Find out everything there is to know about investment trusts, including their pricing, performance, and the impact of gearing.

What exactly is a mutual fund investment trust?

Through the use of investment trusts, such as unit trusts and open-ended investment companies (Oeics), investors are able to combine their funds with the funds of other investors in order to gain exposure to a diverse range of assets through the use of a single investment.

Investment trusts have been around since the 1860s, and for many years, their supporters have considered them to be the industry’s best-kept secret. This is due to the fact that historically, investment trusts have had lower ongoing charges than unit trusts, and as a result, they have had the potential for higher returns.

Since January 2013, when fee structures for mutual funds were modified, this benefit has, for the most part, been rendered obsolete.

In this article, we will explain how they operate and help you decide if you should use them.

Comparing trusts with open and closed ends

The London Stock Exchange is the primary market for trading investment trusts, which are organised as businesses.

Investment trusts are required, just like any other company that is quoted on a stock market, to submit an annual report as well as audited financial records. In addition to that, there is a board of directors that serves as the point of accountability for the manager of the trust. When you buy shares in a firm through an investment trust, you automatically become a shareholder in that business.

The two types of trusts, unit trusts and investment trusts, have fundamentally distinct organisational structures.

Investment trust prices

The value of an investment trust’s holdings is referred to as the net asset value (NAV), and it is typically given as a number of pence per share. If a trust has assets worth £1 million and one million shares in total, then the NAV is equal to 100 pence.

When you invest in a unit trust, the value of the assets held by the trust is immediately reflected in the price of the units that you purchase in the trust.

When it comes to investment trusts, the price of shares is established by the supply and demand of those shares on the stock market. Because of this, the price that you pay will almost certainly not be the same as the NAV.

If the current price of a trust is:

It is said to be trading at a discount when its current price is lower than its NAV.
It is selling at a premium since its price is higher than its NAV.

Discounts are common when it comes to the trading of investment trusts. This appears to be a fantastic deal given that you are paying less than £100 for assets that are worth £100. On the other hand, there is no assurance that the size of any discount will have decreased by the time you come to sell the item. In the event that the discount grows larger, you will suffer a financial loss in relative terms regardless of what happens to the NAV of the trust.

Trusts will trade at a premium to their NAV much less frequently. This indicates that you are paying more than one hundred pounds to own one hundred pounds’ worth of assets. One reason why you could be willing to do this, for instance, is due to the expertise of the fund management. Nevertheless, you need to ask yourself if this kind of outperformance is likely to continue for the foreseeable future.

Where do trusts put their money to work?

Investment trusts, much like unit trusts, are classified according to the region in which they operate and the sort of investments in which they participate.

The Association of Investment Companies (AIC), which is the trade organisation that represents investment trusts, has compiled a list of more than thirty distinct industries, including the following:

Growth in the UK
Growth Across the World
Infrastructure Property Private Equity Across Europe, Asia, and the Pacific

The amount of a discount or premium will typically shift depending on the sector and how the market feels about that area.

The degree of risk associated with a trust will be somewhat determined by the locations and types of investments it makes.

Trusts for the ethical investing of capital

The majority of large investment firms include what is known as socially responsible or “ethical” investing as part of their investment strategy, and many of these firms ought to have separate “ethical funds” from which investors can pick.

This indicates that they will only invest in businesses that fulfil a predetermined list of requirements, avoiding those whose goods or methods of conducting business do not live up to the standards that have been established.

Some ethical funds, for instance, may not invest in businesses that manufacture meat products or businesses that contribute to the emission of greenhouse gases.

The performance of investment trusts

Investors in investment trusts typically do so because they are under the impression that the trusts will outperform other types of “open-ended” funds, such as unit trusts and Oeics.

Numerous studies have consistently found that investment trusts typically have better performance than open-ended funds that are equivalent. AJ Bell, a stockbroker, conducted research that was released in 2019 and found that over the long run, which is defined as 10 years or more, 75 percent of investment trusts outperformed open-ended funds that invested in identical assets.

In 2018, researchers at Cass Business School discovered that investment companies had exceeded their benchmarks by an average of 0.8 percentage points on an annual basis.

When investment trusts do outperform their open-ended competitors, as they frequently have in the past, this phenomenon can sometimes be explained by a combination of lower costs (although this advantage has narrowed in recent years), the closed-ended structure of the trust, and the effect of ‘gearing.’ In other words, when investment trusts do outperform their open-ended competitors, this phenomenon has frequently been attributed to investment trusts.

In this section, we will discuss the effect that these elements have on performance.

Trusts in investments and structures with little room for new investors

Investment trusts are able to adopt what is considered to be a more realistic long-term view than their open-ended equivalents. This is possible due to the fact that investment trusts have a set and fixed number of shares and are managed by a board of directors. They are not required to acquire or sell the underlying investments until the board of directors believes that doing so would be profitable at the current moment.

On the other hand, in the case of open-ended funds, the managers of the fund are required to buy and sell shares in order to accommodate investors who are entering or exiting the fund. This can imply that managers are obliged to make transactions at inconvenient periods, such as selling when the market is at a low point and purchasing when it is at a high point, for example.

The performance of an investment in the past is in no way indicative of the profits it will generate in the future, as any investing professional will be sure to point out to you.

When it comes to creating an income from investment trusts, dividends can be a significant contributor.

Utilize our dividend tax calculator in order to see how much you will be responsible for paying in 2021-22.

Trust investments and gearing are both examples.

The fact that investment trusts can borrow money in order to invest is referred to as “gearing,” and this practise can have a significant impact on the value of your investments. This is another significant distinction between investment and unit trusts.

When stock markets are:

The use of gear is beneficial since it multiplies whatever gains you make while you are climbing.
When you’re falling, revving up will make your losses worse.

When put in these conditions, trusts with higher levels of gearing are more likely to suffer greater losses than those with lower levels of gearing.

This indicates that the capital risk associated with a trust is proportionately larger the more borrowing it has, but that the trust also has the potential for bigger profits. As a result of the interaction between gearing and the discount, investment trusts are likely to be subject to greater levels of volatility than comparable unit trusts.

This indicates that if you want to invest in investment trusts, you should be prepared for a more turbulent path with larger swings in both direction.

However, this may not apply to all investment trusts. The AIC is responsible for publishing information regarding the gearing policy of each trust. A gearing rating of 100 indicates that the trust does not engage in any form of borrowing, whereas a rating of 110 indicates that your gains or losses will be magnified by 10 percent, etc. This rating indicates that the trust has gearing equal to 10 percent of its total assets.

Expenses related to investment trusts

Because of the following factors, investment trusts have historically been characterised by having lower ongoing costs than open-ended unit trusts and Oeics.

Investment trusts, on the other hand, do not pay commissions to financial advisers, in contrast to open-ended funds;
Because they do not have to deal with money going in and out, there is less administrative work that needs to be paid for;
They have autonomous boards of directors that look out for the interests of the shareholders, and as a result, they frequently bargain for lower yearly costs as the trusts they oversee expand in size.

Open-ended mutual funds, on the other hand, are now more affordable as a direct result of the Retail Distribution Review (RDR) conducted by the Financial Conduct Authority. There are currently tracker funds available with costs that are far below 1 percent.

When thinking about investment trusts, it is important to keep in mind that the deals you make will be subject to stockbroking commission, just like any other share transaction, but not like transactions involving open-ended funds.

How to decide which investment trust is right for you

When selecting an investment trust, there are a few aspects you should keep in mind, including the following:

Check to discover what its gearing level is. Having a greater gearing level may increase your returns if the fund performs well, but it will hurt you severely if it falls in value.
Check the fees, as many companies have reduced their rates now that open-ended funds are exempt from paying commissions.

In the end, there is no clear answer to the question of which type of investment vehicle, open-ended funds or investment trusts, is superior. The former have some benefits, especially when you want exposure to more illiquid assets; nevertheless, it is not assured that they will outperform, and they may be more volatile over shorter time periods.

You should only consider investing if you are able to maintain a long-term perspective, since the value of any one collective investment fund can either rise or fall at any given time.