Investment Trusts

Investment Trusts have had a difficult time recently and the sector, as a whole, is trading at a relatively large discount. Investment Trusts have also hit the headlines over the last week or so because of the stakes taken in various Investment Trusts by the US Hedge Fund, Saba Capital.

I know that many investors read the Questor column in the Telegraph and they often include Investment Trusts in their portfolio.

As such, I thought I would write an article taking a deep dive into Investment Trusts.

As always, please remember this is not formal investment advice and should not be construed as an investment recommendation.

A Brief History

The first Investment Trust specialised in investing in Government Bonds and was established in 1868 as the Foreign & Colonial Government Trust, known today as the Foreign & Colonial Investment Trust.

In Victorian times, Investment Trusts were created as a way of enabling investors of more modest means to access the stock market.

What Are Investment Trusts?

Investment Trusts are simply companies that are listed on the stock exchange that make investments in shares, bonds, property or other assets and aim to grow the value of them on behalf of its shareholders. They are often referred to as being ‘Closed-ended’ as compared to a Unit Trust or OEIC which is referred to as being ‘Open-ended’.

Implications of Being Close-ended.

An Investment Trust can invest in a range of assets and the total sum of the assets is known as the Net Asset Value (NAV). For example, if an Investment Trust owned £500m of Property and £500m of shares the NAV would be £1bn. This is similar to a Unit Trust or OEIC.

However, the shares of an Investment Trust tend to be finite which means that the share price can go up or down not necessarily in line with the value of the underlying assets. This leads to the Investment Trust trading at a premium or discount to its NAV.

For example, if investors think that the share price of the Investment Trust is going to go up, perhaps because the fund manager has a good track record or the particular sector is doing well, the shares of the Investment Trust will be worth more than the underlying assets – a premium.

Conversely, if investors believe that the fund manager is not doing particularly well or the sector is out of favour, the shares of the Investment Trust will be worth less than the underlying assets – a discount.

When buying an Investment Trust it is important to take into account whether the shares are trading at a premium or discount to its NAV.

Open-ended investments always trade at NAV. This is because when an investor buys units in a Unit Trust or OEIC, the fund manager buys more of the underlying assets and creates more units in the fund.

Borrowing (Gearing)

Unlike Unit Trusts or OEICs, Investment Trusts can borrow money in order to invest and grow the fund and improve performance. Of course, if the fund manager doesn’t use the borrowed money wisely, it can exacerbate poor performance.

Being aware of the level of gearing within the Investment Trust is important when making an investment.

Liquidity

Investment Trusts are often used to purchase illiquid assets such as Property, Renewable Energy and Infrastructure assets. The fact that shares in these Investment Trusts can be bought and sold on a Stock Market provides a degree of liquidity for investors who wish to hold illiquid assets.

This compares with Unit Trusts and OEICs which find it difficult to provide liquidity in times of market distress. This is particularly the case for Property funds. For example, when a large number of investors want to sell a Property Unit Trust, the fund manager will have to try and sell one or more of the underlying assets which can prove to be difficult often resulting in that fund being suspended for a period of time.

For mainstream Investment Trusts liquidity is not generally an issue with shares readily tradable on a stock exchange.

Diversification

Being able to hold illiquid assets means that Investment Trusts can provide a degree of diversification that might not be available to close-ended investments. Holding assets such as Property, Renewable Energy and Infrastructure means that investors can hold assets that might have a lower correlation to the more traditional investments of Equities and Bonds.

There are a number of more esoteric investments available such as funds investing in Music Rights, Hydrogen Technology and Space Technology.

Income

Investment Trusts do not have to pay out all of the income they generate and can retain up to 15% in reserve which can then be paid out in future years especially if dividend levels fall. There are a number of Investment Trusts who have been able to increase their dividends for the past 50 years or more.

For those Investment Trusts that hold ‘real assets’ such as Property, Renewable Energy or Infrastructure, there is often a link to inflation in respect of the income generated by the assets that they hold.

Independent Oversight

Each investment trust has an independent board that acts in the best interests of shareholders, rather than those of the fund manager. It means that the board can push for a reduction in charges, a change in mandate or to replace an underperforming manager if this is deemed to be in the interests of the shareholders.

Voting Rights

Investors also have a say in how Investment Trusts are run, voting on major issues such as whether a trust should continue to exist. Investors in Unit Trusts or OEICs get very little say in how the fund is run.

Greater Transparency

Investment Trusts have to abide by the stock exchange listing rules which open-ended funds don’t have to. This means that Investment Trusts are more transparent in their reporting requirements and their annual and interim reports are typically much more detailed compared to those of Unit Trusts and OEICs.

Fund Size

An Investment Trust, by controlling how many shares are in circulation, can broadly control its capacity i.e. how large it gets. Open-ended funds can’t do this which means that a successful Unit Trust fund manager can start out with a relatively small fund but once more and more investors put money in, the fund grows to a size which could have a detrimental impact on performance or force the fund manager to ‘soft close’ the fund and restrict new investments for a period.

Competitive Fee Structure

Generally speaking, Investment Trusts charge lower fees than their open-ended equivalent particularly where an Investment Trust invests in relatively liquid assets such as Equities. Where Investment Trusts invest in Property or other illiquid assets such as Renewable Energy and Infrastructure, the costs can be higher.

Although fees are generally competitive, there are other costs that you should be aware of:

Bid / Offer Spread – this is the difference between the cost of buying the shares of the Investment Trust (the Offer price) and selling the shares (Bid price).

Stamp Duty – you will normally have to pay stamp duty of 0.50% on UK listed Investment Trusts.

Transaction Costs – depending on whether you use an investment platform or which investment platform you use, there may be a transaction cost for buying and selling shares in Investment Trusts.

Conclusion

Investment Trusts offer a number of similarities to open-ended funds such as Unit Trusts and OEICs and for many investors, both Investment Trusts and Unit Trusts/ OEICs can be held in their portfolio. Investment Trusts are generally preferred when investing in illiquid assets but the Discount or Premium to NAV and the level of gearing should be taken into account.