Investing in Investment Trusts
Investment Trust Shares
What are Investment Trusts and why should you invest in them?
This article is all about the advantages (and disadvantages) of these relatively unpopular equity investments. They are generally only purchased by experienced investors because they are more complicated, but tend to have much lower charges and out-perform unit trusts (mutual funds) and other more popular investments. Generally they invest in the stock markets of the world although may also invest in commodities and bonds.
Additional complications are that some investment trust companies are divided into different share classes; so-called Split Capital Investment Trusts (zero-dividend preference shares, income or capital shares) and to confuse things even more on formation a company may also issue investment trust warrants (long-dated call options with a strike-price typically the same as the launch price of the share providing a highly geared (leveraged) exposure to the underlying investment)
There are far fewer investment trusts than there are unit trusts. Each is an individual company, but most belong to bigger investment groups, such as 3i, Black Rock, Foreign and Colonial (F&C), Fidelity, Gartmore, Henderson, Invesco, JP Morgan, Jupiter, M&G, New Star etc. many of whom also have similar products sold as a unit trust.
Disclaimer: Information in this and other linked articles is unregulated and for general information only and is not intended to be relied upon in making specific investment decisions. Appropriate independent advice should be obtained before making any such decision.
Better than a Mutual Fund or Unit Trust
Financial Advisors won't tell you about them
What Are Investment Trusts?
As a small boy I was terrified of my grandfather. He was just as scared of me and we had nothing to talk about until we discovered that we have a common interest in investment trusts. He was very old, but as it turned out investment trusts are even older. The first, Foreign and Colonial, was established in 1868 and is still going strong. By the time I had some money to invest I knew a lot about this kind of investment.
Investment trusts were the first collective investment, like a unit trust or OEIC, (Open Ended Investment Company) and were invented so that the ordinary person in the street could invest in shares, but without putting all of his money in one company, or wasting money on excessive charges. Unit trusts came along much later, and are now much more popular. The difference between them is that an investment trust is a share in an investment company and a unit trust is a defined portion of an investment portfolio. If you buy a unit for, say Â£1.00, the manager will need to create a new unit and invest that money for you, after first taking Â£0.05 fee, and if you sell it he will need to sell the investments again (even if it's not a good time to do so) The IT company will invest their money in a similar way to the UT manager, but there are a fixed number of shares, so their price you pay for the share reflects both the value of the underlying investment and the supply and demand for those shares. UTs and ITs both have a bid/offer spread, difference in price between buying and selling, but it is far larger for the UT, usually about 5% (the 5p mentioned above) whereas it is small for the IT. Both also charge an annual management fee, but again this is large for the UT at typically 2% or so, and often less than 1% for the IT. Sometimes there will be almost identical products in UT and IT form, such as Fidelity Special Situations and Fidelity Special Values plc. which were both run by the legendary investment manager, Anthony Bolton (now semi-retired and writing music) So, why would anyone buy a unit trust, when they cost more and don't perform as well as investment trusts?
There are many books on the subject of investment, but very few on investment trusts (except Real-estate Investment trusts: REITs) but the same principles apply when investing in unit trusts or mutual funds.
Advantages of Investment Trusts
Investment trusts rarely advertise, and therefore waste far less of your management fee. They also do not pay commission to financial advisors, so, with the exception of truly independent advisors, who are not paid by commission, or who share their commission with the customer, they are unlikely to be recommended. The other reason ITs are often shunned by retail investors is that they are more complicated and can be riskier.
Most investment trusts trade at a discount to the value of the underlying investment (the net asset value, or NAV of the share will be higher than the share price) so you get more shares for your money and more dividend, but the discount still applies when you sell too. The discount generally shrinks during good times because there are usually a fixed number of shares, so the price goes up disproportionately with demand. This magnifies the market movements and makes them riskier during a downturn. Some very popular investment trusts may even trade at a premium during a bull market. When choosing an investment you need to take the discount into consideration, not just its absolute value, but also whether it is higher or lower than usual. This adds complication. It is important to monitor the variation of the NAV when comparing performance with other investment, because this is the measure of the underlying performance, rather than just the value.
Gearing (i.e. Leverage)
Investment Trusts are allowed to borrow money to invest, which is a practice not allowed for unit trusts, thereby gearing-up the investment (that's English for "leverage")
Another complication is the different types of share available for some companies. Some investment trusts are split capital investment trusts which are covered in my other review "Almost crash-proof") and a misselling scandal a few years ago, specifically for the zero-dividend preference share variety of split caused all investment trusts to be tarred with the same brush, causing more mistrust. Conventional investment trust are different, and easier to understand that these more obscure investments.
Investment trusts are companies and therefore have to have an annual general meeting, to which you will be invited if you own shares, or you can vote using the postal vote form sent with the annual report. This, for me makes them more interesting, although I have not yet attended a meeting.
Disadvantages of Investment Trusts
If you want to buy an investment trust through a broker they will charge you a fee, of typically about Â£10 and, as they are actually a share in a company, you will also need to pay 0.5% stamp duty. Neither of these fees are payable when buying a UT, although you do have the big, typically 5%, and upfront fee. If, however you buy direct from the management company (e.g. Fidelity, Foreign and Colonial etc.) they will have low cost ISA and regular saver options which may even be free apart from the stamp-duty. There are also now money supermarkets and discount brokers (e.g. Hargreaves Lansdown) who will give back most of the 5% upfront fee and some of the annual management fee for unit trusts, reducing the advantage of investment trusts. Also in the last few years and new breed of investment has arrived, called the Exchange Traded Fund (ETF). This is similar to a UT excepts its price is quoted continuously through the trading day, like an IT rather than just once for a UT and there is no real manager, because they simply track an index using computers, therefore have very low annual fee and small bid/offer spread. I use these for short term trading and ITs or other shares for longer term trading.
Additional Complications (Zeros, Splits and Warrants)
Most investment trusts are referred to as "Conventional Trusts" which are companies with just one class of share; an ordinary share. Split capital investment trust companies however have two or more classes of share and generally have a predefined life-time before they are wound-up. The Zero Dividend Preference Shares pay no dividend, but have a predefined value on the wind-up date and are therefore tax-efficient for some people and also allow accurate tax-planning.
Income shares may pay out income and dividends derived from the underlying assets to their share-holders and capital shares might return some defined portion of the capital gain of the underlying assets. The exact details of the class of shares, asset and income allocation will vary for each company, with the exception of the Zeros which tend to have very similar terms. The zero-dividend share holders will be paid first on winding up the company before other classes of share, although after any bank-debt. See the related article for details about how to value and invest in zeros.
On formation a company may also issue warrants which are long-dated call options with a strike-price typically the same as the launch price of the share providing a highly geared (leveraged) exposure to the underlying investment. There are very few of these in existence (about 10 at time of writing) These are more difficult to trade, due to low-liquidity and tend to have wide bid-offer spreads. Their value can be determined using normal option-pricing methods (e.g. Black Scholes option pricing) based on length of time to maturity and share price. (Please see the related article)
Investment trusts are fairly unpopular investments will generally give a better performance than unit-trust or OEICs (open ended investment companies, effectively the same as a unit trust) However the difference is less clear-cut than it was a decade ago, with the advent of investment supermarkets, discount brokers and ETFs. If you think the markets will go up from here, the investment trust discount will also probably shrink causing an even better return.
Summary: Some excellent investments
Advantages: Low charges and initial fees, no commission to advisors
Disadvantages: stamp duty, complicated