Investment Trusts – Part 2

Before reading this article you may need to read part 1 written just over a month ago in order to refresh your memory on the technical backdrop. However to remind you of the key point – investment trusts have a closed end structure in contrast to OEICs and unit trusts which are open ended funds. Investment trusts have a limited number of shares in issue, whilst OEICs and unit trusts create and redeem shares or units respectively depending on investor demand. What this means is that the value of an investment trust’s assets (its Net Asset Value or NAV) may differ from its market capitalisation and the shares trade at a discount or premium to the NAV per share. If you get this, understanding investment trusts is a whole lot easier.

In this article I want to explain the benefits and uses of investment trusts for investors.

1. Investment trusts may mean investors can buy assets cheaper than their inherent value

Consider an investment trust trading at a discount to its NAV. Let’s us say the NAV per share is £1. What this means is if you add up the value of the investment trust’s assets i.e. the stocks and shares held, deduct liabilities, and divide by the fixed number of shares in issue each share has an underlying value of £1. However if the trust trades at a discount of 10% to its NAV the share price of the trust on the stock market will be £0.90. In other words an investor buying the trust will acquire £1 of assets for just £0.90. In this situation investors hope the discount will narrow and the share price will move closer to the NAV. If so investors benefit. In some cases this may be without any underlying investment gains on the trust’s portfolio of assets i.e. change to the NAV. For example if the share price rises to £0.96, investors who bought at £0.90 will see their investment rise by 6.67%.

The question is what might cause the share price to rise and the discount to narrow? It is all down to investor demand. To answer the question you have to ask why did the discount arise in the first place. The share price may less than NAV per share, the true worth of the shares for several reasons. One is investors lack confidence in the fund manager and their investment process or the outlook for the trust’s portfolio may be negative. If however an underperforming fund manager turns the investment around or is replaced by a new fund manager the market may take a more positive view of the trust, pushing up the share price. Of course the risk is that the discount widens and the share price falls.

Investors may also buy in at a premium to the NAV and pay more than their intrinsic worth of the shares. The most highly rated investment trusts with top fund managers trade at a premium. Investors buy in expecting further gains to both the NAV and the share price. However if you buy at a premium there is a risk the share price falls, moving closer to its NAV.

In contrast to investment trusts open ended funds are normally priced at NAV and investors cannot buy assets cheaper than their inherent value.

2. Investment trusts can borrow to invest unlike OEICs and unit trusts and may enhance gains

This is called gearing and it magnifies gains and losses. It makes investment trusts more risky than open ended funds although many trusts do not using gearing. Consider a trust which has £50 million of assets which borrows £10 million. If the trust gains 20% the value of the trust rises to £72 million. If the £10 million loan is repaid the net assets are now £62 million. The rise in value of the assets from £50 million to £62 million represents a rise of 24%, more than the 20% the market gains, although borrowing costs have to be taken into account. The reverse effect happens in a falling market, gearing amplifies losses.

3. Investment trusts can retain income for later distribution

OEICs and unit trusts are required to distribute all income they receive, both dividends and interest. However investment trusts can retain up to 15% of their income to distribute to shareholders at a later date. This enables trusts to smooth their income payments to investors as well as increase the dividends an investment trust pays out to its investors year on year. There are a significant number of investment trusts that have done this for 20 years or more and these are called “dividend heroes.” Data from the Association of Investment Companies (AIC)* and Morningstar show three trusts that have increased their dividend per share for 52 consecutive years – the City of London Investment Trust (UK Equity Income), Bankers Investment Trust and Alliance Trust (both in the AIC Global sector). The first ever trust, the F&C Investment Trust launched in 1868 has done so for 48 years.

Whilst the first two benefits might appeal more to growth investors taking more risk, investment trusts are clearly attractive to income seekers wanting steady and rising dividends, for example in retirement. In contrast the yields on open ended funds are more likely to fluctuate, be less dependable and less likely to keep pace with inflation.

4. Investment trusts can invest in less liquid assets than OEICs and unit trusts

Investment trusts are much more suitable for investing in less liquid assets such as physical commercial property, unquoted shares or infrastructure than OEICs and unit trusts. This is due to their closed end structure which means an investment trust manager is never required to sell the assets of the trust to pay exiting investors unlike their OEIC and unit trust siblings. If an investor wants to dispose of an investment trust they sell their shares independently on the stock market to a third party. There is no involvement of the investment trust manager and there is no call on the trust’s assets. It is no different in principle to owning shares of any other company. Let’s say lots of investors want to sell their shares in GlaxoSmithKline or HSBC they don’t sell them back to Glaxo or HSBC, they sell them on the London Stock Exchange to someone else. Glaxo don’t have to sell a research centre or HSBC close a few bank branches to pay out investors.

Just to make sure you are paying attention, here is a question. If lots of people sell their shares in an investment trust what happens to discount if there is one, or to a premium? I knew you were on the ball! You are correct, the share price falls and the discount widens. If there is a premium it will narrow and move closer to the trust’s NAV per share.

In contrast if lots of investors want out of an open ended fund they sell their units back to the fund and if there is insufficient cash available the fund manager will have to sell assets to raise cash. They may be forced sellers at depressed prices which reduces investment returns. If the underlying assets are illiquid there may be no market for them and the fund manager may be unable to deal. This may necessitate gating of a fund, i.e. stopping investors from redeeming their investment, like the Woodford Equity Income fund as explained in my last blog. As noted unit trusts holding commercial property on some occasions have had to close to dealing.

The fact that investment trust managers know there will never be a call on the trust’s assets to meet investor demand means that they can safely invest for the long term and that’s a big plus.

5. Investment trusts tend to outperform OEICs and unit trusts over the long term

The reasons for the superior returns are partly due to lower management charges levied by investment trust managers. However with the abolition of commission paid to advisers and payments to platforms by OEICs and unit trusts at the end of 2012, annual management charge differentials have fallen in recent years. Investment trusts are also more likely to have performance fees which adds to their costs but my assessment is the ongoing charges figures (OCFs – the annual management charges plus additional fund expenses) of investment trusts are generally lower than OEICs and unit trusts.

Other factors for the superior returns include avoiding cash drag (retained income can be invested whilst open ended funds may retain a cash buffer for redemptions) and the ability to invest for the long term. Gearing is another factor. Finally investment trusts tend to be smaller in size than the big beasts of the open ended world and therefore are more nimble with their investments. Of course there are plenty of exceptions here with poor performing investment trusts and OEICs and unit trusts with cracking returns. As ever good fund selection is crucial.

One interesting fact the AIC highlighted in a recent seminar I attended was the investment trust outperformance of sister funds. Many of the big fund management groups run both investment trusts and OEICs or unit trusts, for example Baillie Gifford, Janus Henderson, JP Morgan, Invesco, Fidelity and Schroders. In some cases there are equivalent investment trust and open ended sister funds, managed by the same person or team. They have similar investment strategies, asset allocations and stock selection. Typically over the medium to long term investment trusts have outperformed their sister OEICs or unit trusts.

Summary & Conclusion

Demand for investment trusts has risen in recent years but they have disadvantages as well as benefits. There are no outright ethically managed investment trusts as there are for open ended funds although there are a couple of environmental trusts and many investment trusts adopt ESG principles. ESG is Environmental, Social and Governance and has become a bit of buzz word amongst investment companies but in my view ESG is a very light green form of socially responsible investment (SRI), without strict adherence to a set list of excluded investments such as arms producers, tobacco stocks or companies involved in animal testing. There are no passive index tracking investment trusts, no equivalent to gilt and mainstream corporate bond funds and limited cautious risk multi-asset trusts. The point is investment trusts have limitations in what they can offer certain investors.

Whilst there is plenty of choice of trusts in major AIC sectors such as Global or UK Equity Income in some sectors it is very limited. For example there are just three environmental trusts, two equity and bond income trusts and one property securities trust. In part this in because there are only 338 investment trusts (excluding Venture Capital Trusts, VCTs) compared to around 3,000 OEICs and unit trusts.

So in conclusion, despite their complexity and some additional risks investment trusts can play a valuable role for suitable investors with their unique benefits and advantages, not enjoyed by OEICs and unit trust. They will however complement open ended funds not replace them.

*The AIC is the UK’s only trade body for investment trusts with around 90% of all trusts being members. Please note the terms investment company and investment trust are used interchangeably. The former is a more accurate description of what these investment vehicles are although the latter is still in common use.

The content of this blog is based on my own understanding of investment trusts and is intended as general investment information  only.  Nothing in this article should be construed as personal investment advice for example to buy  investment trust shares. You should seek individual advice based on your own financial circumstances before making investment decisions.

No bank branches were closed as a result of this article.