Investment trusts are not the easiest thing to explain to the uninitiated. They share features with both funds and stocks. They can make you more money than a regular fund, but they can also lose you more. Some are better for producing a regular income; others are better at providing capital growth.
This supplement aims to give you an overview of how trusts work and how you can get started using them to build your portfolio. Once you are comfortable with the basics, this type of investment offers access to a wealth of options and can give your savings a boost.
Investment trusts trade like companies listed on the London Stock Exchange, meaning that you can buy and sell them at a ‘live’ price any time of the day during trading hours, just like all other stocks. The same applies to exchange traded funds (ETFs), whereas open-ended funds are normally only priced once a day.
But trusts also function like funds, in the sense that they buy a range of individual securities, they are run by investment managers who make those buying decisions, and their performance is ultimately dependent on that of the underlying portfolio. Unlike most ETFs, trust managers take an active approach, meaning they do not just aim to replicate an index.
What makes trusts special
This structure comes with various advantages. Like all listed companies, trusts belong to their shareholders, not to the fund house managing them. There is a board of directors governing each trust, which is meant to be independent, and certain decisions have to be voted on by shareholders. With their support, the board can, for example, sack the investment manager after a prolonged period of underperformance. This has recently happened at Murray Income (MUT), a UK income trust whose Aberdeen managers have been replaced by a team from Artemis.
Unlike open-ended funds, investment trusts have ‘permanent’ capital. When you sell your holdings in open-ended funds, you receive cash in return; if many investors sell at the same time, the fund manager will have to sell part of the portfolio to meet the withdrawal requests, potentially with adverse consequences for the long-term performance of the fund – for example, if they find themselves having to crystallise losses. Meanwhile, an investment trust is sold at the market price, with liquidity in effect being provided by other investors, meaning that redemptions don’t force the managers to touch the underlying portfolio.
The complete guide to buying investment trusts
This makes trusts more suited to investing in unquoted assets, such as companies not listed on the stock exchange. These assets cannot be sold quickly, so holding them in open-ended funds can generate all kinds of liquidity issues, particularly if there is a ‘dash for cash’. In the worst-case scenario, investors can end up trapped indefinitely, as happened with Neil Woodford’s funds. Trusts don’t run this risk – if a lot of investors want to sell, only the trust’s share price is impacted.
On the other hand, this mechanism means that there is usually a mismatch between the price of the underlying portfolio – or net asset value (NAV) – and the price of the trust’s shares.
When the shares are more expensive than the portfolio, the trust trades on a premium; when they are cheaper, it trades on a discount. A trust’s discount or premium is in effect a measure of how much investor demand there is for the trust. This ultimately depends on how well the trust is performing, but there can be many other factors at play too. Since 2022, investment trusts have largely tended to trade on discounts, partly due to reduced demand across the board; as at 1 April, the sector’s average discount stood at 13 per cent.
Discounts and premiums can boost investors’ gains or exacerbate their losses. For example, say you buy a trust on a discount and it then starts performing really well. That means more investors want to buy it, so the share price goes up, the discount narrows, and you make money both from the performance of the underlying portfolio and from the trust’s increased popularity. But, of course, the opposite scenario can also unfold, magnifying your losses.
A similar mechanism applies to another investment trust feature: gearing. Trust managers can borrow money to ‘juice’ their portfolio. If they get it right, their wins are boosted; if they get it wrong, they lose more. A geared portfolio is likely to be more volatile. The average level of trust gearing as at 1 April was 10 per cent.
Finally, investment trusts are excellent for providing regular income to shareholders year after year. This is because every year they can retain up to 15 per cent of the dividends generated by the portfolio as reserves. These can then be used to bolster the trust’s payout in the ‘bad’ years, when the companies in the portfolio have cut their dividends.
All these features make trusts complicated, but also incredibly useful for a range of investment goals.