Things are looking good for investment trusts right now. Last week, Morningstar released figures on what sort of investment funds people are searching on their website. They found that investment trusts, companies set up to invest in other companies, are becoming more and more popular.
Today, I want to explain why this is happening, and suggest a few ways you can profit from this trend.
We picked up on this ages ago
Morningstar is the go-to comparison website for pooled investment funds like unit trusts, open-ended investment companies (OEICs), exchange-traded funds (ETFs) and investment trusts. That gives Morningstar plenty of really useful analytical information.
The fact that last week they issued a press release detailing the increasing relevance of investment trusts is very interesting.
But perhaps it shouldn’t be all that surprising. At the beginning of the year, I pointed out that 2013 would see the sector’s popularity increase. The introduction of the Retail Distribution Review (RDR) means independent financial advisers (IFAs) are no longer heavily incentivised to put clients into expensive unit trusts and OEICs. RDR has opened both investors and IFAs to a sector of pooled funds offering some fantastic opportunities.
What’s more, because of the way investment trusts work, investors have benefited from some one-off gains as trusts moved from discounts to premiums.
Don’t worry if you don’t understand the terminology – all will be revealed in a second. But the point is, the Morningstar data reveals that the trend towards investment trusts is still in play. And though some of the one-off gains have been pocketed, I can still see plenty more opportunities in the sector.
What’s going on?
Funds like unit trusts, OEICs and ETFs allow investors to buy a diversified holding of investments through just a single stock. The price you pay is the net asset value (NAV) of the underlying portfolio, plus fees levied by the provider.
Investment trusts, on the other hand, work differently. This is a company in and of itself, like any other you’d buy on the stock exchange. The only thing is, it’s a company set up expressly to invest in the shares of other companies. And like any other stock traded on the exchange, it trades according to market supply and demand, not its NAV.
That means the stock can trade at a premium (higher than NAV) or discount (lower than NAV) depending on how keen investors are to get in on the deal.
Over the many years that I’ve been involved with investment trusts, I’ve found that they nearly always trade at a discount – even as big as 40%, or 50% on occasion. But one of the interesting things about the data revealed by Morningstar is that of the ten most popular trusts searched, nine now trade at a premium to NAV. That hit me like a bolt out of the blue!
Investors are increasingly seeing value in a sector that I believe has been significantly undervalued for decades. Why were they so undervalued? Because investors have been focusing on the pooled funds run in the interests of the financial industry. Funds that have skimmed big fees from clients over the years.
In the last few years, new research reveals that not only have investment trusts been cheaper, but as a sector, they’ve outperformed their more expensive rivals too.
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Three reasons why investment trusts do better
You should be aware that investment trusts are not as highly regulated as the industry’s favoured funds. At first sight, that may seem to be a downside. But to my mind, it’s a good thing.
Regulation can be stifling. For instance, there are all sorts of rules about what unit trusts can invest in – and how they operate their investments. That stifles the fund manager.
And of course, somebody has to pay for all this regulation. And ultimately, that comes down to the investor. After all, they’re paying for the fund manager’s internal compliance as well as the regulatory fees.
This light-touch regulation means that an investment trust investor should keep a close eye on his investment. These days you can download the key information from the investment trust’s website – it’s definitely worth doing your homework. But the point is, investment trusts offer the fund manager massive flexibility to go out and chase what he feels are the best investments – and in the right hands, that can be very useful.
The second reason investment trusts tend to do well is because, as a company, they can borrow money and use it to leverage the portfolio. This is known as ‘gearing’.
Gearing tends to work well in a rising market – something we’ve benefited from over the last few years. But watch out – this can come back to bite you in a falling market. The fund manager’s skill is in harnessing the benefits of gearing during the good times, and reining it in during less auspicious moments.
The third reason investment trusts tend to do well is the fact that they’re very limited in how they can promote their own businesses. Unlike the industry’s mainstay funds, these guys don’t have to waste time and money greasing the wheels of the IFA lobby.
And the managers aren’t hamstrung by following the IFAs’ quarterly league charts. Many fund managers think short-term, wanting to hit the ‘top of the charts’ for any given quarter.
If they hit the spot, they may get noticed by the financial advisers. And if they get noticed, the IFAs may put their clients into the fund. That means more fees for the boys.
Investment trusts, on the other hand, are ‘closed’ funds. If they perform well, and happen to attract more investors, all it does is drive up the share price. It doesn’t actually really affect the fund manager’s fee in the same way it does for ‘open’ funds.
That means there’s no real incentive for short-termism. The fund manager is left to get on with the job of investing for the long term. Remember, many of these funds have been around for over 100 years. For them, it’s the long-term performance that matters – and that gives the manager a much more satisfactory long-term investment horizon. I’m all up for that!
There’s still plenty of bargains to be had
Now, though Morningstar’s research reveals that the most popular investment trusts have been bid to a premium, still the vast majority trade at a discount to NAV.
So, there are still plenty of lesser-known investment trusts that are worth a look. I’ve mentioned quite a few in the past. For instance, Worldwide Healthcare Trust, Ecofin Water and Power Opportunities, Witan, and the JPM Russia fund.
And MoneyWeek editor-in-chief Merryn Somerset Webb has set up a portfolio of six of the best. You need to be a MoneyWeek subscriber to get access though. You can get a trial subscription here if you’re interested (the first three issues are free).
My colleague Ed Bowsher is also a big fan of investment trusts. He’s made a video explaining why.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
Information in The Right Side is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. The Right Side is an unregulated product published by Fleet Street Publications Ltd. Fleet Street Publications Ltd is authorised and regulated by the Financial Conduct Authority. FCA No 115234. http://www.fsa.gov.uk/register/home.do
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