Put your faith in investment trusts

Investment trusts are a much better place to put your cash than unit trusts, says Tim Bennett. Here's why.

If you had asked a financial adviser to recommend a fund for you over the last decade, the chances are they'd have sold you a unit trust. Why? Because they'd have been paid a generous commission to do so. That's one reason why funds under management within unit trusts have soared by around 120% in the last ten years. But we prefer their less popular rivals, investment trusts, where funds under management are up just 18% over the same period. Here's why.

Investment trusts perform better

Investment trusts are seen as the poor relation to the larger unit-trust sector. That's in part because unit trusts can spend more on marketing; and partly because of the reputational hangover from the split-capital mis-selling crisis that hit the sector in the early 2000s. Yet when it comes to performance, "there's just no stopping those fuddy-duddies", as broker Collins Stewart puts it. Their research shows that over the past decade, investment trusts beat unit trusts in eight of nine key sectors (the only sector they struggled in was small caps).

How do they do it?

The simple truth is that if you pick an investment trust and a unit trust with the same investment strategy, the chances are the investment trust will win. That's because they boast four major advantages.

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1. Cost: the initial charges on unit trusts typically range from 4%-6%. You can often get these rebated via a fund supermarket, but there's still the annual fee, where a hit of between 1.5% and 2% is common. An investment trust also levies annual fees, but on average they're lower. Why? Firstly, because investment trusts are companies and as such are barred from 'ramping' their share prices. That limits what they can spend on marketing. Secondly, most investment trusts don't pay commission to financial advisers.

2. Gearing: like other firms, investment trusts are pretty much free to borrow for investment purposes (subject to any restrictions written into their constitution the 'memorandum and articles'). Unit trusts, on the other hand, are usually restricted by regulation. External borrowing can cut both ways, of course (a badly run fund that is geared can be a disaster), but when markets are rising and the trust is run well, gearing will deliver superior returns. See the box for more.

3. Size: investment trusts tend to be smaller than unit trusts on average and so are less unwieldy and more focused on their investment objectives. To grow beyond their initial remit they need permission from shareholders. Many also have a fixed life expectancy. Conversely, unit trusts are called 'open ended' because they can expand and contract to meet demand. Big can be beautiful, as it comes with economies of scale and extra buying power, but some simply get too big and lose their focus in the process.

4. Discounts: because their shares are listed and traded freely (unlike a unit trust, where all deals go via the fund manager and a unit price is only available at prescribed times), investment trusts can end up with a market capitalisation that is greater than (at a 'premium'), or lower than (at a 'discount'), its assets under management (the 'net asset value', or NAV). In effect, a 5% discount means every £1 of assets in the trust is available for 95p (ignoring liquidation costs should you try to wind up the trust and extract this extra value). If the discount narrows after you buy you'll make a small gain on top of any increase in the trust's NAV.

Critics argue that these discounts reflect the market's doubts about the trust's investment strategy and the fact that it may be geared. But for the right trust, gearing is an advantage. Frankly, were investors able to price discounts into unit trusts (they can't because the price of a unit is directly tied to the fund's NAV) you can be sure many of them would be huge!

What to buy

So which trusts look attractive right now? Some of the best outperformance was seen in the Asia Pacific ex-Japan sector, says Collins Stewart. In emerging markets, my colleague Cris Sholto Heaton has long tipped the Scottish Oriental Smaller Companies Trust (LSE: SST), which is trading on a discount to NAV of just under 6%. But be aware that the small-firm bias can make this trust volatile over the short term. For a play on larger-cap Asian stocks, he likes the Aberdeen New Dawn Trust (LSE: ABD) on a discount of just under 7%. The Motley Fool's Harvey Jones also likes Baring Emerging Europe (LSE: BEE),which is 60% exposed to Russia and comes with a 7% discount.

How gearing works

Take two identical funds, A and B, with assets under management of £100m. A is funded solely with shareholder capital; B is funded 50% by debt (so £50m in equity and £50m borrowed). Assume the funds both double in size to £200m. If they were each liquidated, fund A's shareholders would make a profit of £100m. However, shareholders in B would make a profit of three times their initial investment, turning £50m into £200m. That's because once the £50m of debt is cleared, £150m of profit (£200m-£50m) is theirs.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.