So, What’s an Investment Trust?

The Original Investment Choice

Investment Trusts (ITs) are one of the oldest investment vehicles available for both the institutional and private investor to take advantage of. Several Investment Trusts, such as the Foreign and Colonial IT, have survived for over a hundred years of stock market ups and downs, crashes and world wars. The fact that investors are still pouring their money into them today is testament to the way in which these funds are structured and managed.

Investment Trusts are listed companies with shares that trade on the stock market, and they can be purchased in much the same way that you’d buy shares of BP or Tesco. Like mutual funds, ITs pool money from many investors into a basket of holdings that follow a particular theme or market sector. However, unlike mutual funds, ITs are closed-ended vehicles.

What this means is the trust will issue a fixed number of shares on the stock market. The price of each IT is therefore determined by the supply and demand of the market, which in turn influences its share price, again just like a standard stock. But in addition, the Net Asset Value of the trust is considered, which is calculated as the total value of the assets held by the trust, divided by the number of shares that have been issued.

Due to the fixed number of shares in existence, and the varying share price, it’s possible to buy shares of an IT for less than its equivalent assets are actually worth. This is known as the discount, and is a core component of the Investment Trusts appeal.

Many Changes Over The Years

As mentioned earlier ITs have been around for a long time, with Foreign and Colonial being founded as long ago as 1868. By 1914 there were 90 Investment Trusts in existence and their total assets were valued at nearly £90 million. Today, the IT industry comprises over 340 separate trusts with total assets exceeding £115 Billion!

Since these trusts have been around for such a long time, many have veered away from their original aims. For example, one of the largest ITs available today is the Scottish Mortgage Investment Trust, which was launched in 1909 to finance rubber estates in Malaysia. Today it primarily invests in technology stocks such as Tesla and Amazon, and is known as one of the market leaders in finding and holding quality technology companies. Quite a change from the days of those old rubber plantations.

There are several advantages for deciding to invest in an Investment Trust over their more popular open-ended cousins. To begin with, they are controlled by a manager who is overseen by a board of directors. This means that should the manager fail to live up to expectations, then the board can simply dismiss them and replace them with someone who will hopefully perform better.

Secondly, you may be able to pick up shares of the trust while they’re trading at a discount to their NAV. This means that there’s the possibility of benefiting not only from a rising share price and increasing dividends, but also from the increase in the Net Asset Value over time.

Thirdly, ITs have had a historically lower fee structure than mutual funds, with some trusts charging as little as 0.5%, similar to the fees charged by passively run ETFs. However, this gap has closed recently with the abolition of mutual fund performance fees, and it should be noted that most ITs still insist on including performance fees as part of their ongoing charges.

Gearing- A Double Edged Sword

Whilst it’s possible to purchase units of a mutual fund with the same underlying holdings as an IT, it’s been reported time and again that ITs consistently outperform mutual funds over longer time periods. This has been found to be caused by their low fee structure, and the ability of ITs to use gearing as part of their ongoing strategy.

Gearing means that the trust can borrow money to use for additional investments. Something that mutual funds can’t do. However investors should note that gearing is often a double-edged sword. Whilst it can multiply performance gains when the trust is increasing in value, it can also multiply losses when the trust underperforms.

To understand the use of gearing by a trust, let imagine two trusts that have an investment portfolio of £100 million each. The first trust, Trust A, is entirely equity funded to the value of £100 million, while the second trust, Trust B is financed with 50% debt and 50% equity. A year later, both trusts are now worth £200 million. If the both trusts decided to pay their entire portfolio back out to their investors, then Trust A would return its original £100 million, plus £100 million in growth, a 100% increase. But Trust B would repay the £50 million loan, leaving the original £50 million, plus the growth of £100 million to be repaid to their investors. That’s a profit of 200% on the original equity of Trust B.

In that scenario the use of gearing has worked in investors favour, but if Trust B made a loss instead, it would have the opposite effect. Let’s say Trust Bs assets halve from £100 million to £50 million. The trust would then have to use all its assets to repay the creditors, meaning that investors would be left with nothing.

The use of gearing can have a devastating effect on your returns if it’s abused and mismanaged, however, the diversity, enduring nature, low fees and potential discounts of Investment Trusts all add up to making them still worthy of your consideration as a core component of your portfolio.

FinanceFanatics

Personal finance blogger who’s fanatical about financial freedom, investing and making money in the UK

One thought on “So, What’s an Investment Trust?

What do you think? Leave a reply here