Understanding investment trusts
On paper, investment trusts can look a better option than the more popular funds such as unit trusts or OEICs. For a start, they are cheaper to buy and, perhaps more importantly, they have also clearly outperformed their peers over the long term.
According to Morningstar, over five years to the beginning of May 2008, funds in the UK All Companies sector were up by an average 93%, while UK Growth & Income sector trusts have grown by 129%. Over 10 years, the figures are more dramatic - the average global growth fund has increased in value by 48% and the average global growth investment trust by around 110%.
Yet, despite their low costs and strong track record, investment trusts are widely misunderstood; they’re considered complex, difficult to understand and risky. A lot of that suspicion is due to the way they’re priced and the whole confusing business of discounts and premiums.
To see how the discounts work - and work out just how wary you should be - it’s worth taking a look at how investment trusts work in comparison with funds.
Spot the difference
Investment trusts, like funds, are collective investments - they pool investors’ money and use it to run a portfolio of selected shares that will (hopefully) pay dividends and/or grow in value over the long term. However, although both aim to do the same thing, there are some important differences.
Investment trusts are arguably riskier than funds, because they’re able to use ‘gearing’ - in other words, they can borrow money to invest. This is a boon when markets are rising as gains are magnified - but so are the losses when markets fall.
However, the difference that investors generally find most baffling is pricing. OEICs and unit trusts both have an open-ended structure. This means the price of your fund reflects the value of the underlying share portfolio, and varies with it.
The price is not pushed up or down by the pressure of investor demand because, when new investors want to buy into the fund, additional units are simply created to meet the extra demand.
Conversely, if sentiment turns and investors start cashing in their holdings, units are cancelled and the manager may have to sell some of the underlying investments in order to pay investors who want to get their money out.
An investment trust works differently. It is a company in its own right, listed on the stockmarket and with a fixed number of shares in issue. It’s known as a closed-ended investment because the number of shares is fixed at the start (although further tranches of shares may be issued later).
Because there is a limited number of shares, their price depends on the balance between the supply of shares and the demand for them in the market, rather than directly on the value of the underlying investments held in the trust.
There are therefore two prices to take into account when you’re looking at an investment trust - the net asset value (NAV) per share (which is the value of the underlying portfolio after any debts have been accounted for, divided by the number of shares in issue), and the share price at which the trust is trading.
As there is usually some spare stock available in the market, the share price is generally below NAV per share. This gap between the two values is known as the share price’s ‘discount to NAV’ (or the premium, if demand for shares exceeds supply and the price rises above NAV), and is expressed as a percentage. So if you buy a trust at a 10% discount, you are paying 90p for assets worth £1.
What’s the significance of the discount for investors? As Annabel Brodie-Smith, communications director for the Association of Investment Companies (AIC), points out, it’s not the discount itself that makes a difference - what matters is the performance of the trust and changes to the NAV. "If you buy a trust at a 10% discount and sell later at a 10% discount, there’s no difference to buying and selling at the full price," she explains.
Income-producing trusts tend to have a narrower discount because the assets provide an ongoing dividend benefit, which for many investors is more important than the discount. So, for example, the UK High Income sector trusts generally trade at between -5% and +5%. But establishing the range for each sector is a matter of studying the sector statistics - there’s no ready-made guide to ‘natural’ sector discounts.
Provided that you have bought in-line with the discount level for the sector, however, James de Sausmarez, head of investment trusts at Henderson Global Investors, believes that "you can ignore the discount over the long term, because the difference it will make to total returns will be very marginal". It’s much more important to worry about the quality of the fund manager and the consistency of performance.
But over the shorter term, discounts can be quite volatile. Figures from the AIC show that over the last five years to the end of March average discounts across investment trusts as a whole have ranged from -12% to -3.5%. This hides dramatic variations between sectors - the overall average discount is just over 9%, but the direct European property sector average stands at a whopping 40%. So if you buy a European property trust you’re effectively getting two-fifths of the underlying assets for free.
Commercial property's fall from grace
The recent fortunes of the commercial property sector are a good example of how, even if you’ve invested in a top quality trust run by a highly respected manager, you may see the discount widen markedly if the sector slips out of favour. Take F&C Commercial Property, a highly regarded trust trading close to its NAV until the sector’s collapse last year. By October 2007, the discount had widened to 30%, though it has since moved in to around 18%.
Nick Greenwood, chief investment officer of Iimia, which runs trusts of investment trusts, says that the impact of such a change of sentiment on discounts can be dramatically compounded by a downward move in the value of the underlying assets.
"This happened to British Empire in 2007," he adds. "It was a fantastic trust and was trading on a premium of about 10%, which then swung rapidly to a 10% discount. With a fall in asset values of 10% at the same time, investors who timed their purchase wrong could face a loss of 30%."
In such situations, however, the one thing not to do is panic, sell up and get out when the trust is way below its ‘natural’ range. Sooner or later the tide of investor sentiment will turn and the discount will start to narrow again. And when that starts to happen, adds James de Sausmarez, it’s time to buy more.
Indeed, a good trust on an unusually wide discount that’s beginning to tighten as the markets pick up is a great ‘double whammy’, because you’re gaining value not only through strengthening asset values, but also through the rising share price of the trust as it becomes more popular.
Greenwood says the current environment offers some great buying opportunities: "A lot of trusts are now trading at 25-30% below NAV, and when the markets do cheer up there’s scope for an explosive run from high quality trusts."
What about trusts on premiums? When shares are so popular that investors are prepared to pay more than the underlying assets are worth, it’s often time to sell, because a change of sentiment could rapidly erode all that additional value and push the share price back down below NAV. "Losses often come from paying full whack for a top trust; it’s often better to buy an average trust that’s currently perceived as poor," Greenwood warns.
But for high quality trusts with consistently good performance - such as Murray International - there can be an argument for holding on, and even for buying into the premium if it seems sustainable, according to de Sausmarez. "Income funds in particular may be good buys, even on a bit of a premium, because yield and income flow for many people is worth paying slightly over the odds for," he says.
One development that has helped to limit the risks attached to volatile discounts is the increasing trend towards active discount control by trust management boards. If a trust’s share price seems to be drifting too far below NAV - usually because there’s too much loose stock available in the market - the board will buy back its own shares to reduce supply and bolster the price.
It may cancel them altogether, which will give the trust’s net asset value per share an instant boost because there will be fewer shares in issue. In other cases, it will simply buy them in to support the share price and release them at a later date when demand has picked up.
Some boards make a rigid commitment not to let the discount widen beyond a set level, while others take a more flexible approach, setting an acceptable discount range for normal markets. For example, Foreign & Colonial introduced a discount control mechanism in November 2005, with the aim of "maintaining a less volatile discount with a ceiling of 10% and enhancing net asset value per share for continuing shareholders". As a consequence, F&C’s discount has fallen from the mid-teens to a steady 8-10%.
"Share-buybacks are a comfort factor for new investors - and good news for existing shareholders," says de Sausmarez.
So should you worry about discounts and premiums? If you’re saving over the long term and the trust’s discount (or premium) is pretty steady and in line with those of its peers, the answer’s no. Instead, you should concentrate on the quality of the manager, his strategy and track record. Nor should you panic if the discount widens for more ‘macro’ reasons - sit tight and wait for things to pick up.
Discount and premium movements are more interesting if you want to invest strategically by attempting to buy on a wide discount and sell on a narrow one. But that can be a risky strategy that should only ever be employed if you’re an advanced investor with money you can afford to lose.
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).
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
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.
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.
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.
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.
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.