Historically, investment trusts have delivered higher returns for lower costs than more popular open-ended funds such as unit trusts and open-ended investment companies (OEICs), but what are they and how are they different?
Unit trusts, OEICs and investment trusts, also known as investment companies, are all types of ‘pooled funds’, collective investments that spread money from multiple investors across a wide range of assets.
A bit of history
Before the Retail Distribution Review (RDR) changed the rules back in 2013, financial advisers could pocket commission when selling funds such as unit trusts. Investment trusts however, did not pay commission, which may help explain why unit trusts are better known (and have more assets).
Investment trusts have actually been around longer than unit trusts, with many surviving and thriving through wars, depressions and downturns. The venerable F&C investment trust was launched more than 150 years ago, to bring the benefits of the stock market to ‘the investor of moderate means. Unit trusts only hit the market in 1931.
Where investment trusts differ is that they are actually companies listed on the stock market. And because investment trusts issue a fixed number of shares, they are known as ‘closed-ended’ funds. This has a few important implications.
There is a board of directors
Because investment trusts are listed companies, they have to have an independent board responsible for looking after the best interests of the shareholders. The board appoints a fund manager to do the actual investing and can query the performance, enforce discount/premium (more on that later) management policies, and put pressure on fees.
You buy shares, not units
You invest in investment trusts by buying shares, and, as for any listed company, the share price will go up and down, depending for example on the popularity of the individual trust or the area in which it invests, and the performance of the underlying assets. The value of the underlying assets, minus any loans or debts, is called the net asset value (NAV).
The value of your investment is based on the share price of the investment trust, not necessarily the value of the underlying assets (which is the case for open-ended funds). In reality however, the share price of the investment trust tends to move with the value of the underlying assets, but there might be a discrepancy (a bit like some ETFs).
The shares may trade at a discount or a premium
If the share price is higher than the NAV, the investment trust is said to be trading at a ‘premium’. On the flip side, if the share price falls below the NAV, the shares trade at a ‘discount’. This basically means that you can buy assets via the investment trust for less than it would cost if you were buying them direct.
In practice, many investment trusts have policies in place to manage large discounts or premiums. The board may for example decide to buy back shares or allow shareholders to sell some of their shares back to the company at a price closer to the NAV if the investment trust is trading at a significant discount. Conversely, if the trust is trading at a large premium the board may decide to issue shares in order to bring back the price closer to the NAV.
Can be good for illiquid assets
Because investment trusts are listed companies there isn’t an immediate rush to sell underlying assets even if investors are selling the shares of the trust. This can be a great benefit when investing in illiquid assets that are hard to sell in a hurry, such as property or unlisted companies.
In contrast, with open-ended funds, the manager could be forced to sell assets to free up money for investors who want their money back, or in worst case scenarios, be forced to suspend trading if they can’t sell assets fast enough.
They have special powers
Investment trusts are also allowed to do a couple of things that unit trusts can’t. Unlike open-ended funds, investment trusts can hold back some of the income they make in good years, to pay out when times are hard. This ‘smoothing’ has enabled 20 investment trusts to pay out rising dividends, year after year, for more than 20 years, and can be particularly helpful for those looking for a regular income, such as retirees.
Investment trusts are also allowed to borrow money to invest, known as ‘gearing’. The level of gearing in an investment trust is expressed as a % on the factsheet or in the related information on the platform you are using to invest. This leverage can turbocharge returns when markets are flying but can also magnify losses when markets take a tumble.
The pros and cons
Here’s a quick run through the benefits and drawbacks of using investment trusts as a haven for your money:
- Suitable for investing in assets that are harder to sell, such as property, infrastructure and stakes in unlisted companies;
- Pick up more assets for your money, when investment trust shares are trading at a discount;
- Independent board acting on behalf of the investors, as shareholders;
- Track record of delivering higher returns, at lower cost, over the long term;
- Ability to keep back reserves and pay out more consistent income;
- The potential for gearing can enhance returns.
- More complicated to understand than unit trusts;
- Need to pay stamp duty and typically share dealing fees when buying and selling investment trusts, while trading in unit trusts is often discounted, or free;
- Share price can trade at a premium compared to the assets owned by the trust;
- Shares in smaller, less popular, investment trusts can be harder to sell, and smaller trusts may also find it harder to manage discounts should prices fall, particularly if they invest significantly in illiquid assets;
- Losses can be magnified by gearing.
Investment trusts can involve more of a rollercoaster ride than their open-ended equivalents, due to peaks and troughs driven by gearing and share price discounts and premiums.
However, large, long-established, global trusts can provide a core holding, and the closed-ended structure is more suitable for certain types of hard to sell asset, such as property. Investment trusts can also provide more predictable income for income-seekers, although dividends are never guaranteed.
Over the long term, the greater risks with investment trusts have the potential to pay off in greater returns. They may still not be right for your own portfolio, but they are worth a closer look before you rule them out.
The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.
When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.