How to invest using investment trusts: a beginner’s guide

Investment trusts have bells and whistles that private investors can use to their advantage, explains Kyle Caldwell.

Investment trusts, savings vehicles that have been around since the Victorian era, are regarded as the City's best-kept secret.

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Statistically, over the long term, investment trusts tend to a produce superior performance compared with their OEIC (open-ended investment company), or unit trust, cousins. But they have historically been less popular and not as widely promoted by financial advisers.

However, in the aftermath of rules introduced by the Retail Distribution Review (RDR) in 2013, financial advisers are warming to investment trusts. 

Prior to the RDR, financial advisers pocketed commission payments when they bought investment fundsfor their clients. In contrast, investment trusts did not pay commission, so were therefore less popular among advisers.

The RDR levelled the playing field by abolishing commission. As a result, investment trusts have experienced a rise in demand. 

For many seasoned investors, however, investment trusts have been the bedrock of their portfolios for decades, but the investment trust industry is much smaller than the more mainstream fund industry.

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How investment trusts work

Investment trusts, like unit trusts, invest in a ‘basket’ of underlying assets such as equities, bonds, or property. But they are companies listed on the London Stock Exchange (LSE).

Essentially, there are two ‘layers’ of activity. A fixed number of shares is issued (hence why you may see them being called ‘closed-ended’), raising a fixed amount of money for the manager to invest in a portfolio of assets.

The shares are then traded on the stock market. The share price goes up and down according to investor demand and supply, but the fund manager’s investment plans are not affected.

Discounts and premiums

The two layers mean trusts have two values: how much the trust’s underlying investments are worth (the net asset value, or NAV) and its share price.

If the trust is popular (perhaps because the wider industry or geographical sector in which it invests is attracting a lot of interest), the share price will be boosted by extra demand, but this doesn't necessarily mean the underlying NAV has changed.

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When the share price is lower than the NAV per share, this is known as a ‘discount’. When the share price rises above NAV, it’s trading at a ‘premium’, as you’re paying more than the assets are worth.

If you buy at a discount and that discount reduces or narrows (due to increased shareholder demand, say), your holding could gain in value, even if there’s no movement in the underlying NAV.

Conversely, the discount could widen, so your holding loses more value than the underlying assets do.

It’s generally not a good idea to buy a trust on a high premium, of say 5% or higher, because it tends not to be sustainable over the long term and can turn into a discount when conditions change.

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What is gearing?

Investment trusts are allowed to gear, or borrow, to invest. This can improve their performance, but it means they tend to be more volatile than their open-ended peers. Gearing in a rising market magnifies gains for each shareholder; but if the market falls, investors in a geared trust will suffer greater losses per share.

Simply put, if the manager borrows X to invest and the trust grows, the manager must repay X plus interest but retains the investment growth as part of the trust’s NAV. So, if you have £1,000 invested (let’s assume a constant share price for now) and the manager gears by 10%, then there is effectively £1,100 working for you.

Now, if that doubles in value to £2,200, the manager pays back the £100 plus, let’s say, 1% interest. That leaves you – the investor – with £2,099. If the manager had not geared, you’d only have £2,000.

Conversely, if the same investment halves in value to £550, the manager still must pay back £101. This magnifies the losses, leaving you with only £449 instead of the £500 you’d have without gearing.

Many trusts are ungeared or only modestly geared, but specialists such as private equity trusts may have gearing of about 40%.

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The board of directors

An investment trust typically has an independent board of directors overseeing it and ensuring that it’s managed according to shareholders’ interests. In most cases, the directors will appoint an external fund manager to run the trust. If the manager doesn’t do a good job the board can fire and replace them.

A board exercises independent oversight to look after the interests of shareholders (such as by driving down costs).

As a shareholder in an investment trust, you have the same voting rights as shareholders in other companies. This gives you the opportunity to have your say and exert influence.

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Dividend payouts

Income-paying investment trusts have a particular attraction for investors who want a regular cash flow, because – unlike open-ended funds – they don’t have to distribute all the income generated by their assets every year.

They can hold back up to 15% each year, which means they can build up a reserve to bolster dividend payouts in leaner years. During the financial crisis and the more recent Covid-19 pandemic, most UK equity income investment trusts were able to either maintain or increase their dividends, as they dipped into their reserves. In contrast, most UK equity income open-ended funds cut their dividends.

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Will investment trusts suit me?

Investment trust performance can involve rather more ups and downs than the unit trust equivalent (because of gearing and the effect of movements in the discount). But if you are invested for the long term, it’s not worth worrying too much about short-term swings.

Big, steady, internationally diversified trusts, for instance - of which there are many examples in the global sector - can form an ideal portfolio core and are good options to consider for regular monthly investments.

Many global and UK trusts are also ideal for income-seekers, because of their ability to smooth dividend payouts over the years.

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 to release money to investors looking to liquidate their investments when markets dip.