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What is an investment trust?

This guide looks at the differences between open- and closed-ended funds and the pros and cons of each type of product.

Investment trusts – also known as closed-ended funds – are companies in their own right whose shares trade on the stock exchange. The primary function of these companies is to invest in other companies. 

While companies such as Microsoft own patents, factories and computers, investment trusts own investments – which could be in the form of stocks and shares, property, bonds or other more exotic instruments.

What is the difference between net asset value and share price?

The net asset value (NAV) is the value of the underlying investments – what other people are buying and selling them for at that time. For Microsoft, for example, this would roughly be equivalent to the overall value of everything it owns.

The share price is what investors are willing to buy the shares of the trust itself for, which will depend on what shareholders are willing to sell for. This is the equivalent of the share price of Microsoft itself, the price of which reflects how well investors think the company will do in the future.

Because a trust is a closed-ended company, there are always a finite number of shares in existence. If you want to buy a unit trust or OEIC, the managers can create a unit and sell it to you, but with a trust, the shares trade on the stock exchange and you buy from other investors.

This means that the same laws of supply and demand determine the price of the stock as determine the price of shares such as Microsoft.

The share price can deviate substantially from the NAV depending on how many investors want to buy the shares of the company and what price they are prepared to pay.

What are discounts and premiums?

The share price of a trust can deviate from that of the underlying assets for a number of reasons: for example, because the sector the trust invests in is currently unpopular, or because investors don’t rate the management team highly and think NAV is likely to decrease.

ALT_TAGThis difference in price is referred to as either a premium – when an investor pays more to buy a share in the trust than they would to own the underlying assets – or a discount – where the shares cost less than the make-up of the portfolio.

Whether or not a trust on a discount or premium looks attractive depends on what investors think will happen to it in the future.

A trust on a discount could narrow, meaning that investors will make a profit if they sell, or it could continue to widen, leaving investors nursing losses.

Some investors like to look for trusts on a discount that they think is likely to narrow – due to good management or improving sentiment towards its sector, for example.

Others think that it can be worth buying trusts on a small premium: often the market charges this extra cost because the manager has a strong track record.

As long as the share price moves up until you sell, it doesn’t matter what the NAV does, as the share price is the price you will sell at.

What is gearing?

Gearing simply means borrowing. Investment trusts can borrow money to invest, whereas unit trusts have strict regulations that limit the amount they can borrow and stipulate that it must only be temporary.

This means that a trust has the potential to rake in substantially higher returns than a fund, because it can invest more than the money already given to it by shareholders and make a profit on it; however, it also means it can make larger losses.

Investors should find out the gearing policy of a trust they are thinking of investing in. Trusts will often publicise the limits they have set themselves and the circumstances in which they will and will not borrow.

Are trusts more risky?

Trusts tend to be more volatile than open-ended funds, for a number of reasons.

ALT_TAGShare prices can move further than the value of the underlying NAV, due to market sentiment. This can sometimes lead to sudden changes in entire sectors as investors rush to buy or sell.

The ability to gear means that trusts can make more money when the borrowed cash is well-invested; however, it also means they can be left sitting on a pile of debt and stocks that nobody else wants if they invested it badly.

Why do they tend to outperform open-ended funds?

Gearing is one reason, but not all trusts use this tool and many use it sparingly.

Another reason is due to the closed-ended structure. What happens if someone wants to sell a unit in a unit trust?

Managers of unit trusts need to hold back some of their cash to be able to buy back the units of an investor who wants to sell their fund.

Either that or they have to sell their stock on the market to hand cash back to investors, and if this is at a time when the stock is in a bad period, the fund will lose money.

Closed-ended funds, on the other hand, can remain fully invested, as any investor who wants to sell has to go to the market to find a buyer.

This means that managers can invest with full conviction in their ideas, and explains why the trusts of many of the best managers outperform their open-ended equivalents.

Is the management structure significant?

The management structure can also seem complicated, as trusts have a board that is independent of the management team.

However, this is simpler than it looks. The board is simply charged with safeguarding investor interests and making sure that the management is working to achieve this.

The board can even award the management contract elsewhere if it is unhappy with performance, although this is a reasonably rare event.

What about cost?

You will have to pay fees to a broker to buy a trust, just as you would have to with any other share. You will also have to pay SDRT – a 0.5 per cent tax on electronic share transactions payable by the buyer – although this is payable on unit trusts too.

If you bought or sold more than £10,000 in one share, you would also have to pay a £1 levy to the Panel on Takeovers and Mergers, but this is unlikely to apply to most retail investors.

Aside from this, the relative cheapness of the funds is one of their major selling points for advocates: total expense ratios tend to be much lower than on open-ended funds, particularly on those that have been operating for a long time.

Many trusts do charge performance fees, however, although this is a fashion that may be changing.

What are the basic pros and cons?

Track record of outperformance Volatile
Low cost Complicated – require more attention
Greater conviction of management decisions Not as well understood among advisers
Possibility of finding ‘bargains’ Driven by sentiment

Data provided by FE. Care has been taken to ensure that the information is correct, but FE neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.

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