Investment trusts, such as unit trusts and Oeics, allow you to pool your money with that of other investors to get exposure to a range of assets through a single investment.
This diversity means you can spread risk by investing in tens or even hundreds of companies through one investment - but this doesn't mean there is no risk to your capital, and the risks will vary depending on where the trust invests.
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.
Open-ended vs closed-ended funds
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.
There are important structural differences between unit trusts and investment trusts. Investment trusts are 'closed-ended' investments, meaning 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 satisfy investors who want to buy into the fund or sell their stake - this may cause problems, as the manager may have to sell assets at a low point to pay investors who want to sell units.
Find out more: The Which? investment portfolios - use our unique portfolio tool to find the right mix of assets for you
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. 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's said to be trading at a discount. If the share price is 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.
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, ranging from UK Growth, Global Growth, Europe, Asia Pacific, Infrastructure, Property and Private Equity.
The level of discount or premium tends to vary by sector and changes with market sentiment.
Investment trust performance
Investment trust share holders often invest because they believe trusts will outperform similar 'open-ended' funds such as unit trusts and Oeics (open ended investment companies).
When we looked at performance of trusts versus that of funds for three major sectors (global, UK all companies, and UK equity income) in October 2017, we found trusts outperformed for all sectors over the last five, 10 and 15 years.
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 arguable 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.
According to research by the Association of Investment Companies (AIC) - whose purpose is admittedly to promote investment trusts and therefore should be taken with a grain of salt - closed-ended funds have delivered growth of about 550% since 1995, while comparable open-ended funds have delivered just under 300% over the same period.
Of course, as every investment professional is duty-bound to tell you, past performance is definitely not an indicator of future returns. And not only that, but if markets are going up then that's good for investment companies because of gearing - which leads us nicely into our next point.
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 2020-21.
Investment trusts and gearing
Another 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 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. This was in large part because unlike open-ended funds, investment trusts have never paid commission to financial advisers.
And because investment trusts don't have to deal with money coming in and out, there's less administration to pay for. In addition, investment trusts have independent boards of directors representing the interests of the 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.
Those who buy funds through a financial adviser have been benefiting from so-called 'clean units' with ongoing charges of between 0.75% and 1% since 2013 - the financial advice is now paid for separately, by fee. Those who buy open-ended funds through fund supermarkets have been benefiting from clean units since April 2014. Cheaper open-ended funds could represent a challenge to investment trusts' traditional advantage of fees.
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.
Find out more: Are fund charges eating into your returns? - find out more about the impact of fees on performance