What are investment trusts? - the basics

Investment trusts may have been overshadowed in recent decades by higher-profile unit trusts and open-ended investment companies (OEICs), but they have been around much longer.

The granddaddy of all collective investments, Foreign & Colonial Investment Trust, was launched in 1868 "to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk by spreading the investment over a number of stocks".

As F&C's 19th century marketing blurb suggests, collective investments, which include both unit and investment trusts, can help ordinary investors lessen the risks of investing by pooling their cash with that of lots of other investors to buy a portfolio of shares, rather than just one or two.

Diversifying in this way reduces the risk of any individual company's troubles scuppering your investment. Collective investments also have other advantages, including cheaper trading costs and professional management.

But while private investors can access more than 2,400 UK-domiciled funds (unit trusts and OEICs), worth £560 billion in total, as of the end of 2011 they had a choice of just 412 investment trusts, worth £90 billion. This is partly due to the fact that trusts are not promoted to the same extent as their more popular cousins.

Many financial advisers say they ignore investment trusts as they are ‘complex', ‘risky' and ‘only suitable for sophisticated investors', but while they may prefer the relatively simple structure of funds, the fact is that fund sales also bring them a commission, unlike investment trusts.

A better return

Yet the bottom line is that investment trusts tend to outperform funds by a significant margin over the long term. Morningstar data shows the average global growth trust returned 97% over 10 years to 8 March, compared with just 56% for funds in the equivalent IMA Global sector.

The differential is even greater in other mainstream sectors: for example, a hefty 359% in global emerging markets investment trusts, compared with 217% for the IMA Global Emerging Markets sector.

How they work

So how do investment trusts work, why do they tend to deliver better returns and what kind of investors do they suit? An investment trust is actually a listed company such as, say, Vodafone, except that it doesn't manufacture or sell anything but invests in other businesses instead. Like Vodafone, the trust will issue a fixed number of shares to raise capital, a better return which is why investment trusts are described as ‘closed-ended'.

The manager then uses that cash to buy shares in other companies, building a portfolio that contains anything from 20 to 100 or more holdings.

Investors in the trust can buy and sell their shares on the stockmarket. But the price of those shares might be affected by many factors, such as the economic climate or the current popularity of that area of investment. In other words, the share price on the open market reflects wider supply and demand issues, not just the value of the trust portfolio.

Because investment trusts have a two-tiered pricing system, involving both the share price paid by investors and the trust's net asset value or NAV (the total value of a company's assets minus the total value of its liabilities), there's an additional factor to consider – the share price's discount or, more rarely, premium to NAV.

Over the longer term, discounts tend to stabilise, so a wider than average discount may indicate either a trust with problems – the share price is low because no one wants it – or an opportunity for bargain hunters, as short-term returns will be boosted if the discount returns to its usual range.

The trust is trading at a premium when the share price rises above the NAV. Most investors steer clear of buying in such circumstances because premiums don't tend to be sustainable. It's likely the gap between share price and NAV will close again and those who bought at a premium will lose money.

But there may be times when a sector is particularly popular, and those trusts attract investors despite their premium rating. Investors' hunt for income, for example, has held the Global Growth & Income sector (yielding an average 3.5%) on a premium of around 1% since June 2010, according to the Association of Investment Companies (AIC).

In most cases, discounts and premiums are not that significant for long-term investors, although it's good to buy when a trust is on a wider than usual discount, as it's likely to narrow back towards its long-term average and help your returns.

There are other factors to bear in mind when considering investment trusts. Like other companies, they are allowed to ‘gear' or borrow extra money to invest. It's a relatively modest limit for most sectors – generally less than 10% – but racier markets may have higher limits. The effect of gearing is that shareholders have greater exposure to the market – again, great when it's rising but painful when it falls.

The two-level pricing system and an ability to gear both help investment trusts outperform funds when markets are rising, although trusts tend to lose out when markets are falling. But trusts also outperform as they tend to be cheaper than funds.

AIC research last May showed that two-thirds of trusts in the Global Growth & Income sector, and more than half those in the Global Growth and UK Growth & Income sectors, have a total expense ratio (TER) of less than 1%.

The cheapest, Independent Investment Trust in the Global Growth sector, has a TER of less than 0.4% – cheaper than many passive funds, let alone actively managed equity funds (the average TER of UK All Companies funds is 1.61%).

Who will they suit?

The closed-ended nature of investment trusts makes them a good way to invest in a portfolio of more specialist holdings that are harder to sell, because the manager doesn't have to worry about keeping cash available in case investors want to withdraw their money. Trusts are used to invest in portfolios of hedge funds, forestry and commercial property, for example, as well as specialist areas such as technology or single countries.

But so-called generalist trusts are equally suitable for more mainstream investors looking for a broad long-term portfolio, whether UK, Asian, emerging markets or global, especially as many have a special regular savings scheme to keep costs down.

It's clear investment trusts are designed for investors who are in it for the long haul – but if you can tuck your money away for, say, 10 years or more in a consistently performing trust in one of the mainstream sectors, you could find you've made a very sound investment decision.