Why consider investment trusts for income
While some investors prefer to invest directly in equities and bonds, many choose to invest in funds to take advantage of the diversification on offer. One type of fund, the investment trust, offers something slightly different and could add a whole new dimension to existing portfolios.
Investment trusts are slightly unusual in that they are actually structured as a company. They have shares that are traded on the stock exchange and have a board that ultimately answers to shareholders. A fund manager is appointed to invest on behalf of the shareholders and grow the value of the underlying investments.
Unlike typical funds, investment trusts have a finite number of shares in circulation at any given time, with the share price determined by supply and demand in the market. This means the market value of the trust’s assets doesn’t necessarily equate to the trust’s valuation – the trust can trade at less than the sum of its assets (a discount) or more than its asset value (a premium).
The benefits of investment trusts
There are a number of advantages of investment trusts versus regular, ‘open-ended’ funds. One of the most popular with investors is the fact it doesn’t have to pay out all the income generated by its underlying assets; it can retain some and hold on to it as a revenue reserve.
Admittedly this is not the most exciting feature when most companies are growing their dividends, but in a recession when lots of dividend cuts take place, it means the board can dip into the trust’s reserves and maintain (or even grow) the income payments. This is very appealing to those investors who rely on the income their investments generate.
Indeed, for some illiquid asset classes, the close-ended structure of the investment trust is more appropriate than an open-ended one, with property being an obvious example. In the summer a number of open-ended funds closed because of high levels of outflows, and the managers didn’t have time to raise sufficient cash through property sales. Although the funds have now reopened, to prevent further closures they are stockpiling large amounts of cash, which dilutes their ability to generate income.
Investment trusts don’t have this issue. If lots of investors sell their shares the share price is likely to fall, but there is no impact on the underlying assets and the trust’s shares will continue trading. Furthermore, a cash buffer isn’t needed. One property investment trust we favour is F&C Commercial Property Trust, which pays a monthly income sourced from a range of commercial properties situated across the UK.
The pros and cons of gearing
Another important feature of the investment trust is its ability to borrow to invest, also known as ‘gearing’. There are both benefits and pitfalls associated with such a practise though. Borrowing to invest will generally increase the volatility of a trust’s asset value, which leads to a more volatile share price. While gearing can enhance returns in a rising market, the opposite is true in a falling market and, if not carefully managed, the trust can become burdened with expensive borrowing arrangements.
There are plenty of examples of gearing being successfully implemented in the market place. Among the very largest in the UK is Scottish Mortgage, which invests in many of the world’s leading technology companies, including Amazon, Tesla and Facebook. It is geared and has appreciated considerably in the last ten years, making use of its structure to invest in both listed and unlisted companies.
Another successful example in the domestic market is Perpetual Income & Growth, run by UK Equity Income manager Mark Barnett. Being structurally geared, combined with good stock selection, has enhanced both the trust’s capital growth and its ability to generate income.
For those who choose to invest in actively managed funds we believe investment trusts to be worth consideration for patient, long-term investors. In many ways they are more flexible than the typical open-ended fund and often carry lower ongoing charges. As ever, the challenge for us as fund selectors is separating the good from the mediocre.
Ben Johnson is funds analyst at Charles Stanley