The six step guide to investment trusts

What is an investment trust?

An investment trust is a company with a fixed share capital listed on a stock exchange. It is also known as a closed-end fund or investment company. Investors buy shares in an investment trust like they would in Tesco or BT.

There are more than 400 investment companies in the UK, covering a wide range of sectors and asset classes, such as equities, private equity and property. Some are highly focused on sectors, such as Japanese smaller companies, healthcare and timber.

How are they different from funds?

Trusts differ from funds in several respects. Investment trusts have an independent board of directors directly answerable to shareholders. Day-to-day activity is controlled by a fund manager, who is monitored by the board and can be removed if the trust fails to perform well.

The venerable Edinburgh Investment Trust, for example, moved from Edinburgh Fund Managers/Aberdeen Asset Management to Fidelity and then to Neil Woodford at Invesco Perpetual.

Trusts are often cheaper to run than funds, and can trade at a discount or premium to net asset value. Also, managers can employ gearing and keep dividends back in lean years. More on that later.

How much do they cost?

Trusts are usually cheaper than funds. Research by broker Winterflood Securities showed that over 10 years, the average total expense ratio (TER) for investment trusts was lower than funds in the following sectors: global growth, UK equity income, UK smaller companies, Europe ex-UK, North America, Asia Pacific ex-Japan and global emerging markets.

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What are discounts and premiums?

The value of the underlying investments held by a trust is called its net asset value. The difference between the stock market value of the investments and the NAV is known as the discount or premium.

Investment trust shares tend to trade at a discount. This may be because of market sentiment towards a particular type of investment or market the trust invests in, or past performance under a particular manager or board.

Investors can pick up cheaper shares when trusts are trading on a discount, but the discount needs to be narrower (or smaller) when they sell the shares to make a profit if assets don't grow. The average discount is around 10% at the moment.

Trusts in more established or income-focused sectors are on tighter discounts. Some sectors, such as emerging markets, may see trusts trading at a premium, as with Fidelity China Special Situations.
Premiums reflect sustained and ongoing demand for a company's shares. However, when a premium gets too large, it can act as a deterrent, and potential investors may look for a cheaper investment in the same sector.

Read: Our experts' investment trust picks for 2011

What is gearing and how does it work?

Investment trusts can borrow money to invest - a process known as gearing. This allows them to buy an attractive shares and boost performance without having to sell existing investments to pay for it.

By achieving a high return from its investments, a trust can pay off the loan and make a profit on top. If a company successfully gears up and markets rise, the returns will outstrip the cost of borrowing.

However, if markets fall and the performance of the assets in the portfolio is poor, the losses suffered by trust investors are magnified by the cost of borrowing.

What is a dividend reserve?

Each year, investment trusts can hold up to 15% of dividends in reserve. This bank allows a trust to pay future dividends irrespective of economic conditions, something that is particularly attractive to income seekers. Several trusts have increased their annual dividends for 30 years or more.