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 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, 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%.
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).
A hugely unpopular tax paid on property and share purchases. Stamp duty on property is levied at 1% for purchases over £125,000 (£250,000 for first-time buyers) which then moves up at a tiered rate. For property between £125k and £250k you pay 1%, then 3% from £250k up to £500k and then 4% from £500k to £1m and then 5% for properties over £1m. But unlike income tax, which is “tiered” and different rates kick in at different levels, stamp duty is a “slab” tax where you pay the rate on the whole purchase price of the property. On shares, stamp duty is charged at a flat rate of 0.5% on all share purchases. Figures correct as of May 2011.
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.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
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.
A bull market describes a market where the prevailing trend is upward moving or “bullish”. This is a prolonged period in which investment prices rise faster than their historical average. Bull markets are characterised by optimism, investor confidence and expectations that strong results will continue. Bull markets can happen as a result of an economic recovery, an economic boom, or investor irrationality. It is the opposite of a bear market.
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.