over-borrowed direct property trusts around 2008, when the UK property market collapsed.
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.
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.
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.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
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.