Aside from the US/China trade war flaring up again, this time with actual tariffs being put into place rather than just sabre rattling I don’t have a lot to say about the global economy or stock markets. So I thought I would begin a series of articles about alternative investment products. Some you will be familiar with, others you may know little or nothing about. Today’s topic is investment trusts. In the future I’ll look at National Savings & Investments, structured products, investment bonds and tax efficient investments such as venture capital trusts.
As an independent financial adviser (IFA) I am required under the rules to consider the full range of what the regulator, the FCA, call “retail investment products,” when deciding what might suitable for my clients. These are defined in the rules although not entirely clearly. All the alternative products I will cover in these blogs fall into that category. Marketing of retail investment products and advice on them is fully regulated although perversely not all retail investment products are covered under the Financial Services Compensation Scheme (FSCS) in the event of insolvency.
Due to the technical differences between investment trusts and other types of fund I will cover them in two articles. The first is the technical bit requiring a bit of hard work for the reader. The second will cover the more practical investment applications. Don’t worry if you don’t get everything in this article, the applications are more important and interesting.
What is an Investment Trust?
Investment trusts are collective investment schemes just like unit trusts and opened ended investment companies (OEICS), types of funds that you will be very familiar with. In essence an investment trust is a fund which holds a basket of shares or other securities, typically 50-100, similar to unit trusts and OEICs. This spreads and reduces investment risk. Investors money is similarly pooled and the investments are professionally managed.
Historically investment trusts have remained off the radar for several reasons despite being around for much longer than unit trusts,* having lower management charges and generally better performance. Firstly they never paid commission to advisers, secondly they have additional complexities and risks compared to unit trusts and OEICs and thirdly they cannot be advertised for sale. The reason for the latter is that investment trusts have a very different legal structure than their better known collective investment cousins such as unit trusts. An investment trust is not a trust. It is a company, a PLC. Investment trusts issue shares which are listed and traded on the London Stock Exchange (LSE). At least one, the Scottish Mortgage Investment Trust is a FTSE 100 company, others are FTSE 250 listed.
Being an investor in an investment trust is no different in principle to owning shares in any other company whether that is GlaxoSmithKline, BP or Tesco. The difference is that an investment trust’s business is to buy, hold and trade stocks and shares of other companies rather than manufacture and sell drugs, drill oil or sell corn flakes. You won’t see newspaper or other adverts from Glaxo, BP or Tesco to buy their shares because a marketing campaign would distort the market and drive up the share price. Remember share prices are determined by supply and demand. Similarly you won’t see adverts recommending you buy investment trusts per se although their monthly savings schemes can be promoted.
Closed End Structure
The company structure of investment trusts has several key consequences. Most importantly they are said to be “closed end” because there are a limited number of shares in issue. When investors buy or sell their shares in an investment trust it does not affect the underlying assets or holdings, just the share price of the trust. This means an investment trust’s share price can trade at a premium or discount to what is called its Net Asset Value (NAV) per share, see below.
Consider an investment trust with 10,000,000 shares in issue. If the share price on the LSE is £5 per share at a given point of time then the market capitalisation or value of the investment trust is calculated as for other listed companies, i.e. the number of shares in issue x the share price, i.e. £50,000,000. It is important to understand this is the value of the investment trust as a listed company, not necessarily the value of the underlying assets and investments of the trust. In fact in most occasions the two figures will differ.
If there is large investor demand for the investment trust its share price will rise – say to £6 and conversely if the markets take a dislike to it and investors sell, the share price will fall – say to £4. The number of shares in issue however does not change with the variations in the share price but the market capitalisation of the trust will fluctuate – in this case from £40,000,000 to £60,000,000. Changes in the market capitalisation of an investment trust do not necessary reflect changes in the value of the trust’s assets.
In contrast OEICs and unit trusts are “open ended.” Take unit trusts as an example. Consider a unit trust whose assets i.e. the shares and cash it holds are valued at £50,000,000 and there are 10,000,000 units in issue. You will see parallels with the figures for the investment trust above. So what is the unit price? You’ve guessed it correctly, £5 per unit! However investor demand affects a unit trust in a very different way to an investment trust. If money flows into the fund the manager creates more units and if money leaves the fund the manager redeems units. This is the meaning of the term open ended. For example Mr A wishes to invest £1,000,000 in the unit trust. (Probably not a great idea to invest so much, but it is the maths that matter). The price of units we’ve seen is £5 so the manager simply creates 200,000 more units for Mr A. The unit trust now has 10,200,00 units in issue and the value of the trust is now £51,000,000. The price per unit is still £5. Investor demand has not increased the unit price in contrast to the effect on the share price for an investment trust or any other listed company. The same is true if investors are selling.
So in summary an investment trust is closed ended as there are a limited number of shares in issue. Investor demand moves the share price. A unit trust in contrast is open ended, units are created or redeemed by the manager and investor demand does not affect the unit price, except in special circumstances outside the scope of this article. Get this and you are 75% on the way to understanding investment trusts.
Premiums & Discounts
The share price of an investment trust may trade at a discount (or premium) to its Net Asset Value (NAV) per share. The two move semi-independently. The NAV per share is the value of an investment trust’s assets divided by the number of shares in issue. To calculate the value of the assets of a trust each of the constituent stocks and shares held is valued, cash is added and borrowings are deducted. The value of each stock is the number of shares held by the trust x its share price.
The NAV per share is the inherent value of each share but typically this is different to the share price itself. For example we noted above that the investment trust above has 10,000,000 shares in issue, a share price of £5 per share at a point in time and a market capitalisation of £50,000,000. Let us say the value of the underlying assets also happens to be £50,000,000. If however the value of the underlying stocks and shares and other assets held by the investment trust for example cash grows to £55,000,000 the NAV of the trust is now £5.50 per share. However the share price may only rise to £5.25. An investor buying into the trust will now acquire assets worth £5.50 for just £5.25, the price they paid for the shares. The trust is said to be trading at a discount to its NAV.
In contrast if the assets of the trust are worth £45,000,000 the NAV per share is £4.50 and the investment trust has a share price of £5, it is said to trade at a premium to its NAV. This feature is the same as any other listed company which has a NAV per share and a share price which may differ. For example consider a listed company which is a major food retailer. Its assets includes the value of its properties and stores, stock, cash and debtors. Let us say the share price is £1. The following day a take-over bid is announced and the share price rockets to £1.20. The share price has increased 20% but the value of underlying assets will have barely changed unless they secure a great new deal on their corn flakes. The company is now trading at a premium.
In conclusion a closed end fund such as an investment trust as with shares of other listed companies typically has a share price that differs from the underlying value of the company’s assets. This is because the market has priced the investment trust shares on the overall value it perceives the company is worth, which may be more or less than just the value of the assets. Aside from the issue of potential take-overs the market makes assessments of future cash flows, profits and dividends, and business opportunities and risks.
Unit trusts and OEICs in contrast in general have unit and share prices respectively that equal their NAV and do not carry discounts or premiums. The difference has a profound impact on the benefits and disadvantages of investment trusts.
*The first UK investment trust, the Foreign and Colonial was launched in 1868. The first UK unit trust from M&G came to market in 1931.
The content of this blog is based on my own understanding of investment trusts. Nothing in this article should be construed as personal investment advice, for example to invest in investment trusts. These may not be suitable for you. You should seek individual advice based on your own financial circumstances before making investment decisions. Other cereals are available!