The world of investment trusts

Posted by Liz Rees in Portfolio management category on 04 Jul 15

Investment Trusts

The Investment Trust universe does not generate as much press coverage as its larger brethren the OEICs (Open Ended Investment Companies) or the Unit Trust sector despite comprising 396 trusts managing over £136bn* in assets. As we now offer a selection of trusts on our Willis Owen platform and there has been a lot of interest in the recently launched Patient Capital Trust from the Neil Woodford stable, I thought I would outline their main characteristics and examine the arguments for whether they are sleepy dinosaurs or a well-kept secret of the investment world.

Investment Trusts (also known as investment companies) have a longer history than open ended funds with the oldest, Foreign & Colonial, having been established in 1868 while the first unit trust was launched in the UK in 1931 by M&G. The F&C trust had the aim to ‘help the investor of moderate means have the same advantages as large capitalists in diminishing the risk by spreading the investment over a number of stocks’ and it is still one of the largest in the sector today. However, many trusts were actually set up to manage the wealth of Victorian industrialists and their families, particularly those from Scotland. Consequently, several have names that hint at their Scottish roots for example, The Edinburgh Investment Trust and The Scottish Investment Trust. Some are reminiscent of industrial prosperity such as the British Empire Securities Trust while others bear family names such as RIT Capital-the Rothschild Investment Trust. Few have much connection with their history these days and are managed by well- known asset managers, although RIT Capital is still chaired by Lord Jacob Rothschild (and the family retains a significant shareholding).

There are several differences between an investment trust and an OEIC. The first is their structure; OEICS and unit trusts are open-ended funds which issue more units to meet demand, or cancel units to meet redemptions, while investment trusts are closed-end funds whose shares are traded on the London Stock Exchange. To increase their shares in issue they would have to undertake a rights issue or placing, like any listed company. A second difference is regulation; investment trusts are less heavily regulated than open-ended companies but nevertheless have an independent board of directors to whom they are accountable and which has the power to change under-performing managers. A third feature of investment trusts is their ability to use gearing, in other words debt. The level of gearing is decided by the board and portfolio manager and limited by the company objectives. The final distinction is that investment trusts shares are bought at an offer price and sold at a bid price in the same way as any other company listed on the London Stock exchange. This price can be higher (at a premium) or lower (at a discount) than the net asset value (NAV) depending on the demand for the shares. In contrast the unit prices of open ended companies reflect exactly the value of their underlying assets.

These features mean investment trusts have a different risk profile to OEICs. The ability to gear and their pricing structure can increase their risk in terms of volatility. While borrowing enhances returns in rising markets, the downside is that it will magnify losses when markets fall. Also the price of an investment trust may fluctuate more than an OEIC because it will be driven upwards in times of strong demand or downwards when there is a lack of demand creating a discount or premium to NAV. Therefore, investors in trusts need to be prepared for more volatility, particularly in the short term. For example, the average discount for trusts investing predominantly in the UK increased from 6% at the start of 2015 to 8.6%** just before the general election due to increased uncertainty faced by the stock market. After the unexpectedly decisive outcome, however, discounts have started to reduce again.

There are several reasons why investment trust may be worth consideration as part of a diversified portfolio. Firstly, investment companies have outperformed open-ended funds and benchmarks over one year, five years and ten years, and the outperformance over the longer period is quite significant. While past performance is not a guide to the future, the competitive advantages of: the ability to gear, the opportunity to take a long-term view and focus on managing investments rather than cash-flows, lower management fees and NAV enhancements by buying back their own shares (to reduce supply) are all believed to have been contributing factors to this superior performance.

Another attraction of investment trusts is their dividend policies- many have a very impressive history of dividend increases over many years. One of the reasons they are able do this is because they have the ability to set aside income (up to 15%) in reserves during years of strong stock market returns in order to maintain a record of progressive dividend payments in more difficult times whereas OEICs distribute their income on an annual basis. Consequently, despite the widespread dividend cuts by the corporate sector in 2008-2009, many investment trusts were able to maintain their records of paying out and growing dividends – even in the face of a drop in underlying earnings. Many investment trusts put great emphasis on not only continuous dividend payments but also on raising them every year. Examples include City of London Investment Trust and Bankers Investment Trust, both with 48 years of consecutive increases.

As mentioned previously, it is often possible to purchase investment trusts at a discount to NAV, though remember the price reflects supply and demand as well as value. Analysts prefer to look at z-scores (which compare the discount relative to a historic average level) when assessing value. The sector has undergone a significant re-rating since the depths of the global financial crisis with approximately a quarter of companies now trading on a premium to NAV and many issuing new shares to satisfy strong demand. Consequently, the average discount has narrowed from over 10% to around 6%. The industry has become less tolerant of poor performance and Boards of under-achieving companies will initiate a change of manager or strategy. Also, if appropriate, they take action to address excess supply, principally through share buybacks and tender offers. Sectors with the widest discounts at present include private equity, emerging markets and smaller companies while some of the biggest premiums are found in property, listed infrastructure and global income.

Management fees tend to be competitive and many investment trusts have been lowering them and/ or introducing performance fees. For example, Neil Woodford’s new investment trust launch, Patient Capital, has no management fee and a performance fee of 15% above a fairly demanding hurdle rate. However, there is a bid-offer spread when purchasing the shares (unless it is an IPO) and an investor will also have to pay government stamp duty and commission to a broker.

There has been increased interest in the sector of late as more advisors recognize the attractions and include them in client portfolios. This may have contributed to the narrowing of discounts and it is important to remember that in the shorter term at least discounts are vulnerable to any meaningful correction in markets when the number of sellers rises. Furthermore, the level of discount should never be the primary reason for buying an investment trust. If a fund manager has an extremely impressive track record but only runs open-ended funds then it would make sense to back his funds. For example, Old Mutual has some highly rated managers and OEICs but do not run investment trusts. The case for investment trusts is strongest where the asset manager runs both types of funds and the portfolios are run on a similar model. It may be possible to access better performance at a discount to NAV due to the reasons mentioned above and also the flexibility of what is sometimes a fund of more manageable size. Companies that have a good selection of both types in their range include: Aberdeen, Fidelity, Baillie Gifford, Henderson, Schroders and JP Morgan.

Graph 1

Graph 1

The above charts show examples of where investment trusts run by Fidelity and Baillie Gifford have outperformed OEICs run by the same managers over a 5 year period. However, this will not always be the case and it can be seen that the investment trusts demonstrate greater volatility, or fluctuations, in their share prices. Rising stock-markets will have assisted their strong performance for the reasons outlined above.

In conclusion, investment trusts are well worth consideration but like all investments careful research and selection is necessary. There used to be less research available but Morningstar and Citywire now produce ratings and independent research companies such as Edison are starting to take up coverage and their research can be accessed free of charge. The larger trusts will have their own websites and others a section on their asset management company’s website. The Association of Investment Companies website ( also contains a lot of useful information.

Investment Trusts available through Willis Owen can be found at Share Space, where you can also view prices, trust sizes, performance and even interactive charting enabling you to compare and contrast trusts against each other and sectors.

Investment trusts are traded like shares and are charged at our normal online rates, which start from just £7.50. To see our Menu of Charges and to learn more about investment trust simply click here.

*source : AIC data 31/05/2015
**source: Winterflood Securities
***source: The Association of Investment Companies members sector average @31/05/2015

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.

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