10 things you need to know about investment trusts

Published by Faith Glasgow on 19 May 2011.
Last updated on 31 May 2011

For many years now, investment trusts have been portrayed by a lot of investment professionals as the eccentric cousins of the big happy family that includes unit trusts and open-ended investment companies (OEICs).

They can be highly entertaining company at a family do - but you never quite know when they're going to overdo the sherry and pass out in their soup.

But are investment trusts really so unpredictable and complicated, as we've been led to believe?

Here we examine some of the main ways in which they differ from unit trusts, consider the real reasons why advisers are so reluctant to recommend them, and ask whether in fact you should welcome them into your portfolio.


The investment trust industry is much smaller than its more mainstream open-ended rival. According to fund research group Morningstar, there are almost 2,100 UK-domiciled unit trusts and OEICs aimed at the retail market, compared with around 300 UK-domiciled investment trusts (excluding venture capital trusts).

Yet investment trusts tend to outperform significantly over the long term. Independent financial advisory group Collins Stewart found that over the past 10 years, investment trusts have done better than unit trusts in eight out of the nine biggest sectors, in terms of share prices.

For example, if you had bought a global growth investment trust 10 years ago, on average the share price would have risen by 93%, compared with a rise in the average global growth unit trust price of 24%.


There are many similarities between investment trusts and their more popular cousins, unit trusts. Both are collective investments where investors' money is pooled and used to buy a portfolio of stocks or shares, which is professionally managed on their behalf.

There might be anything from 30 to 100-plus holdings - more than most investors could afford if they bought the shares individually.

A broader range of holdings obviously means there would be less damage to the overall portfolio if trouble should hit any individual company.


Trusts are long-term investments, so they won't be right for anyone wanting either to access their cash in the next few years or to make a quick buck.

Investment trust performance can involve rather more ups and downs than the unit trust equivalent (because of gearing and the effect of movements in the discount), so they're not ideal for those of a particularly nervous disposition either.

But remember, if you're invested for the long term, it's not worth worrying too much about short-term swings.

However, trusts are a good bet if you want a big, steady, internationally diversified fund at the heart of your portfolio - perfect for regular monthly investments. The global growth sector includes such leviathans as Witan, Foreign & Colonial investment trust, RIT Capital Partners and Scottish Mortgage.

Many of the global and UK funds are also good for income-seekers.

Finally, the closed-end structure is particularly suitable for more specialist funds holding assets that cannot be easily or swiftly bought and sold (such as property or start-up companies). This is because managers don't have to sell in order to release money back to investors when markets dip.

There's a wide choice of specialist funds too.


Unit trusts are simple: they are structured as open-ended funds, so investors' money goes into the fund manager's investment cash. As more people invest, the fund gets bigger and more units are created; conversely, as people pull out, it shrinks.

The value of your units will move up and down according to how well the underlying holdings are doing, so if investors get nervous and there's a run on the fund, the manager will have to sell holdings to free up enough cash to return to investors.

That can mean he's selling when prices are falling and no one wants to buy.

Investment trusts work differently. They're actually companies listed on the London Stock Exchange, and like any other listed company they issue a fixed number of shares (hence 'closed-end'), which are then traded on the open market.

As a consequence, there are two 'layers' of activity. At the trust level, the manager issues a fixed number of shares and raises a set amount to invest.

But the shares themselves are then resold and bought on the stockmarket. The share price goes up and down according to investor demand and supply, but the fund manager's investment plans are not affected.


Because of these two layers, these trusts have two values: how much the trust itself is worth (the net asset value or NAV) and its share price.

If the trust is popular, the share price will be boosted by extra demand, but this doesn't necessarily mean the underlying NAV has changed.

When the share price is less than the NAV per share, this is known as a 'discount', because you're buying the trust's assets at less than their actual value. When the share price rises above NAV, it's trading at a 'premium', as you're paying more than the assets are worth.

If you buy at a discount and it narrows, your holding gains in value even if there's no movement in the underlying NAV.

Say you buy a trust trading at a 10% discount to NAV; you invest £1,000 but the discount means the underlying holdings are worth £1,111. Over the next six months, the share price rises and the discount narrows to 5%. Even if there's no movement in the underlying asset values, your shares will rise in value from £1,000 to £1,055.

Even if the discount remains the same, you won't lose out.
If the NAV doubles from £1,111 to £2,222, but the discount holds fast at 10%, your shares will double in price to £2,000.

Of course there's a risk that the discount will widen, although over time they tend to stabilise and many trust managers also control them artificially through share buybacks.

In addition, it's generally not a good idea to buy a trust on a premium, because the discount is likely to widen.


Investment trusts are companies, so they're allowed to gear, or borrow, to invest. This can improve their performance, but it also means they tend to be more volatile than their open-ended peers.

The effect of gearing in a rising market is to magnify the gains for each shareholder; but if the market falls, investors in a geared trust will suffer greater losses per share.

Many trusts are ungeared or only very modestly geared - the global growth sector average potential gearing is 8% - although some specialist investments such as private equity trusts have much higher potential gearing of around 40%.


Another important reason why investment trusts tend to outperform unit trusts and OEICs is that their charges are lower.

According to data from Lipper, the average total expense ratio (TER), including performance fees, for an investment trust in the global sectors is 1.14%, compared with 1.66% for global unit trust sectors.

For UK sectors, the TER is 1.29%, compared with the equivalent unit trust TER of 1.63%. These may appear to be small savings, but they can add up to significant sums over time.

The big difference - as far as charges are concerned - is that investment trusts don't have to pay any commission to financial advisers, which will typically save around 0.5% a year in trail payouts.

Alan Brierley, head of investment companies research at Collins Stewart and author of the Collins Stewart report, says this is also why unit trusts have grown so much more dramatically than investment trusts over the past 10 years.

"While it's impossible to quantify the impact [on open-ended fund sales] of the commission paid to so-called 'independent' advisers, it's fair to say superior net asset value performance has certainly not been the key driver," he says.

But what about the purchasing costs? The good news is there's no front-end fee involved with trusts if you make a lump-sum payment, but you'll have to pay the broker's dealing charges.

A cheap alternative is to go for one of the regular saving schemes that many trusts run.


Like other listed companies, investment trusts are overseen by an independent board of directors. Its job is to ensure the trust is managed in the interests of the shareholders.

In most cases, the directors will appoint an external fund management team to run the trust on a day-to-day basis, and if it doesn't do a good enough job, it risks being sacked and replaced with another.

By contrast, unit trust fund managers are answerable to the parent company and its shareholders, rather than the investors in their funds. There's no independent overseer breathing down their necks, looking after investors' best interests.


Income-paying investment trusts have a particular attraction for investors who want a regular cash flow, because - unlike unit trusts - they don't have to distribute all the income generated by their assets every year.

They can hold back up to 15%, which means they can build up a reserve that can be used to bolster dividend payouts in leaner years.


Gearing: Investment trusts can 'gear' or borrow money to invest. This can magnify the return, but makes the trust riskier, as each share gives more exposure to the market.

Net asset value (NAV): The net worth of an investment trust's equity capital, usually expressed in pence per share.

Closed-end funds: An investment vehicle, such as an investment trust, with a fixed capital structure. Variation in demand for shares is shown through movements in the share price rather than in the supply of shares.

Open-ended funds: Investment funds, such as unit trusts and OEICs, where the number of units in issue varies daily, according to demand.

Discount: If the share price of an investment trust is lower than the NAV per share, the trust trades at a discount, shown as a percentage of NAV.

Premium: If the share price is higher than the NAV per share, it trades at a premium.

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