Why own an investment trust?
What is the core attraction of investment trusts? Primarily they allow even investors of modest means to own part of a diversified and professionally managed portfolio of shares.
For wealthier individuals a big advantage of investment trusts is that changes within their portfolios are free of capital gains tax (CGT) even if they are not sheltered within an ISA or pension plan.
Unitised funds offer similar opportunities, but are better known because there are more of them and they are more heavily marketed.
But there are more than 250 trusts and UK-quoted offshore investment companies (excluding venture capital trusts and hedge funds) and Moneywise gives them extensive coverage, particularly in our annual investment trust awards.
Reasons in favour of investment trusts
One reason for our enthusiasm about investment trusts is their outperformance over funds.
Research by Alan Brierley, head of research at stockbroker Collins Stewart, found that over the decade to the end of 2009, investment trusts on average outperformed open-ended investment companies (OEICs) and unit trusts in popular investment areas, including global emerging markets, global growth, UK growth, North America, Europe excluding the UK, and UK equity income.
Another reason for favouring trusts is that they are better suited than funds for investing in illiquid but potentially rewarding sectors such as very small companies, frontier markets, and emerging sectors such as biotechnology.
The reason is that they are closed-ended (they have a fixed number of shares) so managers do not have to worry about large inflows or outflows of funds when their investment remit goes in or out of favour.
Such surges can harm the returns of open-ended funds, as incoming money can force fund managers to invest even if the market looks expensive, while outflows can force them to sell holdings, sometimes at excessively depressed prices.
Being closed-ended is even more critical in the private equity space where managers need several years of active involvement to get the most out of their investments.
Private equity has been through a rough patch, but over the past 20 years it has made a lot of money for investors, and good managers will almost certainly do so again in due course.
A third reason for keeping a close watch on trusts is that they offer little or nothing in the way of upfront and annual commission payments to financial advisers. Not paying commission helps trusts to keep costs down, which contributes to their superior performance.
But it also means that the majority of advisers avoid them so many investors are unaware of their appeal.
Trusts arguably need to do more to educate advisers and investors, as they can have more complicated structures than funds, and shares trade at a variable discount to net asset value (NAV).
These complexities create scope for finding profitable anomalies, but only for those who understand what is happening.
Almost a 10th of the trusts on the market have been serving investors since the Victorian era, whereas there were no UK-based unit trusts until 1931 and they remained relatively rare until the 1970s.
Foreign & Colonial Investment Trust is the oldest trust and one of the largest. Since 1868 it has aimed to offer the small investor the same advantages as large institutions by reducing risk through a professionally managed and diversified investment portfolio.
While Foreign & Colonial and its peers have stayed true to that objective, they have also moved with the times to maximise returns.
In the early days this consisted mainly of shifting the balance of their portfolios between equities and fixed interest, and raising or lowering exposure to overseas markets.
For instance, some trusts were big investors in South American and Far Eastern railway bonds before World War I, and gold-backed bonds were popular a century ago.
In recent decades these trusts have concentrated on equities, partly because they offered the best returns, but also because until last year open-ended funds were a more tax-efficient vehicle for investing in fixed interest securities such as corporate and government bonds.
Moving with the times
However, investment trusts did not let the grass grow under their feet. They were pioneer investors in Japan in the 1960s, in continental Europe in the 1980s and, more recently, in the Bric economies of Brazil, Russia, India and China.
Trusts such as BlackRock Latin American and JPMorgan Russian Securities offer focused exposure to far-flung places.
But for investors who find it hard to decide when to adjust exposure to these regions global growth trusts look after such asset allocation decisions.
As you might expect, these global trusts, which form the backbone of the investment trust industry, are exceptionally varied so it is important to pick carefully.
For instance, Alliance Trust errs on the cautious side and has a widely diversified portfolio, whereas Scottish Mortgage Trust is bolder, has far fewer holdings and places more emphasis on the Asia Pacific region and emerging markets.
Over the past five years it has been more rewarding but also more volatile.
Foreign & Colonial Investment Trust is differentiated by its commitment to invest in private equity, and a number of more recent trusts have diversified into an even wider spread of assets.
RIT Capital Partners, for instance, has done well by investing in a mix of equities, fixed income, private equity, hedge funds and property, combined with active currency management. An open-ended fund would find it impossible to replicate this asset mix.
Around 18% of RIT is owned by its chairman, Lord Rothschild, who uses the trust as a tax-efficient, low-cost way of investing his fortune.
Many more trusts are used by their managers to manage their personal wealth. Artemis Alpha, Capital Gearing Trust, Establishment Investment Trust, Hansa Trust, and Manchester & London Investment Trust are among those noted for having managers with significant "skin in the game".
Shareholding managers like the closed-end format as it prevents inflows of new money that could force them to diversify more or concentrate on larger investments.
Other important aspects of trusts include the ability to gear and to issue different classes of shares, and their discounts. Gearing means borrowing extra funds.
This can accelerate returns in a rising market, but exacerbate losses in hard times. Gearing can be used to increase a trust's dividend, but at the expense of capital growth.
It increases a trust's potential volatility and expensive long-term gearing can be a drag on growth in all but the most bullish markets, so those of a nervous bent should opt for ungeared trusts.
Splitting trusts into different share classes allows shareholders to concentrate on their priorities, be they income or capital growth.
'Split caps' have been unpopular since the furore of the early noughties, but a number of trusts have raised new funds by issuing zero dividend preference shares.
If they do not rank behind hefty bank borrowings for repayment and are well covered by assets, zeros should provide relatively steady capital appreciation over a finite period.
For low-risk investors they are even more appealing as all their returns rank as capital growth so can be tax-free if sheltered within an ISA or covered by the annual CGT allowance.
A widening share price discount to a trust's NAV is bad news for shareholders who want to sell, but unimportant for long-term holders and good news for prospective buyers.
It means they will get more in underlying assets than if they were buying into a open-ended fund with an identical portfolio.
Dividend yields should also be higher and if the discount tightens they should enjoy enhanced returns.
Some investors fear discount volatility, so several of the largest global trusts are committed to keeping discounts in single figures through share buy-backs.
Other trusts have set even tighter discount targets, with some using periodic tenders to ensure investors can sell at close to NAV.
Both forms of discount control can reduce the size of the trust, which is a problem if it makes them so small as to be uneconomic. But this is where outflows can be more predictable than with an open-ended fund.
And that's less damaging to shareholders, who are the ultimate concern of the trust manager and its board.
This article was originally published in Money Observer - Moneywise's sister publication - in July 2010
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.
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.
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 practice of locating your financial affairs (banking, savings, investments) in a country other than the one you’re a citizen of, usually a low-tax jurisdiction. The appeal of offshore is it offers the potential for tax efficiency, the convenience of easy international access and a safe haven for your money. However, offshore is governed by complex, ever-changing rules (such as 2005’s European Union Savings Directive) and, as such, is the exclusive province of the wealthy and high-net-worth individuals.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
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.
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.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
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).
An acronym, which stands for Brazil, Russia, India and China; countries all deemed to be at a similar stage of advanced economic development. The term was coined in 2001 in a report written by Goldman Sachs director Jim O’Neill who speculated that, by 2050, these four economies would be wealthier than most of the current major G7 economic powers.
A sophisticated absolute return fund that seeks to make money for its investors regardless of how global markets are performing. To that end, they invest in shares, bonds, currencies and commodities using a raft of investment techniques such as gearing, short selling, derivatives, futures, options and interest rate swaps. Most are based “offshore” and are not regulated by the financial authorities. Although ordinary investors can gain exposure to hedge funds through certain types of investment funds, direct investment is for the wealthy as most funds require potential investors to have liquid assets greater than £150,000m.