Take a fresh look at Investment Trusts
For many years, the UK IFA community has not, in the main, promoted the benefits of investment trusts to their clients. This has perhaps been due to the alternative unit trusts and latterly OEICs offering commission paying spreads making open ended investments more rewarding. However, since the Retail Distribution Review (RDR), the introduction of clean share prices and client agreed remuneration, this playing field should now be level.
Investment trusts are listed companies and therefore like shares in public companies, are traded throughout the day on the London Stock Exchange. Purchasing investment trusts via a platform is simple but can attract trading costs, although these costs are repeatedly being reduced. Some platforms such as Acentric do not charge to buy or sell investment trusts while others like Old Mutual Wealth and Standard Life only charge £1 per transaction.
Investment trusts were a Victorian invention and were a means to raise private capital to fund new developments, like railways across the world. They allowed more moderate investors the same access to the stock market that had previously only been available to much larger capital investors and institutions. Throughout its long history, the investment trust industry has continued to adapt to meet investors’ needs with many of the UK leading investment trusts boasting attractive investment returns for several decades and some over a century. This evidences their capability and stature.
The investment trust industry has continued to invest in ground-breaking opportunities including technology, biotechnology, healthcare, emerging and frontier markets, private equity and venture capital. These recent developments continue to make investment trusts both highly attractive and relevant to investors.
The case for using investment trusts instead of the corresponding open-ended unit trusts is easily made when comparing the longer-term performance of each sector average. Recent research from the Association of Investment Companies (AIC) illustrates that over the past twenty years, investment trusts, on average, delivered a return of 372% which is over two times higher than the average return on open-ended funds and 3 times higher than the total return for the FTSE100 and FTSE All-Share Indices for the same period. Out of the sixteen sectors, twelve investment trust sectors have outperformed OEICs over the long-term.
There are important structural differences between unit trusts and investment trusts. Investment trusts are “closed-ended” investments. They issue a fixed number of shares when they are set up which investors can then buy and sell on the stock market. This means investment trust managers always have a fixed amount of money at their disposal and do not have to buy and sell the underlying investments in order to meet consumer demand for shares. This can add a degree of stability to investment trust managers that unit trust managers do not have. By contrast, unit trusts are “open-ended” investments and must issue or redeem units at any time to satisfy investors who want to buy into the fund or sell their stake. This may restrict the performance of unit trusts as the manager may have to hold excessive cash balances or sell assets at a low point to pay investors who want to sell units.
Because investment trusts have a limited and constant number of shares and are governed by a board of directors, they can arguably take a more genuine long-term view than their open-ended counterparts. They don’t have to buy or sell the underlying investments until the board thinks it is the best time to do so. Being ‘closed-ended’, managers can invest in less liquid assets such as private equity, infrastructure and specialist commercial property. A longer-term plan can be engaged. This process can bring greater diversification to the strategy resulting in better long-term returns and more varied sources of income.
A unique feature of investment trusts is that as a listed company that invests in other listed companies, there can develop a difference in the share value of the investment trust to that of the collective share value of the underlying assets owned by the trust. If the share price of the investment trust is higher than the net asset value (NAV) of the holdings, the trust is trading at a premium. As such it will cost an investor more to buy the investment trust than to buy its underlying assets. Investment trusts trading at a premium is usually due to the success of the fund manager, the popularity of the trust or sector and demand for its shares. A high premium means also that an investor is paying over the odds for the underlying assets but may be happy to do so.
Investment trusts trading at a premium is not as common as trusts trading at a discount. This occurs when the share price of the trust is lower than the cost of the underlying assets. Investors are then accessing a portfolio of stock at a lower price than the market values its holdings. This feature is not available to OEIC investors as they always pay the NAV price. This range of premiums and discounts can vary and move upon investor demand. The closing of a discount will mean a trust is popular and there is a demand for its stock. This feature can enhance returns above that of the growth in the underlying stock.
The benefit of an investment trust trading at a discount is that investors get an asset at a reduced price that can aid returns but this can also add a measure of additional volatility not seen in OEICs. Overall discounts can be viewed as a positive feature but we at Crossing Point only consider investment trusts that trade between a -15% discount and +5% premium in order to manage these factors. Our current Heritage portfolios’ investment trust holdings trade at an average discount of -3.5%.
Another major difference between investment and unit trusts is that investment trusts can borrow money to invest. This ability (known as gearing) can have a dramatic effect on the value of an investments. The attraction to an investment manager to be able to borrow additional capital to further participate in growth markets is evident and can be an aid to outperformance during rising markets but can also be detrimental during declining markets. For this reason, we at Crossing Point only consider investment trusts with gearing ratios under 15% in order to manage this factor. Our current Heritage portfolios have an average gearing on investment trust holdings of 3.3%.
The combined effect of both gearing and discounts means that investment trusts can exhibit greater growth potential but can also be more volatile in down markets than the equivalent unit trust or OEIC. A well-selected and managed investment trust portfolio has been shown to provide very attractive longer-term returns for retail investors at competitive costs.
Heritage portfolios use investment trusts to provide superior returns and consistent dividends over longer investment horizons. Heritage portfolios offer greater diversification and a broader range of holdings. Due to the nature of investment trusts these portfolios are managed on a long only basis and do not use trend-following.