Investment trusts have never been this expensive – is it time to sell?

We’ve always been big fans of investment trusts here at MoneyWeek magazine.

Investment trusts are similar to unit trusts (traditional funds) in that they employ a manager to run a portfolio of shares (or other assets). But a major difference is that shares in the trust itself trade on the stock exchange.

This means the trust’s share price moves independently of its portfolio. So it doesn’t always reflect the underlying value of the stocks it holds. That in turn means that you often get the opportunity to buy the underlying shares for less than they’re actually worth.

This chance to buy when shares trade at a ‘discount’ is one of the many things we like about investment trusts.

So it’s a little irritating that the rest of the investment world finally seems to be cottoning on. Because it seems that the bargains are fast disappearing…

Investment trusts are more popular than ever before

The discount on the average investment trust has narrowed to the lowest level – just 3.4% – since records began in 1970.

In other words, if you buy shares in an average investment trust, the share price would be only 3% below the trust’s net asset value.

That doesn’t look like a bargain. Even worse, around 20% of trusts are actually trading on a premium to their net asset value. In other words, by buying these trusts, you’re paying more than the underlying portfolio is worth.

So why has this happened? And have investment trusts lost their sheen?

Well, there’s no doubt that rising stock markets have played a big part in driving trusts higher.

When markets are in the doldrums, investment trust discounts usually widen (in other words, shares in trusts fall harder than their portfolios) as people pull their money out of the market. The opposite applies when times are good.

This has happened in every market cycle since 1970, so the fact that discounts are narrowing today is not unusual. What is unusual, however, is just how far they’ve narrowed. So we can’t just put it down to a buoyant market.

I suspect that what’s super-charged trusts is the big change to regulations governing financial advice – the Retail Distribution Review (RDR), which came into force from the start of this year.

Under the old rules, fund management companies could pay commission (aka bribes) to financial advisers for recommending unit trusts and OEICs (open-ended investment companies). But investment trusts never paid commission to advisers.

Under the new rules, financial advisers can’t be paid commission for any fund, so investment trusts are now competing on a level playing field. We said in 2012 that this change would boost demand for investment trusts, and it looks like that’s starting to happen.


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It’s not just the discounts that make trusts attractive

It’s a shame that discounts have narrowed. It’s always nice to buy assets on the cheap.

But that doesn’t mean you should completely ignore them. Investment trusts have other attractions. For starters, managers can borrow money for the trust and buy more shares if they wish (known as ‘gearing up’). Unit trusts and OEICs can’t do this. When share prices are on the up, borrowing can deliver a nice boost to performance – although you should remember that the reverse is also true.

What’s more, I like the fact that all investment trusts have independent boards. If these boards are unhappy with the fund management company that is running the trust, they can switch to another manager.

Investment trusts have also delivered strong performance in recent years, and it’s not just down to discounts narrowing. As John Authers points out in the FT: “UK investment trusts have trounced their competition, and their benchmarks, and they have done this over one, three, five and ten years.”

Over the last ten years, the net asset value of the average UK All Companies investment trust has risen by 321%, whereas the FTSE All-share only rose by 243.6%.

Some trusts also have lower charges than rival OEICs and unit trusts. That said, you do need to be careful here – not all investment trusts have low fees, and as the RDR continues to transform the industry, the gap is likely to keep closing. I’ve just done an analysis of all the investment trusts in the FTSE 250, and the average total expense ratio (TER) is 1.03%. I’d be reluctant to invest in an investment trust with a TER higher than 0.9%.

Some even argue that discounts just aren’t that important. For example, John Newlands at Brewin Dolphin argues that performance is really what counts. On his argument, if you buy a trust at a 2% premium and then benefit from very strong performance, why would you complain?

I wouldn’t go that far, I have to say. I can understand Newlands’ point, but I’d still be extremely reluctant to buy a trust on a premium. Why pay a premium when I could buy the underlying shares in the trust myself for less?

But given the advantages that investment trusts offer, I’m happy to invest on a small discount if I’m convinced that the manager and fund are very strong and the charges are reasonable.

So what is the discount telling us?

When I first saw that discounts had narrowed so much, I thought this might be a signal that we should be avoiding investment trusts. But in truth, I think it’s sending a much wider message – it’s another signal that the UK stock market is looking a little pricey.

In other words, this probably isn’t the best time to invest, particularly in property and infrastructure sectors where many funds are at a premium. One particularly expensive example is the Standard Life Property Income trust which trades at a 22% premium, albeit with a 6% dividend yield. Some income funds also look pricey. But if you are looking for active fund management in a specific sector, then a good quality, inexpensive trust is still a good way to do it.

We’ve been running an investment trust portfolio in MoneyWeek magazine for a couple of years now. The ultimate goal of the portfolio is to be boring – we’re looking to beat inflation, and to preserve our capital in the hard times. We also look at taking profits on the more successful trusts and trying to find ones that still look good value. You can read the most recent update here. If you’re not already a subscriber, get your first three issues free here.

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  • Pete Comley

    I’m pleased this article highlights the higher ongoing costs of Investment Trusts. Compared with ETFs (especially ones like Vanguard) they are massively higher. For example, their FTSE100 ETF has a TER of just 0.1%, not 1%. Moreover that probably includes all the hidden charges which not all Investment Trusts do.

    If that was not bad enough, you have to pay dealing charges when buying a Investment Trust (although only about £10, that is still 1% if you’re buying £1000 worth). In addition you pay 0.5% stamp duty and suffer a bid/offer spread. Therefore you can often have lost 2% of your investment before you’ve even factored into account that the Trust might be trading at a premium.

    I can see that lots of people have switched to Investment Trusts post RDR but do they realise that they have probably ended up with higher charges than the Unit Trust they switched from? MoneyWeek needs to be a bit more impartial and make their high costs much clearer to their readers.

    Pete Comley
    Author – Monkey with a Pin
    PS I do not hold any Vanguard ETF funds nor have anything to do with that company. I’m an independent analyst/author.

  • buygeorge

    A good article and very interesting. Another reason trusts have out-performed is that many are geared. Investing £1 of assets can in some cases bring benefits of £1.25 of investments. When markets become more volatile or decline the discount will widen to reflect this gearing element. If you are cautious on the market and trusts in particular this factor of ‘geared falling prices’ is relevant I think to your case.

  • hanzando

    Why pay a premium when I could buy the underlying shares in the trust myself for less?

    You must have VERY deep pockets if you can buy the assets of even the more concentrated trusts. Surely we buy trusts to spread the risk over a far greater area than most individuals can manage, or to buy more niche areas of investment to complement our individual shareholdings.

  • Orchardsparks

    You will often find that a significant proportion of a fund manager’s portfolio is in a small number of shares. Whilst you might miss on a nascent Apple by omitting the rest it is possible to DIY.

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