Understanding investment trusts…60 second back to basics guide
Want to know the difference between an investment trust and a unit trust? Here’s a 60 second guide to help you understand key features of each.
What is an investment trust?
An investment trust is a company listed on the stock market which invests in a range of shares or other assets on behalf of investors. They allow investors to spread their risk and access investment opportunities that they wouldn’t be able to on their own. Investment trusts are closed-ended: in other words, they have a fixed pool of assets, with their shares traded backwards and forwards on the stock market. They are long-term investments and investors should be prepared to hold them for at least five years, and preferably 10 or more years.
What is the difference between an investment trust and a unit trust?
An investment trust is a company, with an independent board of directors listed on the stock market, managed by a fund manager. Investors buy and sell shares from existing shareholders, whereas in an open-ended fund it is run and managed by a fund management group and investors buy and sell units directly from the fund itself. An open-ended fund, as the name suggests, increases and decreases in size as investors move their money in and out of the fund.
What are the pros and cons of using an investment trust versus an open-ended fund?
When choosing an investment structure, investors need to consider the various features carefully before deciding which one is for them. It doesn’t have to be an ‘either/or’ scenario either – many investors combine the two products in their portfolios.
Managers of open-ended funds have to manage the fund to be able to meet the demands for investors who may want their money back at any time. Managers of investment trusts, with their closed-ended structure can take a long-term view of the portfolio and do not have to hold cash or manage the portfolio for redemptions. This is particularly important when markets are poor, as open-ended managers may be forced to sell holdings to meet redemptions (investors selling their units). In contrast, investment trust managers can sit out the volatility and position their portfolio for the market recovery.
The closed-ended structure also allows investment companies to invest in less liquid asset classes that open-ended funds cannot offer, such as private equity and infrastructure. After the EU referendum, one particular illiquid asset – property – plunged, with some of the open-ended property funds forced to close meaning investors could not buy or sell them. The share prices of property investment trusts suffered severely after the referendum but investors were able to continue to trade and they did bounce back.
Investment trusts can also gear, which open-ended funds cannot. At its simplest this means borrowing money to buy more assets in the hope the company makes enough profit to pay back the costs of the debt and make a return on top for shareholders. Gearing works by magnifying performance: in strong markets gearing can boost performance, but conversely can be a drag on performance in poor markets.
Investment trusts trade at the share price. The share price of an investment trust can be lower or higher than the value of the underlying assets minus any debt (NAV) and this is known respectively as trading at a discount or premium. Open-ended funds trade at Net Asset Value (the value of the underlying assets) so investors do not have to consider discounts and premiums.
How do I buy one?
If you invest without advice, you’ll need to select your own investment company. The Association of Investment Companies website is a good place to start finding out about investment trusts. You can buy investment trust shares directly through a stockbroker or an execution-only dealing service (platform). Investment trust managers also offer investment trusts through wrapper schemes such as ISAs or saving schemes.
Annabel Brodie-Smith is communications director at The Association of Investment Companies