Investment trusts: What they are and why we like them

Unit trusts are by far the most popular form of pooled investment vehicle in Britain. That's probably because advisers get juicy commissions for recommending them. Yet there's an alternative that not only has a longer pedigree, but also a better record: the investment trust.

The very first, the Foreign & Colonial, was set up in 1868 to give domestic investors a cheap, diversified way to tap growth in Britain's vast empire. The trust is still around today. Unit trusts came along a lot later and achieved their popularity largely by paying big commissions to financial advisers.

Now, with commission of this type about to be banned, investment trusts and other alternatives to unit trusts should get more exposure than they have in the past. Even if you don't plan to take complete control of your own money just yet, it's worth understanding what these trusts are so that you can ask your IFA about them. Unit trusts are open-ended funds; investment trusts are closed-ended.

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This means that the amount of money invested in the trust is usually fixed when it starts up new shares are not issued in the same way that units' are when more people want to invest in a unit trust. Instead, the shares are traded freely between investors on a stock exchange. This means that if you want to put your money into an investment trust, you have to buy its shares through your stockbroker. It also means that the price of the shares rises or falls directly in line with demand for them.

As a result, the overall value of a trust will not always equal the value of its underlying investments (its net asset value, or NAV). Sometimes the shares are worth more: they are said to be trading at a premium to NAV. Sometimes they are worth less and trade at a discount. A 10% discount effectively means you can buy £1 of assets for 90p. However, it's a good idea to compare the current situation to the historical average before you buy as discounts can persist for some time.

Some investment trusts use what is known as a no-discount policy. What this means is that the trust tries to make sure that the share price is always at, or around, the NAV. So when the shares trade at a discount, the trust buys its own shares in the market to push up the price. If the shares trade at a premium, it will issue new shares on the stock exchange to push the value per share down towards its NAV.

One advantage of being closed-ended is that the investment trust manager doesn't have to worry about selling off assets from his portfolio to raise money when investors sell out. This should, in theory at least, allow the manager to take a longer-term investing approach, and also buy assets such as property or small-cap shares that might not always be easy to trade.

Another difference between unit and investment trusts is that an investment trust can borrow money to invest. This is known as gearing or leverage. It can boost market returns when the value of investments is going up, but also magnifies losses in a falling market.

But perhaps the most important difference is that investment trusts are generally much cheaper than unit trusts. That's because they don't pay commissions to financial advisers or fund supermarkets. The investment trusts in the FTSE 250, for example, have an average total expense ratio (TER) of 0.94%, compared to an average TER of 1.69% for unit trusts.

The most important thing about all these features is they help boost performance. Studies have shown that the average investment trust tends to beat both its unit-trust rivals and the underlying market over the long run. With the introduction of the RDR, this cost gap between unit trusts and investment trusts is likely to close, otherwise unit trusts will lose a lot of business.

The good news is that added competition is likely to persuade both types of fund to reduce costs where possible to attract more business. Of course, you can't just go out and buy any old trust some are better than others. That's why we recently put together a model portfolio of core' trusts we think deserve a place in most people's portfolios they are listed below.

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