What are investment trusts? - the basics
Investment trusts may have been overshadowed in recent decades by higher-profile unit trusts and open-ended investment companies (OEICs), but they have been around much longer.
The granddaddy of all collective investments, Foreign & Colonial Investment Trust, was launched in 1868 "to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk by spreading the investment over a number of stocks".
As F&C's 19th century marketing blurb suggests, collective investments, which include both unit and investment trusts, can help ordinary investors lessen the risks of investing by pooling their cash with that of lots of other investors to buy a portfolio of shares, rather than just one or two.
Diversifying in this way reduces the risk of any individual company's troubles scuppering your investment. Collective investments also have other advantages, including cheaper trading costs and professional management.
But while private investors can access more than 2,400 UK-domiciled funds (unit trusts and OEICs), worth £560 billion in total, as of the end of 2011 they had a choice of just 412 investment trusts, worth £90 billion. This is partly due to the fact that trusts are not promoted to the same extent as their more popular cousins.
Many financial advisers say they ignore investment trusts as they are ‘complex', ‘risky' and ‘only suitable for sophisticated investors', but while they may prefer the relatively simple structure of funds, the fact is that fund sales also bring them a commission, unlike investment trusts.
A better return
Yet the bottom line is that investment trusts tend to outperform funds by a significant margin over the long term. Morningstar data shows the average global growth trust returned 97% over 10 years to 8 March, compared with just 56% for funds in the equivalent IMA Global sector.
The differential is even greater in other mainstream sectors: for example, a hefty 359% in global emerging markets investment trusts, compared with 217% for the IMA Global Emerging Markets sector.
How they work
So how do investment trusts work, why do they tend to deliver better returns and what kind of investors do they suit? An investment trust is actually a listed company such as, say, Vodafone, except that it doesn't manufacture or sell anything but invests in other businesses instead. Like Vodafone, the trust will issue a fixed number of shares to raise capital, a better return which is why investment trusts are described as ‘closed-ended'.
The manager then uses that cash to buy shares in other companies, building a portfolio that contains anything from 20 to 100 or more holdings.
Investors in the trust can buy and sell their shares on the stockmarket. But the price of those shares might be affected by many factors, such as the economic climate or the current popularity of that area of investment. In other words, the share price on the open market reflects wider supply and demand issues, not just the value of the trust portfolio.
Because investment trusts have a two-tiered pricing system, involving both the share price paid by investors and the trust's net asset value or NAV (the total value of a company's assets minus the total value of its liabilities), there's an additional factor to consider – the share price's discount or, more rarely, premium to NAV.
Over the longer term, discounts tend to stabilise, so a wider than average discount may indicate either a trust with problems – the share price is low because no one wants it – or an opportunity for bargain hunters, as short-term returns will be boosted if the discount returns to its usual range.
The trust is trading at a premium when the share price rises above the NAV. Most investors steer clear of buying in such circumstances because premiums don't tend to be sustainable. It's likely the gap between share price and NAV will close again and those who bought at a premium will lose money.
But there may be times when a sector is particularly popular, and those trusts attract investors despite their premium rating. Investors' hunt for income, for example, has held the Global Growth & Income sector (yielding an average 3.5%) on a premium of around 1% since June 2010, according to the Association of Investment Companies (AIC).
In most cases, discounts and premiums are not that significant for long-term investors, although it's good to buy when a trust is on a wider than usual discount, as it's likely to narrow back towards its long-term average and help your returns.
There are other factors to bear in mind when considering investment trusts. Like other companies, they are allowed to ‘gear' or borrow extra money to invest. It's a relatively modest limit for most sectors – generally less than 10% – but racier markets may have higher limits. The effect of gearing is that shareholders have greater exposure to the market – again, great when it's rising but painful when it falls.
The two-level pricing system and an ability to gear both help investment trusts outperform funds when markets are rising, although trusts tend to lose out when markets are falling. But trusts also outperform as they tend to be cheaper than funds.
AIC research last May showed that two-thirds of trusts in the Global Growth & Income sector, and more than half those in the Global Growth and UK Growth & Income sectors, have a total expense ratio (TER) of less than 1%.
The cheapest, Independent Investment Trust in the Global Growth sector, has a TER of less than 0.4% – cheaper than many passive funds, let alone actively managed equity funds (the average TER of UK All Companies funds is 1.61%).
Who will they suit?
The closed-ended nature of investment trusts makes them a good way to invest in a portfolio of more specialist holdings that are harder to sell, because the manager doesn't have to worry about keeping cash available in case investors want to withdraw their money. Trusts are used to invest in portfolios of hedge funds, forestry and commercial property, for example, as well as specialist areas such as technology or single countries.
But so-called generalist trusts are equally suitable for more mainstream investors looking for a broad long-term portfolio, whether UK, Asian, emerging markets or global, especially as many have a special regular savings scheme to keep costs down.
It's clear investment trusts are designed for investors who are in it for the long haul – but if you can tuck your money away for, say, 10 years or more in a consistently performing trust in one of the mainstream sectors, you could find you've made a very sound investment decision.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
Investors who borrow money they use for investment and use the securities they buy as collateral for the loan are said to be “gearing up” the portfolio (in the US, gearing is referred to as “leveraging”) and widely used by investment trusts. The greater the gearing as a proportion of the overall portfolio, the greater the potential for profit or loss. If markets rise in value, the investor can pay back the loan and retain the profit but if markets fall, the investor may not be able to cover the borrowing and interest costs, and will make a loss. Also used to describe the ratio of a company’s borrowing in relation to its market capitalisation and the gearing ratio measures the extent to which a company is funded by debt. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.
A sophisticated absolute return fund that seeks to make money for its investors regardless of how global markets are performing. To that end, they invest in shares, bonds, currencies and commodities using a raft of investment techniques such as gearing, short selling, derivatives, futures, options and interest rate swaps. Most are based “offshore” and are not regulated by the financial authorities. Although ordinary investors can gain exposure to hedge funds through certain types of investment funds, direct investment is for the wealthy as most funds require potential investors to have liquid assets greater than £150,000m.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
Net asset value
A company’s net asset value (NAV) is the total value of its assets minus the total value of its liabilities. NAV is most closely associated with investment trusts and is useful for valuing shares in investment trust companies where the value of the company comes from the assets it holds rather than the profit stream generated by the business. Frequently, the NAV is divided by the number of shares in issue to give the net asset value per share.