Plan for the long term with investment trusts

You may have invested in an ISA or other funds before, but the chances are you've never heard of investment trusts. This may be because there are relatively few available in the UK compared with their better-known and more widely hyped relations, unit trusts and open-ended investment companies.

But if you ignore investment trusts, you could be missing out on a great opportunity.
What are investment trusts and how do they work?
An investment trust is basically a company listed on the stock exchange, which buys and sells shares in other companies rather than specific products or services. As the trust holds shares in many different companies, your investment is much more diversified than if you invested in individual shares. This means your portfolio won't be as adversely affected if a specific company does badly.

Different investment trusts have different focuses – they are categorised into more than 50 sectors by the Association of Investment Companies (AIC). So there's generally something for every type of investor; you can choose a fund to match your attitude to risk and the type of market you would like to invest in.

Some trusts, for example, focus on a specific industrial sector such as healthcare, infrastructure or technology, or a particular region or country, while others concentrate on sniffing out undervalued companies.

How do they differ from unit trusts?
Investment trusts differ from unit trusts in a number of ways. Firstly, they are 'closed-ended'. This means they issue a set number of shares, so there's always a fixed number in circulation among investors at any one time. This set-up can be useful – it means the fund manager can plan ahead because the amount of money available for them to invest is fixed from the start.

They are also priced in a different way from unit trusts and OEICs. If you take the value of all the assets held by an investment trust, minus its liabilities, and divide it by the number of shares in that company, you get the net asset value, or NAV, per share. But as the share price of the trust is governed by its popularity, this is often different from its NAV per share.
This means that supply and demand affects the share price regardless of what's happening to the value of its underlying investments – for example, when a trust is popular, shares are snapped up by eager buyers and the price is pushed up. If that happens, shares trade at a premium, basically at a higher value than the underlying assets.
Conversely, when a trust is unloved, the price will fall as sellers offload their shares. The shares will then trade at a discount.

When to invest

Although a trust may trade at a discount, this doesn't necessarily mean it's a bad place to put your money. In fact, in a bull market, the discount is one of the big attractions of investment trusts – if you buy when the market is moving upwards and the discount is narrowing as the trust gains in popularity, you stand to reap a double benefit.
For example, say you buy a share for 160p on a discount of 20%, then you are getting 200p worth of assets for your 160p investment. If the NAV per share goes up to 220p on the back of a strengthening market, demand for the trust may increase too, narrowing the discount.

If the discount narrows to 15%, your 160p share will now be worth 187p (110 - (110 x 0.15)). You've made a total gain of 27p for a market move of 20p.

As a wide discount can be offputting for existing and potential shareholders – especially if it's getting wider – a growing number of trusts 'manage' their discounts to keep them at an attractive level.

How does gearing work?

Another important feature, which helps improve the performance of investment trusts in a bull market, is their ability to 'gear' or borrow money to buy more shares. This allows fund managers to take immediate advantage of good opportunities. The idea is that they will then make a high enough return on the investments to repay the cost of the loan and still be able to make a profit.

The more a trust borrows, the higher the potential returns, as successful gearing produces greater returns per share. Of course, the downside is that when things go wrong, you have to bear losses on both the core trust investments and those funded by borrowing – even before you factor in the cost of the loans.

What are split investment trusts?
Some types of trusts also have the capacity to offer different types of shares within them. These are known as split capital investment trusts, and they offer different rights and levels of risk, depending on which type you own.

Annabel Brodie-Smith, AIC spokesperson, explains: "Split capital investment companies issue different classes of shares with specific rights and entitlements to the income and/or capital returns of the portfolio, allowing different investors to receive either solely income or solely capital growth, or a combination of the two."

However, different types of shares have very different levels of risk attached.

What do investment trusts cost?
A further benefit of investment trusts compared with unit trusts is the dealing costs and cheaper administration. Whereas you'll pay up to 5.5% of your investment in initial charges on a unit trust or OEIC, the costs of buying or selling an investment trust is the dealing charge, which may be as low as £10 with online brokers such as Interactive Investor and the stamp duty of 0.5% for buying shares.

On top of the charges for buying and selling shares, you will have to pay an annual management fee and ongoing administration costs, but these also tend to be lower than with unit trusts.

The combination of discounts, lower costs and gearing means that when the markets are picking up, you are likely to do rather better than investors in comparable unit trusts and OEICs.
Simon Elliott, head of research at Wins Research, says: "Trusts have historically been popular as 'recovery plays', with investors prepared to buy when the market is low."

But investment trusts are more complex than unit trusts or OIECs, so make sure you do your research or get professional advice from a stockbroker or financial adviser.

Investment trusts versus unit trusts

Investment Trusts

• Investment trusts are essentially companies listed on the stock exchange which buy and sell shares in other companies.
• Investment trusts are close-ended which means there is a fixed number of shares in circulation at all times.
• Investment trusts can make use of gearing, which means they can borrow money to buy more shares.
• The price of the investment trust reflects investor demand, so if a trust is popular its price is pushed up.
• If a share is trading at less than the value of its underlying assets, it's said to be on a discount. If it trades above its value, it's on a premium.

Unit Trusts

• Unit trusts, like investment trusts, are pooled investments, actively managed by a fund management team.
• Unlike investment trusts, managers can't borrow capital.
• Investors buy or sell issued units, rather than shares, directly through the fund manager. If demand for units goes up, the manager simply issues more units.
• The price of a unit in a unit trust reflects the underlying value of the shares at the time.
• Initial charges on a unit trust could be up to 5.5%.