Different types of investment What are investment trusts

What are investment trusts?

Investment trusts can borrow money to magnify gains but could increase losses

Investment trusts, like unit trusts and OEICs, are a way of investing in shares, bonds and property in the UK and elsewhere. They enable you to pool your money with other investors to invest in a range of assets to spread your risk. As a result, they should be lower risk than buying individual shares. But this doesn't mean there is no risk to your capital, and the risk will vary depending on where the trust invests.

Investment trusts have a more complex structure than unit trusts and OEICs. But, they appeal to some investors because they generally have lower annual charges than unit trusts and the potential for higher returns. They can also invest in a wider range of securities.

Investment trusts are set up as companies and floated on the London Stock Exchange. As with any company quoted on the stock exchange, investment trusts have to publish an annual report and audited accounts. They also have a board of directors to which the manager of the trust is accountable and which looks out for the shareholder’s interests. When you invest in an investment trust, you become a shareholder in that company.

Open-ended vs closed-ended

There are important structural differences in the structure of unit trusts and investment trusts. Investment trusts are 'closed-ended' investments. They issue a fixed number of shares when they are set up, which investors can then buy and sell on the stock market. This means investment trust managers always have a fixed amount of money at their disposal, and won't have to buy and sell to meet consumer demand for shares. This can add a degree of stability to investment trust management that a unit trust manager won't have.

By contrast, unit trusts are 'open-ended' investments and can issue or redeem units at any time to people who want to buy into the trust or sell their stake. However, this may cause problems, as the manager may have to sell assets at a low point to pay investors who want to sell units.

How are investment trusts priced?

The value of the assets held by an investment trust is called the net asset value (NAV), usually expressed as pence per share. If a trust has £1million worth of assets and one million shares, the NAV is 100p. However, the price of an investment trust's shares is determined by supply and demand in the stock market. This means the price you pay will almost invariably differ from the NAV.

With unit trusts the price of the units you hold directly reflects the value of the assets held by the trust. Things aren't that simple with investment trusts. If a trust is trading at less than its NAV, it is said to be trading at a discount. If the share price is higher than the NAV, it is trading at a premium.

Typically, investment trusts trade at a discount. This looks like good value, as you pay less than £100 for £100 worth of assets. However, there is no guarantee that any discount will have narrowed by the time you come to sell. If the discount widens then you'll lose out in relative terms, whatever happens to the NAV of the trust.

Less often, trusts will trade at a premium to NAV. This means you're paying more than £100 to own £100 worth of assets. You might be prepared to do this, for example, because of the skill of the fund manager. However, you need to ask yourself whether this type of outperformance is likely to last.

Like unit trusts, investment trusts are grouped by the geographical area and type of investment with which they are involved. The Association of Investment Companies (AIC), the trade body that represents investment trusts, lists over 30 different sectors, ranging from UK Growth, Global Growth, Europe, Asia Pacific, Infrastructure, Property and Private Equity. The level of discount tends to vary by sector and changes with investment fashions.

How can investment trusts produce better potential returns?

A major difference between investment and unit trusts is that investment trusts can borrow money to invest. This ability (known as gearing) can have a dramatic effect on the value of your investments.

Investment trusts use this borrowed money to invest in shares and other securities. Gearing is very useful when markets are rising as it magnifies any gains you make. However, when stock markets are falling, gearing will heighten your losses. A trust with a high level of gearing should fall further under these circumstances than trusts with low gearing.

This means the more borrowing a trust has, the greater the capital risk you face, but you also have the potential for higher returns. The combined effect of gearing and the discount means investment trusts are likely to be more volatile than the equivalent unit trust. This means if you invest in investment trusts you should expect a rockier road with bigger ups and downs.

Not all investment trusts gear.You can find details of a trust's gearing from the Association of Investment Companies (AIC). A gearing rating of 100 means the trust has no borrowing, a rating of 110 means your gains or losses will be magnified by 10 per cent etc – in other words, the trust has gearing of 10% of total assets.

What are split capital investment trusts?

Conventional investment trusts tend to issue just one type of share. These offer income through dividends and the chance of capital growth. Split-capital trusts issue more than one type of share and, unlike conventional trusts, have a set winding-up dates.

Issuing more than one type of share means that, in theory, split-capital trusts can meet the differing needs of shareholders. The simplest type of split-capital trust issues two types of share. Income shareholders get all of the income from the trust during its life, while capital shareholders get any capital growth.

Split-capital trusts typically issue more types of shares than this- the most well-known being zero dividend preferences shares (zeros). Zeros pay no income but offer a pre-set return when the trust winds up. This makes them attractive to people who want a specific sum at a set time in the future - for example to pay for university fees.

At the winding-up date, the different classes of shareholders are paid out after the repayment of any loans. Holders of zeros are usually first to be paid out. This makes them lower risk than other shares in the same trust.

However, in 2001/2002, many people lost a lot of money in the split-cap investment trust scandal. Today, the split capital trust sector is in much better shape, and regulatory changes made in the wake of the scandal means that it could never happen again.

How much do investment trusts cost?

Generally, investment trusts have lower total expense ratios (TERs, or the total annual cost of the fund) than open-ended unit trusts and OEICs. This is because of their structure as a company – the independent board of directors represent the interests of the shareholders and therefore, can keep costs low. You can find out more in our guide to fund charges and its impact on your investments. 

According to Lipper research carried out in August 2010, the average TER on an investment trust was 1.2%, compared with 1.65% on unit trusts and OEICs. However, 54% of investment trusts levy a performance fee, sometimes up to 20% on returns over a certain benchmark (or hurdle, as it’s often called).

The argument in favour for this is that it aligns the fund manager’s interests with that of the shareholders, and the addition of a performance fee is often in return for a reduction in the annual cost. These arrangements will vary significantly from trust to trust, so if putting your savings into an investment trust, it’s important to take note what performance fee might be levied and what level of return triggers it.

For more on investing, also see our book Save and Invest.

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