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What is an investment trust?
The structure of investment trusts gives them various advantages compared to other types of funds. How do they work?
Investment trusts can be one of the most effective means of gaining exposure to certain types of asset.
An investment trust is a type of investment fund, meaning it is a single investment that gives you access to a portfolio of multiple stocks (or other assets, such as bonds).
Investment trusts are ‘closed-ended’ funds. In simple terms, this means the trust’s shares trade on a stock exchange and are valued by supply and demand for these shares, rather than by the value of the portfolio’s assets.
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Can trade at discounts or premiums to the value of the assets they hold;
Can invest in illiquid asset classes more comfortably than other types of fund, making them useful vehicles for long-term investments;
Can borrow money to amplify returns (known as ‘gearing’);
Can smooth dividend payments to shareholders over time.
“Investment trusts are companies, so they have independent boards of directors who look after shareholders’ interests and maximise shareholder returns,” said Annabel Brodie-Smith, director at the Association of Investment Companies (AIC), an industry body that represents investment trusts.
What does closed-ended mean?
There are two main types of fund: open-ended and closed-ended. Both types invest in a portfolio of assets. When you buy a ‘share’ in either type of fund, you acquire a percentage of its underlying portfolio.
Open-ended funds buy and sell assets when investors buy or sell shares (or ‘units’) in the fund – so the value of your holdings in the fund change according to the change in value of the underlying assets (net asset value or NAV), regardless of how many other investors are buying or selling the fund itself.
Investment trusts, as closed-ended funds, work differently. The number of shares in a closed-ended fund is fixed, so the price you pay for them – and their nominal value in your portfolio – changes according to supply and demand for the investment trust itself, not its NAV.
That means investment trusts can (and often do) trade at premiums or discounts to NAV; effectively, the total value of all of an investment trust’s shares can be more or less than the total value of all the assets it has invested in.
If you buy an investment trust while it trades at a discount to its NAV, you are effectively buying its underlying assets cheap, thanks to the way closed-ended funds work.
However, there is no guarantee that the discount will narrow over time – it could, in fact, get wider.
What are the advantages of investment trusts?
Investment trusts have other levers they can pull that open-ended funds and exchange-traded funds (ETFs) can’t, by virtue of their status as listed companies.
“Trusts have many advantages,” said Max Orminston, assistant portfolio manager at Unicorn Asset Management, a fund that invests in investment trusts. These include “the ability to enhance returns through gearing, flexibility in allocating their income and capital distributions, a public listing and an accountable independent board of directors.”
Gearing means borrowing in order to boost the value of investments in a given asset. If the fund manager gets it right, it can lead to superior returns compared to what is possible through other types of funds.
Investment trusts are able to buy back shares or issue new ones, and they can also borrow to boost the amount of capital they can invest.
Another key advantage over open-ended funds is around dividend payouts. Open-ended funds have to pay all their income to their investors every year. In a cyclical sector, that can mean peaks and troughs in terms of dividend payments. Some years you’ll get great income, but some years you might get very little.
Investment trusts, though, can set aside up to 15% of their income every year. In boom years, they can set plenty aside – meaning that they can still pay dividends in bust years, smoothing dividend payments over time. The AIC tracks a list of ‘dividend heroes’ – investment trusts that have raised their dividend payout for at least 20 years in a row.
In Orminston’s view, the greatest advantage of investment trusts is “having permanent or semi-permanent capital that allows managers to take a longer-term view”.
Because the managers of investment trusts aren’t forced to buy or sell assets every time their shares are sold, they can invest with a much more long-term time horizon in mind, and potentially in much less liquid assets compared to other funds.
“To paraphrase Warren Buffett, that fixed capital gives trust managers the ability to be greedy when others are fearful,” said Orminston.
It makes them particularly useful vehicles for investing in high-growth but illiquid private companies or long-term projects like energy infrastructure.
What are the risks of buying investment trusts?
Many of the unique features of investment trusts have both upsides and downsides. Gearing can increase returns if it goes well, but can also amplify losses if it is used to borrow for assets that then fall in value.
Similarly, if discounts widen rather than narrow after you buy (or if you buy at a premium that then falls), this could impact your returns.
As much as having shareholder rights is a benefit for many shareholders, it can also cause complications.
While these kinds of corporate activity can potentially increase returns for shareholders over the long term, they can also lead to changes in investment strategy. This might mean a trust’s risk profile and objectives no longer suit other shareholders that had previously bought the trust.
How to invest in investment trusts
Because they are listed companies, shares in investment trusts are bought and sold on stock exchanges just like shares in any other company. You can buy them in a stocks and shares ISA.
Before doing so, it’s advisable to become fully acquainted with any given investment trust and understand the area it invests in, as well as the track record of the portfolio manager.
You can buy funds or investment trusts that invest in investment trusts. MIGO Opportunities (LON:MIGO) is an investment trust that holds discounted investment trusts where its management perceives a potential catalyst to extract value. The Unicorn Mastertrust Fund is an open-ended fund that invests in investment trusts its managers believe show potential to grow and are priced attractively.
Activist investor Saba Capital launched an ETF in March – the Saba Capital Investment Trusts UCITS ETF (LON:UKIT) – designed to offer exposure to the discounted UK investment trusts that the hedge fund’s own strategy targets.
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Dan is a financial journalist who, prior to joining MoneyWeek, spent five years writing for OPTO, an investment magazine focused on growth and technology stocks, ETFs and thematic investing.
Before becoming a writer, Dan spent six years working in talent acquisition in the tech sector, including for credit scoring start-up ClearScore where he first developed an interest in personal finance.
Dan studied Social Anthropology and Management at Sidney Sussex College and the Judge Business School, Cambridge University. Outside finance, he also enjoys travel writing, and has edited two published travel books.
