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Investment trusts under the bonnet
The benefits of investment trusts are often overlooked, but they can make an ideal holding for any investor
Despite their lengthy history, investment trusts have been the poor relation of unit trusts and OEICs for a number of years. Investors have been put off by unpredictable discounts, volatile performance and the taint of the split capital scandal at the beginning of the century. And advisers have been reluctant to recommend them because their charging structure doesn’t include commission payments. As a result, their undoubted advantages – low costs, liquidity and stability of structure – have been overlooked, and the sector has often only marginally featured in investors’ portfolios. So what is an investment trust? How do they work and what are the advantages of investing in one?
Both investment trusts and unit trusts are collective investments, ploughing investors’ money into a pool of holdings to ensure broad exposure and diversification. But whereas unit trusts are open-ended, investment trusts are closed-ended, and this is the root of many differences between the two.
As the names suggest, the size of open-ended funds is not limited. This means that when an open-ended fund receives new money or investors want to cash in their units, the pool of assets expands and contracts accordingly. In contrast, an investment trust manager always manages the same asset pool, no matter how popular the fund is.
It’s also easier to assess the worth of unit trusts: as the total value of the assets goes up, so does the share price. With investment trusts there are two layers to look at: the real value or net asset value (NAV), which is worked out by
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Investment trusts under the bonnet
1FIVE REASONS TO USE INVESTMENT TRUSTS IN A PORTFOLIO
AS A SOURCE OF INCOME Investment trusts have the ability to reserve income in buoyant times, which can help smooth the income return to investors in tougher years. Also, if an investor buys a trust at a discount, they get part of the income for free.
2AS A CORE HOLDING The large global general investment trusts often have lengthy track records, stability of management and a well-diversified portfolio. They can be cheap to access, with low minimum investment levels. As such, they make an ideal core holding for any investor.
3TO ACCESS SPECIALIST INVESTMENT CLASSES Many specialist investment classes – private equity, forestry, hedge funds – may be more suited to an investment trust structure because it allows for better management of assets with less liquidity. Some are only available through a closed-ended structure.
4TO GENERATE A LEVERAGED RETURN If an investor believes that equities are likely to move higher, an investment trust that offers gearing allows them to back that bet with higher conviction. However, if they are wrong, losses will be higher.
5FOR REGULAR SAVINGS Investment trusts tend to have low minimum investment levels and low costs. Many offer very cheap regular investment schemes, with a number specifically designed for children. As such, they make a good option for regular savings. However, investors should beware brokers that impose fixed dealing costs as this will add disproportionately to costs for small regular savers.
dividing the value of the holdings by the number of shares, and the share price (based on demand).
NAV AND SHARE PRICE When the share price is less than NAV, the trust trades at a discount, and when the share price is greater than NAV, it trades at a premium. The difference is expressed as a percentage of NAV.
To illustrate, if a trust is trading at a 20% discount to NAV, an investor can buy 100p worth of assets for 80p. If the trust were to be wound up, the investor would receive the full 100p of assets and have made a tidy 20p gain. Of course, trusts are not generally wound up and therefore the share price can stay at a discount to the value of the portfolio, though that discount may become larger or smaller (or turn into a premium) as demand for the trust shares changes or the portfolio value rises or falls.
Investment trusts are often a better structure for managing less easily traded investments, such as smaller companies or property. If an asset class falls quickly and investors rush for the door, managers of open-ended funds will have to sell out of their holdings just when prices are at their cheapest in order to return investors’ money, which can hurt performance. In contrast, investment trusts may move to an uncomfortable discount, but the manager does not have to sell his best holdings to deal with short-term market turmoil.
GEARING Investment trusts are structured as companies and listed on the stockmarket. This means, among other things, that they can borrow money to improve returns – a practice known as
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