Why you should own an investment trust
There have been many benefits to investing through an investment trust, but the bottom line is this - like unitised investment funds - they offer ordinary investors access to a well-diversified, professionally managed portfolio of shares.
For investors with larger portfolios, an additional advantage of these collective investments is that changes to the underlying shareholdings are free of capital gains tax (CGT) even if they are not sheltered within an ISA or pension plan.
Investment funds are much more heavily promoted by investment groups, and by financial advisers; there's also a much larger universe from which to choose: over 2,400 UK-domiciled funds, against 274 trusts and UK-quoted offshore investment companies (excluding venture capital trusts and hedge funds).
But investment trusts have the edge when it comes to performance - a key reason why Money Observer has long championed their use and given them extensive coverage. Recent research by Alan Brierley, head of research at stockbroker Collins Stewart, found that over the decade to the end of 2010 investment trusts on average outperformed unitised funds in eight of the nine main sectors, including global growth, UK growth, North America, Europe excluding the UK and UK equity income. Only the UK smaller companies investment trust sector failed to beat its unit trust equivalent.
A second reason for using trusts is their closed-end structure (meaning there are a fixed number of shares in circulation), which makes them better suited than open-ended funds when it comes to investing in illiquid but potentially rewarding areas such as very small companies, frontier markets or specialist sectors such as biotechnology.
Because they are closed-ended, an increase in demand for the trust's shares or a mass exodus or shareholders will affect the share price on the open market, but not the amount of money under management.
So managers don't have to worry about large inflows or outflows of cash when their investment remit goes in or out of favour. Such surges can harm thew returns of open-ended funds, because incoming money can force fund managers to buy new shares even if the market is looking expensive, while outflows may mean that they have to sell holdings into a falling market.
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.
A third attraction of trusts compared with unitised funds is that they offer little or nothing in the way of upfront and annual commission payments to financial advisers. This keeps costs down, contributing to their superior performance.
Other important aspects of trusts include their ability to gear and to issue different classes of shares, and their discounts.
Gearing means borrowing extra funds to invest. This can accelerate returns in a rising market, but will exacerbate losses in hard times, so those of a nervous disposition should opt for ungeared trusts.
Splitting trusts into different groups of shareclasses allows different groups of 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 recently raised new funds by issuing zero dividend preference shares (which pay no dividends but offer a pre-determined rate of capital growth).
If these do not rank behind hefty bank borrowings for repayment and are well covered by assets from the start, zeros should provide relatively steady capital appreciation over a finite period. For low-risk investors they are even more appealing as all their returns are treated as capital growth, and therefore tax-free if sheltered within an ISA or covered by your CGT allowance.
Share price discount
Finally, a widening share price discount to a trust's net asset value (NAV) is bad news for shareholders who want to sell, but unimportant for long-term holders and can be good news for prospective buyers. It means they will get more in underlying assets than if they wee buying into a fund with an identical portfolio. Dividend yields should also be higher, and if the discount tightens they should enjoy enhanced returns. Many trusts now muse share buybacks or other measures to limit the extent of discount volatility.
Trusts arguably need to do more to educate both advisers and investors, but it is those complexities that create scope for finding profitable anomalies - but only if you understand what is happening.
This article was written for Money Observer
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 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.
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.
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.
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.
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.
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.
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.