Don’t invest in another fund until you’ve read this

I've always been a big fan of investment trusts (ITs). And here in The Right Side, I've shared with you some ideas for good ITs to hold.

Judging by some new research out from financial services firm, Bestinvest, we're right to put our faith in this investment class. Take a look at this...

As you may know, many fund managers offer both unit trusts and ITs. Let me briefly explain the difference.

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ITs are basically companies that are quoted on the stock exchange just likenormal company shares. You can buy them through your stock broker and all you pay are your normal broker fees.

The sole purpose of an IT is to buy a portfolio of shares. The first one was set up by Foreign & Colonial way back in 1868. It allowed investors to buy a diversified mix of shares with just one investment.

Today, there are hundreds of specialist trusts covering everything from commodities, to countries and sectors. I've alerted you to quite a few over the last couple of years. You could, if you wanted to, invest your whole pension fund using just ITs. And if I wasn't so keen on a hands-on' approach to my investments, that's exactly what I'd do.

How unit trusts are fleecing private investors

Now, as I said, many fund managers also offer unit trusts. These are the industry standard product. They are stringently regulated and there's a standard model for fees too... one that fleeces punters up to 6% initially and then around 1.5% to 2% a year. Now that's quite a difference compared to an IT where your in-fee (broker commission and stamp duty) is nearer 1% and your annual fee isusually less than 1%.

But we already knew that. So what's new? Well, as Merryn Somerset Webb pointed outthis week, the interesting bit of research by Bestinvest shows that fund managers are producing much, much better results on their ITs. There's more to this than just fees.

Take one of my favourite fund managers, Neil Woodford. The unit trust (or open-ended fund) he manages has grown by 58% over the last three years. That's pretty good. But not when you compare it to his IT, which has doubled over the same period!

Take a look at this table from The Sunday Times recently. We can see a similar story from some other big-hitting fund managers:

How the star managers' returns compare

Source: Bestinvest (as published in The Sunday Times, 15 April 2012)

So why are these ITs doing so much better than the unit trusts managed by the same men? I can see three main reasons. And these three points may make you consider when and how to use ITs.

Why investment trusts do better

First, what you've got to remember is that the markets have done very well over the last three years. And ITs tend to do well in a rising market. That's because most of them use a little bit of leverage to spice up returns.

Unlike a unit trust, an IT is allowed to borrow money to buy even more shares of the companies it likes. And in a rising market, it's a strategy that does very nicely. On the other hand, if you're worried the markets may turn south, then arguably an IT isn't going to be great... leverage works in reverse too!

The second reason the trusts have done well is because they got so badly massacred during the financial crisis. The industry standard unit trust is priced relative to the value of the investment it holds. So during the crisis, if the shares in a unit trust held halved, then so did the price of the unit.

But ITs tended to fare far worse. These trusts can trade a lot lower than the value of their assets. And when the markets are in fear mode' they tend to trade at a lot less. At the market's bottom three years ago, many trusts were trading at 20% or 40% less than their net asset value (NAV).

Clearly, when the markets are in a panic it can be a great time to buy ITs. As the markets recover, discounts tend to narrow. But even today, many trusts trade at a discount of around 10%. That means you can effectively buy a thousand pounds worth of shares for just nine hundred pounds. The point is, as discounts have narrowed, it has bolstered performance. And I believe there's still a bit of mileage in that.

I can't prove my final reason why ITs have outperformed. It's a hunch. But here it is:

As I keep saying, the unit trust really is the industry standard. It's what most financial advisers and banks put clients into. Well they would do, wouldn't they? I mean, some of those fat fees charged by the unit trusts ultimately trickle down to the advisers.

Now in fairness to the advisers, they'll keep a beady eye on whose units are performing best and therefore where they're going to pump client money. And this puts a lot of pressure on the fund manager.

And I don't think that sort of pressure is any good for the manager's performance. Many studies have shown that industry-wide, unit trusts tend to underperform their benchmarks. I suspect that a lot of this is down to managers constantly meddling with their portfolio on short-term whims and trying to get to the top of the investment charts.

My hunch is that IT managers can afford to take a more long-term approach. As I say, I can't prove this. But I have worked in this industry and I have met these guys. I also know where they tend to put their own money... and that is ITs.

Knowing that it's shrewd long-term private investors you're selling to (rather than financial advisers) means the manager can take a different approach. ITs aren't under the spotlight of the industry' and they don't have these guys constantly breathing down their necks.

To my mind, that makes it easier for the fund manager to make the right long-term investment decisions. There's no constant battle to try to get to the number one slot in the investment charts. Over the long run, the value of management is expressed in the IT's share price.

That's only my opinion of course. Do you have another? If so, leave a comment below.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

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