Three reasons to buy investment trusts

published 1 August 2007

When investors are thinking about putting their money into a fund, their thoughts often turn first to unit trusts. But another type of collective investment, investment trusts, offer some distinct advantages in terms of costs, yet are surprisingly low profile. Cynics might argue that this could be something to do with the fact that independent financial advisors don't get paid a commission for recommending such trusts. In any case, here's a reminder of the benefits of investment trusts particularly pertinent right now when a number of good ones look to be a bit of a steal.

Simply put, investment trusts are just companies, listed on the London Stock Exchange, that make a living by buying shares in other listed companies. The directors choose the investment strategy and are allowed to borrow funds to meet their goals. As with any other company, the share price is ultimately determined by supply and demand. This is quite different to a unit trust, where units, rather than shares, can only be bought and sold via the fund manager at set points during the day and where the unit price always reflects the underlying assets.

As soon as you buy into an actively managed fund you are handing a chunk of your money over to a professional fund manager to cover administration costs, salaries and advertising spend, among other things. Unit trust fees can be pretty brutal a 5% entry charge is not uncommon (though avoidable if you use an intermediary), plus an annual fee of say 1% to 2% and sometimes an exit fee on top. Investment trust shares, on the other hand, are bought and sold like any other shares. There are still costs to consider, such as stamp duty at 0.5% when you buy, the bid/offer spread, and any broker charges, but you will still be paying quite a bit less overall and management fees also tend to be lower. This is partly down to UK advertising rules unit trusts can spend a fortune on marketing, but investment trusts, being companies, are not allowed to "ramp up" their own shares and so marketing spend tends to be lower.

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Unlike unit trusts, investment trusts are allowed to borrow money to "gear up", which can enhance returns although it can also exacerbate losses. Let's take a simple example: suppose you have two funds with identical investment strategies and £100 in shares. Fund A, a unit trust, is financed 100% with equity (money from investors) and Fund B, an investment trust, is financed 50% with equity and 50% with debt. Let's assume that both have a good year and the assets under management double to £200 in each case. If fund A is now closed, it has £200 available to return on the original equity stake of £100 so anyone who invested at the start has doubled their money. But things look even better in Fund B. It has the same £200 available, but £50 goes on repaying debt, while £150 is left to repay investors who only put in £50 in the first place, and so have tripled their money. Of course, in a bad year an investment trust with borrowings will underperform an unleveraged unit trust. But choose the right trust and a bit of gearing will spice up your returns very nicely.

Back towards the end of 2005, MoneyWeek editor Merryn Somerset Webb bemoaned the lack of inexpensive-looking investment trusts most were trading close to their underlying net-asset value, or even above it. However, the situation has changed. Today, large numbers of investment trusts are trading at large discounts to their net-asset value. On Trustnet.com you can see that of the 268 trusts listed, over 80% are trading at a discount and for 65 of them it is greater than 10%. A discount (or premium) arises because buyers and sellers at the London Stock Exchange determine the share price for the trust, which drives its market capitalisation, whereas the net-asset value of the underlying portfolio held by the fund is based on the market value of the investments chosen by its manger. When the market capitalisation of the investment trust itself is less than the value of the portfolio it manages, you get a discount. This may reflect some investor pessimism about the sector or management team, or just the fact that the ability to gear carries extra risk.

So why is this a great opportunity? Well, pick the right heavily discounted investment trust and you get a double whammy in terms of returns. You will get the performance of the underlying portfolio reflected in a rising share price for the investment trust itself over time.However, if, on top, the discount narrows (the market capitalisation and portfolio values start to align more closely), or even disappears altogether, you get an additional kicker for free. With some large, well-established trusts trading at discounts in excess of 10%, this is ever-more likely to happen as arbitrageurs (traders) start to buy into the investment trusts and short the stocks they hold.

The following are worth a look as they all have strong performance track records, but currently trade on substantial discounts. While these could widen a little further in the short term, for patient investors there should be some handsome returns to be made. For those who don't mind a bit of risk, Edinburgh Dragon Trust, on a 13.1% discount, is highly geared but has returned 150% over five years, focusing on large-cap Far Eastern equities. Offering a similar performance is JP Morgan Russia, on a discount of 11.1%, which is up 42% this year alone. Investors looking for less volatility could consider Murray Income, on a discount of 10.1%, or Keystone, on a discount of 13.2%, which both hold a range of UK large-cap shares with decent dividend yields.

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.