Most private investors gravitate towards open-ended funds over investment trusts, as their distinctive terminology of net asset value, premiums, discounts and dividend cover can be off-putting. But beneath the veneer of jargon, the basic concepts are not hard to understand.
What are the key concepts that make investment trusts different from conventional unit trusts? And what should investors consider when choosing one?
1 Who’s in charge?
The great majority of investment trusts and investment companies are actively managed and so the fund manager with overall responsibility for the portfolio is key.
“When considering a trust, it is important to check who is in the driving seat and how long they have been in situ,” says Jason Hollands, managing director at wealth manager Evelyn Partners.
“If there has been a recent change, the past record may be of little relevance and you should seek evidence of how the current manager has done in the past on any similar funds they may have managed.” He advises picking a manager who has a personal holding in their trust, as this aligns their interests with those of investors.
2 Discounts and premiums
One of the unique features of an investment trust when compared with funds is that they can trade at a discount to the value of their underlying assets (the net asset value or NAV). This is a bit like buying something on sale, where you are getting it for less than its true value.
However, investors shouldn’t buy an investment trust just for the discount. Instead they should buy trusts that they think will be a good investment, and if it’s on a discount, that can be an extra reason to buy now, or top up an existing holding.
Annabel Brodie-Smith of the Association of Investment Companies says investors need to put this in context. “Ask yourself how has the discount or premium changed over time. Compare the discount or premium to other companies in the same sector. Can you see an obvious reason why an investment company is rated differently to its sector?” A wide discount is not necessarily a buying opportunity, she says, but it’s worth investigating further.
Also, many trusts have the authority to buy back their own shares to cancel them, in an attempt to limit the extent of any discounts, says Hollands. “This is a sign of being shareholder friendly and so it is important to scour the annual reports for indications of whether such policies are in place. Buying a trust at a big discount may be great, but having to sell your shares for less than they are worth is not.”
Investment trusts can borrow cash against the value of the portfolio — or use “gearing” — to make additional investments. Done effectively, this can boost returns, enabling managers to scoop up extra investments at times when they feel there is an opportunity, without having to find new investors.
But it comes at a price. “Higher levels of gearing add more risk to the portfolio, which can result in higher returns but can mean you go on more of a rollercoaster ride to get there,” says Laura Suter, head of personal finance at AJ Bell. “Trusts will state two things: their gearing policy, which is the limits of the amount they can borrow, and their current gearing or borrowing. Check out both to make sure you’re comfortable.”
Many people regard investment trusts as relatively cheap compared with open-ended funds, a hangover from the days when unit trusts had much higher fees than now because they included banned adviser commissions. That is no longer the case, says Hollands.
“We have previously studied investment trusts and open-ended funds with similar strategies, managed by the same teams and there was no convincing evidence that trusts were overwhelmingly the lower cost option,” he says.
Investors need to look on a case-by-case basis. One thing to be wary of is that some trusts, particularly those focused on niche areas, incorporate performance fees. Sometimes these can be heavily loaded in favour of the managers so that they could get a big cut of the returns over and above a certain target. Check you are comfortable with any performance fees.
Income seekers will also want to look at a trust’s dividend record. Investment trusts are well suited to giving investors a steady income, as they can withhold up to 15 per cent of the income they receive each year to be used to boost dividends in future years when payouts may be lower.
“If income is part of your objectives, check for how frequently distributions are made — annually, twice yearly or quarterly — and how consistent a trust has been in paying out and growing their dividends,” says Hollands.
Another useful measure for income seekers is dividend cover, which indicates how long an investment company could make payouts using its revenue reserve. Dividend cover is helpful in analysing the security of an investment company’s dividend — something that’s useful to understand in these challenging markets.