What is an investment trust?
“Active” investment funds come in two main varieties, one of which is investment trusts. But what exactly is an investment trust?
Actively-managed funds come in two main varieties. There are investment trusts, also known as closed-ended funds. And there are open-ended funds, commonly known as unit trusts or oeics.
Closed-ended investment trusts are listed on the stock market and they have a fixed number of shares in issue, with a fixed pool of capital. If you want to invest in one, you buy shares in the trust directly.
On the other hand, open-ended funds expand and contract with investor demand, and if you want to invest, you have to go through the fund’s manager via a broker.
Where investment trusts have the advantage
This key difference between the two fund structures gives investment trust managers far more flexibility when it comes to portfolio management.
With the fixed pool of capital, a trust manager doesn’t have to spend lots of time worrying about managing flows of cash in and out of the fund.
The investment trust – like any other listed company – raises money by issuing shares.
When a new investor wants to come on board, he or she has to buy the existing shares from another holder. The underlying portfolio is untouched.
With an open-ended fund, it’s different. If you put money in or take it out, it effectively has to go into or come out of the portfolio itself.
So, if the manager holds a lot of hard-to-sell assets, he or she runs the risk of being unable to sell quickly enough, if lots of people decide to take their money out at once.
Open-ended fund managers can also suffer from the curse of success. If an open-ended fund is successful, investors tend to pile in, and the fund manager needs to invest this cash.
This can push the manager to buy stocks they might not have bought in the past, or pay high prices for assets just to invest the capital - a very short-term mentality.
As such, an investment trust manager is more able to take a long-term view when investing, and the different structure also means trusts can target different types of assets, such as property, private equity, wind farms and container ships.
Investment trust quirks you should be aware of
With a fixed number of shares in issue, investment trust share prices rise and fall with demand for the trust, rather than the value of the investments in the underlying portfolio (as is the case with open-ended funds).
Therefore, trusts can trade at both a discount and premium to their underlying net asset values depending on the demand for their shares.
Savvy investors might be able to take advantage of this quirk. If a trust is trading at a 10% discount to its net asset value, for example, investors are effectively able to buy £1 worth of assets for 90p - a great deal.
There are a couple of other reasons why investment trusts have an edge over open-ended funds.
Trusts have an independent board of directors, who’re charged with monitoring performance, keeping costs down, and approving the issuance of new shares. If these directors get fed up with a manager’s performance, they can require a change of manager.
Investment trusts can also borrow money to invest. Thanks to the company structure, they can borrow over long periods, and many have issued long-term bonds to buy assets at discounted prices in the past.
Then there’s the investment trust revenue reserve to take into account. Trust can hold back 15% of their income every year in a reserve, which then can be used to meet dividend commitments if income from the portfolio drops.
Many trusts relied on this reserve in 2020 to maintain their dividends when companies slashed their dividends to preserve cash during the coronavirus pandemic.
With this reserve as a backstop, some trusts have been able to grow their dividends every year for over five decades!
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