What is an investment trust?
Investment trusts, such as unit trusts and open-ended investment companies (Oeics), allow you to pool your money with that of other investors to get exposure to a range of assets through a single investment.
Investment trusts have been around since the 1860s and they have long been regarded by their fans as the best kept secret of the investment world because they have traditionally had lower ongoing charges than unit trusts and therefore the potential for higher returns.
This advantage has largely disappeared since January 2013, owing to changes in the way funds could charge fees.
Here we explain how they work, and whether they're right for you.
Open-ended vs closed-ended trusts
Investment trusts are set up as companies and traded on the London Stock Exchange.
As with any company quoted on the stock market, 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. When you invest in an investment trust, you become a shareholder in that company.
There are important structural differences between unit trusts and investment trusts.
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Investment trust prices
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 £1m worth of assets and one million shares, the NAV is 100p.
With unit trusts, the price of the units you hold directly reflects the value of the assets held by the trust.
With investment trusts the price of shares is determined by supply and demand in the stock market. This means the price you pay will almost invariably differ from the NAV.
If a trust is trading at:
- Less than its NAV: it's said to be trading at a discount.
- Higher than the NAV: it's trading at a premium.
Often, 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 out-performance is likely to last.
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Where do trusts invest?
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 more than 30 different sectors, including:
- UK Growth
- Global Growth
- Europe, Asia Pacific Infrastructure
- Private Equity
The level of discount or premium tends to vary by sector and changes with market sentiment.
Where and in what a trust invests will partly determine how risky it is.
Ethical investment trusts
Most big investment companies factor in socially responsible or 'ethical' investing in their investment strategies, and many should have dedicated 'ethical funds' that investors can choose from.
This means they would only invest in companies that meet a certain set of criteria, steering clear from those whose products or business practices don't meet the required standards.
Some ethical funds might exclude producers of meat products, for example, or avoid companies that emit greenhouse gasses.
Investment trust performance
Investment trust shareholders often invest because they believe trusts will outperform similar 'open-ended' funds such as unit trusts and Oeics.
Studies have repeatedly shown that investment trusts tend to outperform comparable open-ended funds. Research published in 2019 by the stockbroker AJ Bell found that over the long term – 10 years or more – 75% of investment trusts outperformed open-ended funds investing in similar assets.
A study from Cass Business School in 2018 found that investment companies outperformed by an average of 0.8 percentage points a year.
When investment trusts do out-perform their open-ended rivals, as they frequently have in the past, it can sometimes be explained by a combination of lower costs (although that advantage has narrowed in the last few years), the closed-ended structure of the trust and the effect of 'gearing'.
Here, we explain the impact of these factors on performance.
Investment trusts and the closed-ended structure
Because investment trusts have a limited and constant number of shares, and are governed by a board of directors, they can arguably take a more genuine long-term view than their open-ended counterparts. They don't have to buy or sell the underlying investments until the board really thinks it's the best time to do so.
With open-ended funds on the other hand, fund managers have to buy and sell shares to accommodate investors joining and leaving the fund. This can mean managers might be forced to transact at inopportune times - selling when the market is low and buying when it's high, for example.
Of course, as every investment professional is duty-bound to tell you, past performance is definitely not an indicator of future returns.
Dividends can play a powerful role in generating an income from investment trusts. Use our dividend tax calculator to find out how much you'll pay in 2022-23.
Investment trusts and gearing
Another major difference between investment and unit trusts is that investment trusts can borrow money to invest, known as 'gearing', which can have a dramatic effect on the value of your investments.
When stock markets are:
- Rising: gearing is useful because it magnifies any gains you make.
- Falling: gearing will increase your losses.
A trust with a high level of gearing will likely 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 equivalent unit trusts.
This means if you invest in investment trusts you should be prepared for a rockier road with bigger ups and downs.
But not all investment trusts gear. The AIC publishes details of each trusts gearing policy - 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%, etc - in other words, the trust has gearing of 10% of total assets.
Investment trust costs
Traditionally, investment trusts have had lower ongoing charges than open-ended unit trusts and Oeics for a few reasons:
- Unlike open-ended funds, investment trusts don't pay commission to financial advisers;
- There's less admin to pay for because they don't have to deal with money coming in and out;
- They have independent boards of directors representing the interests of shareholders - as such they will often negotiate lower annual charges as trusts grow.
However, as a result of the Financial Conduct Authority's Retail Distribution Review (RDR), open-ended funds have become cheaper. Some tracker funds now have fees well under 1%.
When considering investment trusts, it's also necessary to consider that, like any other shares, but unlike open-ended funds, your deals will be subject to stockbroking commission.
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How to choose an investment trust
There are a few things you should consider when choosing an investment trust:
- Check to see what level of gearing it has - higher borrowing will boost your returns if the fund performs well, but will hit you hard if it falls in value.
- Check on charges - now that open-ended funds don’t pay commissions, many have cut their fees.
In the end, there is no definitive answer to whether investment trusts or open-ended funds are better. The former have advantages, particularly when you want exposure to more illiquid assets, but they’re not guaranteed to outperform – and they may be more volatile over short-term periods.
You should only be investing if you can take a long-term approach – and all collective investment funds can fall in value as well as rise.
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