Investment Trusts a better bet than Unit Trusts?

I have long preferred putting my cash into investment trusts than into unit trusts. There are a variety of reasons for this investment trusts are easier to trade for example. But the swing factor as far as I'm concerned has always been cost. We all know how fast the costs of investing can add up half a percent here, half a percent there suddenly you find that over 10 years a fund manager has taken 20% of your capital in fees. Investment trusts cut the danger of this. Unlike unit trusts, they are simply listed companies, the business of which is to buy and sell shares in other companies. This means that when you buy into them you simply buy their shares on the open market. You don't get hit with the absurd entry fees that unit trusts charge (these can sometimes cost you 5% of your capital) and as IFAs aren't part of the deal your fund manager won't have to pay out trail commissions (payments made to your IFA every year that you continue to hold a unit trust you bought through him). Trail commission usually comes to half a percent a year or so and its absence is one of the reasons why investment trusts can charge lower annual fees: a unit trust will generally charge 1.5% -1.75% a year to look after your money but investment trust fees tend to come in at or under 1%.

However there is a complication with investment trusts. Very few companies on the stock market trade at a price that exactly reflects the value of the assets they own and investment trusts are no exception. Instead they usually trade at a discount to their net asset value (NAV). These discounts reflect the fact that there would be costs to winding the trust up and that many trusts have high levels of debt, something that comes with both cost and risk. Particularly big discounts can also reflect investor pessimism: if investors think share prices are likely to fall in the future they won't want to pay full price for them now. All this makes investing in them seem rather more difficult than investing in unit trusts: you have to take the discount and the odds of it widening or narrowing into account when you buy. If it widens you could lose money even if the shares the trust holds don't fall in value.

Still, discounts aren't all bad - if you can buy £1 worth of assets via an investment trust for 90p but still collect dividends on the £1 worth of shares, why complain? And lets not forget too that the more investors hate a market or a sector and hence bid down the shares of trust operating in that sector, the more likely it is that they are wrong. In fact over the years investment trust discounts have allowed many savvy investors to make a great deal of money by buying when discounts are wide and selling when they are narrow. In general I'm all for buying investment trusts when they are trading on large discounts.

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Here however we run into a problem. Big discounts just aren't as common as they used to be. Today, of the 277 unit trusts listed on www.trustnet.com, 59 are trading at a premium to their NAV and another 100 or so are trading either at par or at a small discount. One of the reasons for this unusual situation is that many investment trusts are doing all they can to make big discounts a thing of the past.many now have provisions that allow then them to buy back their shares. So if the shares are trading at what the company to be too much of a discount they will enter the market to push up demand and hence their share price.

But the emergence of this kind of strategy goes nowhere to explain why so many trusts should be trading at a premium to their NAV. Property investment trusts are trading on a average premium of 8% and 25 other funds are trading at premiums of over 10%. This makes little sense. Why would you pay 110p for £1 worth of assets? That's a huge vote in confidence in the fund manager: you pay 2% a year for an active fund manager in the unit trust sector (which is an awful lot) but if you buy into one of the property trusts trading at a 10% premium today you are effectively paying 10% for the manager's services. To make buying the fund worth your while, its net asset value is going to have to rise by a great deal more than 10% over the year. That's possible, but given the environment, it isn't very likely and if it doesn't happen the premium attached to the shares will fall and you will lose money.

The same is true of many of the other trusts trading at premiums: the recently launched Schroders Oriental Income fund is trading at a 7% premium, reflecting an assumption that it will return you considerably more than 7%, and of course beat the market by at least 7%. Perhaps it will. But before you count on it, remember that betting large amounts on the ability of most fund managers to outperform the market has never been a top idea: by end of this September the average active fund manager had returned 14.4% for 2005, yet the FTSE 100 had risen by16% over the same period.

To my mind the number of trusts trading at premiums suggests a great deal of over optimism among investors, something that in turn suggests this might be a good time to sell. When everyone else comes to their senses and does the same you can buy the shares back at their net asset value or perhaps even at an old fashioned discount.