Understanding investment trusts

Published by Moira O'Neill on 30 June 2008.
Last updated on 01 November 2017

Investment trusts – the ins and outs

Why Moneywise thinks you should consider investment trusts for long-term saving. Here’s the lowdown on how these closed-ended investments work, their main advantages and how to limit the risks.

Investment trusts have been around for 150 years, making them the oldest type of investment fund. Today, many beginners are told that they don’t need to consider them because they’re “more complicated”, or “higher risk” than other types of fund.

But at Moneywise, we think that you should pay them attention and at least include one or two in your portfolio. That’s why we’ve picked 10 investment trusts for our First 50 Funds for beginner investors.

In fact, investment trusts’ key attributes can make them an ideal long-term investment – I hold them myself in my self-invested personal pension, in which I am growing my money for retirement over the next 20 years.

Our columnist Jeff Prestridge, the personal finance editor of the Mail on Sunday, now in his 50s, also recently described his long-standing love affair with investment trusts, saying: “What I love most about investment trusts is that they are understated, are rarely marketed by the asset managers who run them, and represent great value for money.

“At a time when increasing focus is on the high charges that many fund managers levy, this low-cost investment trust vehicle appears more attractive than ever.”

There is nothing innately special about investment trusts. They are simply companies in their own right, listed on the stock market and with boards made up of the great and good to hold the investment managers to account. This is why they are also known as “investment companies”.

But their “business” is that of investing on behalf of their shareholders.

Like other investment funds, they are invested across a broad range of companies and they are run by professional fund managers who aim to beat the wider stock market. Some might say that they are boring. But that is part of their huge appeal.

And their investment performance is far from boring. Many professional advisers know this, and put their clients’ money into investment trusts. The latest research from the Association of Investment Companies (AIC), which represents the investment trusts industry, reveals that purchases by independent financial advisers and wealth managers hit a record level in the first half of 2017 at £514 million, the highest figure ever for the first six months of a year.

As well as using them to invest for retirement, many people use them to save for children. According to figures from the AIC, if you had regularly invested £25 a month in the average investment company over the past 18 years, this would have grown to over £16,000, while investments of £50 a month would have grown to over £32,000. For those parents who were able to save £100 a month over 18 years, this would have grown to more than £65,000 – enough to clear a child’s student debt and have some money left over.

On paper, investment trusts can look a better option than the more popular open-ended funds, such as unit trusts or Oeics.

The past decade has been more profitable for the average investment trust investor than those holding open-ended funds, research by FE Trustnet on 4 October 2017 suggests.

Investment trusts beat open-ended funds over the 10-year period in seven out of 10 sectors: Global, Global Equity Income, North America, Japan, UK Smaller Companies, Europe ex UK and Asia Pacific ex Japan. The sectors where trusts lagged behind their open-ended rivals are UK All Companies, UK Equity Income and Flexible Investment.

Yet, despite their 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 stock market 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 the number of shares is limited, 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.

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.

Pricing

What’s the significance of the discount for investors? It’s not the discount itself that makes a difference – 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.

What matters is the performance of the trust and changes to the NAV. If you buy at a 10% discount and the trust subsequently becomes more popular with investors, they may be willing to pay more for your shares and you might be able to sell them at a 10% premium to NAV.

Over the shorter term, discounts can be quite volatile. Some investors attempt to use this to their advantage, 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.

However, if you’re holding the investment trust for many years, at least five and preferably 10, you don’t need to worry so much about the discount or premium, 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.

What happens if a trust you’re holding suddenly trades at a massive discount? 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, it’s time to buy more (see the case of F&C Commercial Property, below).

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.

What about trusts on premiums? When shares are so popular that investors will pay more than the underlying assets are worth, it’s often time to sell, because a change of sentiment could rapidly erode that extra value and push the share price down below NAV. However, for high-quality trusts with consistently good performance, there can be an argument for holding on and even for buying into the premium if it seems sustainable.

Limiting risk

One development that has helped to limit the risks attached 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 NAV 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.

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 other trusts in the same sector, the answer is no. Instead, you should concentrate on the quality of the manager, his or her 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.

Gearing advantage

Investment trusts can borrow money, called ‘gearing’, to boost performance. The trust’s manager uses the extra cash raised from borrowing to make more investments and potentially produce a better return on the capital investments. However, if the manager makes the wrong investment decisions, then gearing can lead to greater loss if the investment turns sour.

Use of gearing can therefore make a trust higher risk. Some trusts use more gearing than others, so check before you invest. A trust’s gearing policy can be found in its prospectus or report and accounts.

The majority of investment companies have a gearing range from no gearing (0%) to 20% gearing in normal market conditions.

Dividend advantage

The ability of investment trusts to smooth dividend payments is a unique selling point for income investors (open-ended funds do not enjoy this facility).

Every year, an investment trust can set aside up to 15% of the dividends it has generated. It can then use this income buffer to supplement its dividend payments in future years should the yield generated from the investment portfolio fail to meet its targets – for example, as a result of dividend cuts among individual companies held in the portfolio.

Many investment trusts have used this facility to achieve a more reliable income stream for investors and to build up long records of dividend growth.

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 member of the Moneywise First 50 Funds for beginner investors. It was trading close to its NAV until the commercial property sector’s collapse in summer 2016.

Commercial property is an ‘illiquid’ asset, meaning it cannot be sold quickly, so open-ended property funds can run into severe difficulties when many investors try to sell at the same time, as properties need to be sold to provide the cash to repay them.

Commercial property investment trusts don’t face the same problem of selling assets, as the investor exodus simply pushes the share price down, giving bargain hunters an opportunity to buy.

After the EU referendum on 24 June 2016, many big, conventional, open-ended property funds faced huge waves of redemptions as investor pessimism led to a mass exodus. Many of these funds had to suspend trading, locking investors in until enough cash could be raised through building sales or the situation stabilised.

The negative investor sentiment spread to investment trusts. On 5 July 2016, F&C Commercial Property was trading at a massive discount of -24%, its lowest level since 2009. However, by November 2016, it was trading at a premium again and as at 4 October 2017, it is on a premium of 8%.

TOP TIP: Where to find more information

The Association of Investment Companies’ website has detailed information on gearing and discount levels for individual investment trusts. Visit www.theaic.co.uk.

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