Investment trusts may be old but they are worthy of consideration. Adrian Mill looks at why investment trusts are sometimes misunderstood by investors and when and how to use them in client portfolios.
New and increasingly complex financial instruments have their place in the investment world, but sometimes longevity across many market cycles is a mark of success. Certainly, this can be said of investment trusts, now often called investment companies, which are the oldest form of collective investment.
The first investment trust was created by Foreign & Colonial, back in 1868 – and it continues to run to this day. The Association of Investment Companies, the AIC, dates from 1932 and was formed to inform investors about investment trusts. Their mission is “to support and promote the long-term benefits of investment companies by engaging with members, investors, and the wider financial community”.
Despite existing for a long time, investment trusts are sometimes misunderstood and investors, both private and professional, may feel that there are aspects of their structure which are risky, compared to open-ended funds. Indeed, risk exists, but with risk comes possible opportunity. Therefore, an understanding of investment trusts can help point to their positive potential.
For paraplanners and other investors wishing to read some facts about investment trusts, summarised below is a selection of points to consider, as a brief overview:
What are investment trusts, also known as investment companies, and how do they work?
• Investment trusts are closed-ended investments. They are listed companies which have a fixed number of shares, traded on exchanges. These shares are invested across a basket of assets, such as equities. This allows investors to invest a relatively small amount of money and gain exposure to a number of companies, which would be impossible to do if buying stocks directly, using the same amount of money.
• As investment trusts are companies, they have independent boards of directors. The boards appoint the investment managers responsible for managing the investment trusts.
• Unlike open-ended funds, investment trusts may employ modest gearing. Risk is increased when gearing is used, however this magnification of returns can generate significant outperformance, although any falls would be amplified too.
What does it mean if an investment trust is trading at a Discount or Premium?
• The net asset value (NAV) of an investment trust varies over time, but the share price can trade at a different level from this. The share price will not track the NAV because of supply and demand in the market.
• The share price of an investment trust could be higher than the NAV if there is strong demand in the market for its shares. This excess demand leads to a share price Premium, which is quoted in terms of percentage of NAV. If a Premium persists, the board of an investment trust may issue shares to help reduce it.
• Conversely, out-of-favour trusts may lead to the shares trading below NAV. Such a share price is called a Discount. If this situation persists, the board of an investment trust may undertake share buybacks to reduce the number of shares in the market, thus narrowing the Discount.
• If an investment trust is bought at a Premium and sold at a Discount, then this will be a source of negative return for an investor, separate from the underlying share price movement between purchase and sale.
• If an investment trust is bought at a Discount and sold at a Premium, then this will a source of positive return for an investor, separate from the underlying share price movement between purchase and sale.
What do they offer and why should they be considered?
• They have diversification benefits for asset allocation, when considered alongside other types of investment. When investment trusts invest in a portfolio of firms, they help to reduce stock-specific risk.
• There is a very wide range of sectors in which to invest and a good selection of investment trusts within these sectors.
• The structuring of investment trusts allows for some hard-to-access, more esoteric themes to be accessed.
• The scale of investment trusts may allow their investment managers to gain superior access to the boards of investee companies, for improved understanding of governance issues.
• Investment trusts must distribute at least 85% of income in each accounting period, rather than the 100% required for open-ended mutual funds. This allows boards to retain 15% of income, which can be placed in revenue reserves. In turn, these reserves may be accessed to boost income in leaner years and maintain smoothness of income.
• Shareholders can be active in their monitoring of the trusts’ governance by the independent boards of directors.
• Investment trusts have fixed capital, apart from when their boards decide to undertake share issuance or buybacks. As capital is not required to be liquid to cover potential redemptions, as is the case for open-ended funds, then investment trusts can access longer-term investments or investments with poorer liquidity, such as property, if that is in line with their objectives.
• The presence of boards of directors is positive for investors. There is a separation of roles between the board and the investment managers which they appoint, so this reduces the chance of possible conflicts of interest. Furthermore, boards help investors in other ways:
– they set dividend policy.
– they manage the number of shares in issuance when investment trusts are enduring sustained periods of premium of discount.
– they negotiate fees on behalf of investors.
• Open-ended funds trade daily, but investment trusts may be traded on an intraday basis on an exchange, just like any other listed company. This may be helpful for the timing of dealing.
I hope that after reading this brief summary about investment trusts, you might wish to take another look at the various aspects of their structure, operation and coverage. They range from mainstream core growth investment trusts to those specialising in unusual sectors, which might be suitable as satellite holdings. There really is something for most investors to consider, but the usual caveats remain regarding past performance not being a guide to the future and capital being at risk.
The AIC is a useful resource and there are a number of independent companies which provide high-quality research for paraplanners, IFAs, other investment professionals and private investors alike.
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