Beginner's guide to investment trusts
This type of investment can potentially deliver better returns than index trackers due to its different structure.
If you want to beat the market, putting your money in an investment trust is arguably the best way to do it.And they're becoming increasingly popular as a result.
What is an investment trust?
Investment trusts are quite simple really. You pay a manager to pick shares which are then bought by the trust. You own shares in the trust.
From that description, investment trusts don’t really sound any different from unit trusts such as managed funds. However, their corporate structure is different.
Strictly speaking, an investment trust isn’t a fund or even a trust. It’s a company that invests in other companies as well as other assets. You own shares in the company just like you would for any other company that is quoted on the London Stock Exchange. In contrast, a unit trust is a fund and isn’t quoted on the stock market.
There are some other differences which can make investment trusts a more attractive vehicle. Let’s look at those differences.
Low charges
Investment trust charges tend to be lower than for unit trusts, especially the largest investment trusts with assets of £500 million or more. That said, you will have to pay a dealing charge when you buy into the trust. If you use a discount investment platform such as Hargreaves Lansdown or BestInvest, you can keep those charges low.
Costs
You are also guaranteed a small loss in the difference between the bid and offer prices of shares. And unlike a lot of other investment options, investment trust purchases incur Stamp Duty (0.5% on purchases). There are also annual management fees and some further administrative costs.
All of the costs associated with investment trusts don’t necessarily mean that they make for overly expensive investment vehicles. Unlike unit trusts, investment trusts are not allowed to advertise, so this means their running costs are somewhat lower. And as investment trusts are, in effect, companies, their management charges are controlled by directors with the aim of running the company in a way that is conducive to the best interests of the shareholders.
The end result is that investment trusts can make for a low-cost investment option, with the largest investment trusts having very low costs indeed.
Borrowing
Unit trusts aren’t allowed to borrow. If a unit trust is invested in shares that are worth £100 million, the manager can only buy more shares if new investors come in and pay money into the trust. Or they can sell some shares in the existing portfolio to raise the necessary cash.
An investment trust manager, however, can borrow. So if they want to buy further shares, they can just go and borrow £5 million to pay for them. They don’t have to sell any shares in their existing portfolio. This is known as 'gearing'.
This ability to borrow means that investment trusts can deliver higher returns, although it makes them riskier too.
Discounts
The price of a unit trust is always linked to the value of the assets held by the fund. So if the value of the assets in the fund is £100 million, then the value of the unit trust is £100 million. If there are 100 million units in the fund, the unit price is £1.
However, the price of an investment trust is set by supply and demand for that trust. Indeed, shares in the trust are traded on the stock market. Just because the investment trust’s assets are worth £100 million, don’t assume that the market will value the trust at that level. The investment trust’s market value might be £80 or £90 million. Or even £110 million!
If the market value of the fund is lower than its assets, the investment trust is trading at a ‘discount'. Some investment trusts can trade at discounts as large as 20%. So if you buy a trust with that kind of discount, there’s the potential to make a significant profit if the discount narrows in the future, say to a 5% or 10% discount. Of course, you’ll also be hoping that the value of the assets held in the fund will rise too.
Discounts vary between trusts. If the manager of a trust is well-respected with a good track record, you could expect the discount to be narrow. In fact, the trust might even trade at a ‘premium’ where its market value is greater than the value of the underlying assets. Trusts with a poor track record may have a big discount.
The potential for discounts to narrow means that, once again, investment trusts can deliver a bigger return than unit trusts. On the other hand, if the discount expands, investment trusts can lose you more money.
How do I choose an investment trust?
That very much depends on what you want to invest in. Do you want to be local or global? Big companies or small? You can have a look at investment trusts' performances at the Trustnet website. However, as we always have to say, past performance is no guarantee of future returns. Investment trusts should ideally be part of a diversified portfolio that also includes cash and perhaps some exposure to bonds.
Where to buy an investment trust
You can buy an investment trust via an investment platform, or fund supermarket as they're also known, such as Hargreaves Lansdown or BestInvest, directly from the trust provider (though this is usually much more expensive), or a stockbroker, or via an independent financial adviser or financial planner. The investment platform and stockbroker methods are always the cheapest.
Charges
In addition to annual charges on the investment trusts themselves you will also have to pay charges for buying and/or selling them.
Investment platforms may also charge a range of other fees, from annual management fees to exit fees, so make sure you read the small print before you sign on the dotted line. For more on what charges to watch out for, take a look at our Beginner's guide to investment platforms.
More on investing:
Beginner's guide to stocks & shares ISAs
Beginner's guide to index tracker funds
Beginner's guide to Exchange Traded Funds
Beginner's guide to bonds
Beginner's guide to managed funds
How to invest in an IPO
Hargreaves Lansdown tops investment platform poll
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If anyone asked me for a recommendation of only one share to buy on the stock market, the company I would recommend would always be an investment trust. If you are investing in the stock market for the first time, in my opinion, you can do no better than buying an investment trust. "What should I buy?"you ask yourself. "I'd love to own GlaxoSmithKlein, Royal Dutch Shell, Vodafone...but I've only got a few hundred quid." Well, you can search through the investment trusts, and go through their annual reports. They will usually give you their ten largest holdings. (Sometimes they will give you the lot.) If you find one that has GSK, RDS a or b, and VOD listed there, you can invest in all three through your investment trust...and a whole lot of other companies, too. Through investment trusts you can have access to markets most people can only dream about. The variety of these things is almost limitless. I've been looking through these companies for years, and I am still finding companies that invest in things I never even knew existed. [B]"This type of investment can potentially deliver better returns than index trackers due to its different structure."[/B] Yes, you can get a London index tracker in investment trust form. (The only one I know of is run by Aberdeen. But there may be others.) If you want income, growth, income & growth; if you want to invest in India, Japan, China, USA, Russia; if you want to invest in commodities, bonds, derivatives, ETFs; other investment trusts: there is an investment trust out there for you. Want to become a landlord? You need to buy property, and you get calls from a tenant at 3 in the morning to tell you the pipes have burst, and if he doesn't pay the rent....Or, you can invest into a Real Estate Investment Trust. (REIT) .Through these I am a part owner of shopping centres, medical centres, hotels, apartment blocks. And through the company, I have firms like Tesco paying me rent. If all you've got is, say, a couple of hundred quid, you can become a landlord by proxy with a REIT. As with any other stock market security, profits will be paid to you through dividends, through management share buybacks or through paying off debt, (Investment trust debt is usually referred to as "gearing." By law, at least 85 percent of profits have to be paid to the shareholders. (90 percent in the case of REITs.) My own personal experience with investment trusts are that they are less volatile than shares in one single company. That means you are less likely to come back from holiday to find yourself a pauper, but also less likely to become a billionaire overnight, although I did once have an investment trust that doubled my money in a couple of years. Otherwise these would tend to be investments for the long term. Like any other new stock market company, any new investment trust has an Initial Public Offering...like Royal Mail Group recently. So you can buy a new investment trust that way if you so desire. [B] "Unlike unit trusts, investment trusts are not allowed to advertise,"[/B] This is true, but one way around this is that an advert will appear on a website by one of the bigger companies inviting you to press a link and view their company website and inspect their range of investment trusts. Another way around this - that you can use yourself - is to inspect a unit trust you are interested in, then inspect the company website, and look at their list of investment trusts. You may find that unit trust in an investment trust form. Until recently, everybody was raving about Invesco Perpetual High Income Fund managed by Neil Woodford (who has since left Invesco). Everybody knew about the fund, but few knew that Neil Woodford also ran the Edinburgh Investment Trust. So far as I could see, this was his unit trust in an investment trust form. Other unit trust high-hitters like Templeton Emerging Markets and Standard Life Smaller Companies also have their funds in investment trust form. I have more fun with investment trusts and other investment companies than with any of the other places I put my money. So, if you are the type of investor who is excited by seeing what you can discover and a love of an adventure that has the maximum of opportunity with the minimum of risk, I would heartily recommend investment trusts.
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03 May 2014