Investment trusts have rarely been the first starting point for Britain’s retail investors, who prefer the notoriety of conventional open-end funds and direct stakes in listed companies. However, as yield-hungry investors seek new opportunities, what was once “the City’s best-kept secret” is moving to the mainstream.
In a comparison of conventional open-end funds versus investment trusts to end-September 2021, according to Morningstar, trusts outperformed funds in more than 70 percent over the past five and 10-year periods. Total returns from 14 out of 20 investment sectors were higher from closed-end funds than from open-end funds over both of those medium to long-term periods.
What makes investment trusts different from other funds – and how can investors go about choosing one?
Investment trusts are closed – that is, they usually raise money only once by issuing shares at launch. On the other hand, open funds such as unit trusts grow or shrink depending on the inflow and outflow of investor money.
Investment trusts are not nearly as well known or as strongly marketed as their open-end fund cousins and there are far fewer of them – about 400, compared to several thousand unit trusts on the market.
Moira O’Neill, head of personal finance at investment broker Interactive Investor, says investors who want to move to these vehicles should first focus on their investment goals.
“If you want to make regular monthly investments while building a retirement fund, choose one of the large, stable, internationally diversified trusts in the global sector as a core stake,” she says.
However, if you want to draw a regular income, she says you should look for a large global or UK trust that has a good return. Many of these have the ability to smooth out dividend payments to investors over the years.
“In fact, some have brilliant records of paying out increasing levels of income to investors every year, ”she says. “This”dividend hero‘includes City of London Investment Trust and F&C Investment Trust.
Once you have decided what type of trust you want, you can move on to the question about a fund’s performance record.
Annabel Brodie-Smith, director at the Association of Investment Companies, the trading body for investment trusts, says the average investment company has risen by 267 percent over the past 10 years.
“It is useful to look at different periods such as one, five and 10 years, but also individual years so that you can understand how a manager has performed in different market conditions,” she says. “You also need to look at when the current manager started running the investment company so you can see what performance is related to their tenure.”
Since an investment trust is a company, market sentiment can determine its share price. It can move above or below the value of the assets, known as the net asset value (NAV). When the share price is higher than the value of those assets, it trades at a premium; if below it trades at a discount.
Discounts often attract investors looking for a bargain. But Laura Suter, head of personal finance at AJ Bell, warns investors not to buy an investment trust just for the discount. “They should rather buy trusts that they think will be a good investment. If it is at a discount, it could be an extra reason to buy now, or to replenish an existing stock. ”
By looking at historical data, investors should be able to see if a trust is constantly trading at a discount or if it is a recent blip. Those who trade at long-term discounts may do so because their strategy has been unfavorable for some time or the market is not convinced of the investment rationale. This could mean investors being forced to wait longer before recovering.
Although price is key, there are other factors to consider when choosing a trust. “Costs are clear,” says Suter. “You do not want to pay too much for people to manage your investments. If the trust invests in a niche area, costs may be higher than one that invests in broad UK stock markets, for example, which means that two trusts’ costs are not necessarily comparable. If that is the case, you can compare the trust with its peer group and see how they stand on top of each other. ”
Another factor is gearbox. One of the great benefits of investment trusts is that they are allowed to gear up or borrow to invest. It adds risk, but it can boost long-term performance.
It’s worth looking at how much leverage an investment company currently has, as well as its leverage range. The series shows how much or little leverage an investment company would expect to have in normal market conditions, so is a useful indicator of how the company’s leverage may change in the future.
Darius McDermott, managing director of research group FundCalibre, says leveraged financing is often used when a manager sees an increase in a certain stock or sector. “If that share or sector rises in value, it can boost returns for the trust, but if they fall, it can easily make up for the losses – that means the trust carries extra risk. The additional cost of leverage must be taken into account when investing. ”
Income seekers will also want to look at a trust’s dividend record. Investment trusts are well suited to give investors a steady income, as they can withhold up to 15 percent of the income they receive each year to be used to advance dividends in future years when payouts may be lower.
“This means that the fund manager can spread income between years by using the income withheld from previous years to supplement slimmer years when dividends are more difficult to obtain. It is ideal for investors who rely on that money to finance their lifestyle, ”says Suter.
She makes the point that although dividends are not guaranteed, a long record of rising dividends shows that it is a priority for the fund manager and the board.
Another magic ingredient is the independent oversight that looks after investors’ best interests. An investment trust typically has an independent board of directors whose role includes ensuring that it is well managed.
“Many investors like the fact that the directors have interests in the trust, which is often called skin in the game,” says O’Neill. “It means their interests are now aligned with yours. Just look at the report and accounts to find out. ”