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.
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.
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.
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.
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.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
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.
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.
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.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
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.