A great way to invest

We look at a cheap way to invest in the stock market which might even deliver an above-average return.

At lovemoney.com we often extol the virtues of index tracker funds. These funds have low charges and aim to match the performance of a particular stock market index. So if the FTSE 100 index rises 5% in a year, a FTSE 100 index tracker should rise by roughly the same amount excluding charges.

The beauty of index trackers is that they should always match the performance of the index, but that’s their downside too. If they work as they’re supposed to, they’ll never beat the index. Over the long-term, the market’s performance will probably be good, but that doesn’t stop many investors being tempted to try to do better and beat the market.

Best way to beat the market

If you want to beat the market, investing in an investment trust is arguably the best way to do it. 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. 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. A unit trust, by contrast, is a fund and isn’t quoted on the stock market.

There are some other differences which make investment trusts the more attractive vehicle in my opinion. 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 the trust. If you use a discount stock broker such as Hargreaves Lansdown, you can keep those charges low.

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 he can sell some shares in the existing portfolio to raise the necessary cash.

An investment trust manager, however, can borrow. So if he wants to buy further shares, he can just go and borrow £5 million to pay for them. He doesn’t have to sell any shares in his existing portfolio.

This ability to borrow means that investment trusts can deliver higher returns, although it also makes them riskier too. I’m happy to take the risk!

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.

Rule changes

These differences between unit trusts and investment trusts have existed for many years but a regulatory change is about to kick in which could boost the value of investment trusts. I’m talking the RDR (Retail Distribution Review).

As things stand, most Independent Financial Advisers  make their money by getting commission from product providers. Unit trusts pay nice chunky commissions to advisers whereas investment trusts pay nothing. As a result, many advisers have rarely recommended investment trusts.

The RDR will take effect in 2013 and will mean that advisers will now be paid via fees, not commission. As a result, advisers are more likely to recommend investment trusts in future. That should boost demand and may help to narrow discounts a little in the years to come.

If this article has tempted you to buy some investment trusts, you can find some recommendations here.

All in all, I’m very happy to recommend investment trusts. My stock market investments are divided between shares, index trackers and investment trusts. That’s how I’m going to continue to invest.

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