Why investment trusts trump unit funds

According to Winterflood Securities, over the past decade investment trusts have performed better than unit trusts and open-ended investment companies (OEICs) in seven out of eight important sectors in the market. The biggest discrepancy was in the emerging markets sector, where investment trusts have beaten unit trusts by 6.6 percentage points a year for ten years. The only sector of the eight where unit trusts won was Japan. Yet unit trusts are more popular. What's going on?

Investment trusts tend to perform better for three reasons. Firstly, they can borrow money as well as taking it from investors. This allows them to boost returns in rising markets (although it can lead to bigger losses when the market falls).

Next, unlike unit trusts, investment trusts issue tradeable shares that are listed at the London Stock Exchange. Since the price can rise and fall according to investor demand, this means that the shares can trade at a different value to that of the assets held in the trust. Where the market capitalisation (the share price multiplied by the total shares in issue) is below the value of the trust's assets (the stocks and shares it owns) you get a discount to net asset value (NAV). Over the last decade typical discounts have fallen from 11% to 8% on average and that has boosted returns. But the key attraction of investment trusts is that they're cheaper. The total expense ratio (TER) is typically 1.09%, compared to 1.67% for a unit trust. That's largely because unit trusts spend more on marketing as regulations that restrict firms don't apply to them.

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Yet despite all this unit trusts continue to be more popular. Financial advisers have tended to push unit trusts harder as they get more commission from them. This discrimination may end when commission is scrapped in 2012, but we wouldn't necessarily bet on it. Investment trusts are also seen as more complicated due to their discounts and premiums. "This attitude surprises me," says John Newlands, an analyst at Brewin Dolphin, in The Daily Telegraph, "because nowadays people buy everything from cars to cosmetics at a discount to the full retail price."

So which trust looks best? Edinburgh Investment Trust (LSE: EDIN), says Paul Farrow in The Daily Telegraph. Managed by Neil Woodford, it has a high-quality portfolio of defensive companies