The world of investment trusts
The investment trust is considered an underdog in the investment world, often overlooked in favour of the sexier, more heavily marketed unit trust. Take a closer look at this investment vehicle, however, and you might be pleasantly surprised. But what is an investment trust?
"Investment trusts are a company like any other, with a fixed number of shares and a board of directors representing shareholders' interests," says Job Curtis, director of the value and income team at fund management firm Henderson Global Investors.
The difference, however, between an investment trust company and a normal company, like BT for example, is that an investment trust company makes its money by buying and selling shares and securities in other companies, rather than through selling a specific product or service.
An investment trust company issues shares in itself, which is what an investor buys. These shares are generally only issued when the investment trust is created, which means the total number of shares available stays constant. This is known as being 'closed ended'.
The Association of Investment Companies (AIC) says there were 316 investment trusts in existence in the UK at the end of July 2007, worth around £95 billion, and this figure has grown steadily in recent years.
So what are the characteristics that set investment trusts apart from other collective investments? One feature unique to investment trusts, compared with vehicles such as unit trusts, is the way they are priced. If you take all the available shareholder funds in an investment trust - the company's assets less its liabilities - and divide it by the total number of shares in that company, you get the net asset value or NAV per share.
Supply and demand
Because investment trust companies are quoted on the stock exchange, the price of shares is determined by the stockmarket according to supply and demand and may not equal the NAV per share. This means they can be sold at a discount or a premium from that value.
"With a unit trust or an open-ended investment company (OEIC), the price of the fund is the same as the value of the underlying investment," says Patrick Connolly, certified financial planner at independent financial adviser firm Towry Law.
"That is not the case with an investment trust. The price of an investment trust depends on the demand for or supply of the investment trust, just like any other share. It depends on how much people are willing to pay for it and sell it for, so the price of an investment trust can be more or less than the net asset value."
This adds an extra level of complexity, because when an investor sells shares in an investment trust, the difference between the price paid for the share and the value of the underlying asset can increase or decrease. But James Saunders Watson, head of sales and marketing for investment trusts at JP Morgan Asset Management, says this offers opportunities when buying investment trust shares.
"We quite like getting clothes at a factory outlet," he says, "because it's cheaper than buying them on Bond Street. Similarly, it's nice to be able to buy £1 worth of assets for 90p, and that's what the discount enables you to do."
Costs vary between investment trusts, but are generally considerably lower than similar collective investments. That is because the board of directors is separate from the fund manager, so it can work to keep running costs low. Also, investment trusts do not pay commission to financial advisers or spend money on extensive marketing.
A typical unit trust can include an initial charge of less than 3% and an annual management charge of up to 1.5%. The total expense ratio (TER) on an investment trust, however, is generally much lower. On the average global growth investment trust, for example, it is less than 1%. However, charges can vary, and investment trusts with performance fees can be more expensive.
Sherry-Ann Sweeting, marketing manager of the Scottish Investment Trust, says: "Whatever the charges are, they are going to be very cost-effective compared to the typical unit trust."
An important factor that investors need to bear in mind with investment trusts is their ability to 'gear' or borrow money to invest. Alan Adam, financial consultant at Scottish IFA Alan Steel Asset Management, says: "If they're very positive about something, such as a particular stock that they believe is going to be a great story, they can borrow money and buy more of that stock, which works out well if they get the decision right."
But, while gearing can amplify the gains if markets are doing well, the reverse can happen, as Patrick Connolly explains. "The problem is that when you borrow money, you pay interest on that money to whoever you borrowed it from. If you invest it in an area that's going down - so the investment is going down in value - not only are you borrowing the money and paying interest on it, you've actually got more exposure to a falling market," he says.
Because of the extra risk - or opportunity - added by gearing and the fact that investment trust shares can sell at a discount or a premium, experts recommend holding your investment for the long-term. This gives you time to ride out any market fluctuations.
Pros and cons
"Investment trusts are an easy, cost-effective route to the stockmarket," Sweeting says. "They give diversity - some invest in tens, some invest in hundreds of companies, usually far more than the average investor could access - especially with areas like global growth, where you're investing across the world and across all market sectors." Sweeting also points out that with investments trusts, you have a team of experienced fund managers managing your money for relatively little cost.
Many investment trusts have saving schemes that let you put in as little as £50 a month, or even £25 in some cases. But because you pool your money with other investors, you benefit from economies of scale, keeping dealing and administration costs low.
Sweeting stresses the flexibility that investment trusts offer. Investors can invest monthly or in the form of a lump sum - or a combination of both - and they can start and stop investments as needed without penalty.
A wide range of investors make use of investment trusts, from those dabbling in the stockmarket for the first time, through to more experienced investors. "Basically, whatever the investor, there's probably an investment trust to suit their requirements," says Sweeting. However, some IFAs believe that, because of their added complexities, investment trusts are better suited to the savvier investor.
You can buy shares in an investment trust through a stockbroker or financial adviser and also get access through an investment trust manager if it is an investment trust saving scheme or an individual savings account. You will have to pay fees to the adviser or stockbroker along with the normal stamp duty on buying shares, which is 0.5%.
Usually charged as a percentage of returns for performance above a specified benchmark, such as an index. The fee can range from 10% to 20% of total investment returns on a low starting benchmark such as Libor and investors could find themselves paying extra fees for merely average performance. Note that these funds do not compensate investors when the manager underperforms the benchmark.
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.
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.
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 financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.