Investment trusts: five things to know
An investment trust is a publicly-listed company, just like BT or Shell. Whereas BT’s business model is to make money for shareholders by providing telecommunications services and Shell supplies oil and oil-related services, an investment trust invests in other companies. They are a type of fund.
1. A different structure to ‘regular’ funds
The principle is very similar, but when you buy a ‘regular’ fund, you are buying units of that fund and the fund manager can create an unlimited number of units to meet demand. This is known as being an 'open-ended' fund.
Because an investment trust is listed as a company itself, you instead buy shares in that company. However, the number of shares is limited, so investment trusts are known as 'closed-ended' funds. The price of the shares is affected not only by the performance of the underlying investments, but by investor sentiment towards the investment trusts' own shares.
The closed-ended structure is particularly suitable for specialist trusts holding assets that cannot be easily or swiftly bought and sold (such as property, private equity or very small companies). This is because managers don't have to sell their holdings in order to release money back to investors looking to liquidate their investments.
2. Premiums and discounts on investment trust shares
This structure can, however, cause a trust’s share price to fluctuate quite a bit. Think about it like this.
Sometimes in life, the more popular something is, the more expensive it is, and vice versa. The same is true for investment trusts. The price you pay for a share is based on the value of the investments held in the trust, but also on how popular the shares are.
If the shares are seen as desirable, their price may rise to a premium (against the value of its investments). If they are not so appealing, their price may fall to a discount. This means you are sometimes paying a bit more for a share in trust or could be getting a 'bargain'.
However, while a sale at your favourite clothing store, for example, may only last a few weeks, some trusts can trade at a discount or a premium to their net asset value for very long periods. It’s important to understand this concept therefore, as it can have a big impact on your returns.
3. How gearing works
One of the other key differences to understand between an open-ended fund and a close-ended fund (or trust) is gearing, which basically means borrowing money.
Most of us borrow money at some point in our lives. Gearing refers to the mechanism by which an investment trust borrows money, usually from a bank or third parties, to make extra investments, with the aim of earning a return greater than the cost of the borrowing.
For example, take an investment trust with a value of £100 million. In a rising market, the fund manager may see lots of potential opportunities, but to take maximum advantage, he or she might want to invest an extra £20 million. Having borrowed the money he needs, the investment trust is now 20% geared.
So, the smaller capital value of £100 million has the power to drive a larger £120 million of investible assets. When the market gathers momentum, the investment trust gets an extra boost. On the other hand, if opportunities fail to materialise and market conditions worsen, it may increase the losses made.
This means gearing can increase the risk of an investment trust but also magnify the returns.
4. Revenue reserves
Saving for a rainy day is an idiom we all know well. Investment trusts can do this too, via a revenue reserve.
When the economy is strong, dividends payments from companies can be a great source of regular income for investors, but how reliable they are can be anyone's guess. As we have seen in recent years, companies can cut their dividend payments or stop them altogether if times are bad and they don't have the spare cash to return to their shareholders.
During the good times, investment trusts can retain up to 15% of the dividends they receive in a pot called the revenue reserve. The better the dividends the fund manager gets, the more money can be put aside for the future.
During the bad times, when dividends become more scarce, the fund manager can tap into the reserve and boost lacklustre dividends for a more steady return.
5. Independent board
These days, accountability is top of the list for businesses in finance, and an independent board is often the best way to ensure the best outcome for shareholders.
An independent board is made up of a group of experienced professionals that support the fund manager in delivering his or her ideas. They have the acumen to spot if the fund manager is going off track and the authority to question how performance may be improved. They also act as a fair and objective earpiece for investors.
Where to next?
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Original content provided Henderson Global Investors.
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