Closed-ended funds – otherwise called investment trusts – are investment companies that also trade on the stock exchange.
Whereas companies such as Microsoft own patents, factories and computers, investment trusts own other investments – which could be stocks and shares, property, bonds or other more exotic instruments.
This can seem complicated and may discourage first-time investors, but the level of complexity is often exaggerated.
The key to understanding investment trusts comes down to two figures: net asset value (NAV) and share price.
Performance of trust price vs NAV
Source: FE Analytics
For a unit trust (UT), the value of a unit is calculated from the value of the underlying assets minus fees, but with a trust it is not that simple.
The NAV is the value of the underlying investments – what other people are buying and selling them for at that time. For Microsoft, for example, this would roughly be equivalent to the overall value of everything it owns.
The share price is what investors are willing to buy the shares of the trust itself for, which will depend on what shareholders are willing to sell for. This is the equivalent of the share price of Microsoft itself, the price of which reflects how well investors think the company will do.
Because a trust is a quoted company, there are always a finite number of shares in existence. Laws of supply and demand therefore determine the price of the stock, meaning that the share price can deviate substantially from that of the underlying assets.
This difference is expressed as either a premium – when an investor pays more to buy a share in the trust than they would to own the underlying assets – or a discount – where the shares cost less than the make-up of the portfolio.
Whether or not the price of a trust looks attractive depends on what investors think will happen to it in the future.
A trust on a discount could narrow, meaning that investors will make a profit if they sell, or it could continue to widen, leaving investors nursing losses.
Another key factor to be aware of is the ability of trusts to use gearing – meaning to borrow money in order to invest it.
This means that a trust has the potential to rake in substantially higher returns than a fund, because it can invest more than the money already given to it by shareholders and make a profit on it; however, it also means it can make larger losses.
Tim Cockerill (pictured), head of collectives research at Rowan Dartington, says that while investment trusts often outperform open-ended structures, they tend to be more volatile.
"In general terms, the closed-ended funds are more volatile because of the laws of supply and demand and because of the operation of discounts and premiums," he explained. "There are times when they are relatively stable for a long period of time and then something happens, some event, and you get a period of greater volatility."
Data from FE Analytics shows that the IT UK Growth sector has made 135.28 per cent over 10 years, at an annualised volatility score of 15.17 per cent.
The IMA UK All Companies sector has made 108.28 per cent over this period, with a volatility score of 14.86 per cent.
Performance of sectors over 10-yrs
Source: FE Analytics
Cockerill also points out that investment trusts have an advantage over open-ended funds in that the manager does not have to sell any holdings in order to pay an investor back if they exit the fund.
When investors put money into a unit trust the manager will use it to buy more investments, which is not the case with trusts.
Similarly, when investors start to take their money out of a unit trust, the manager has to sell the stock to give them their money back. In practice, managers tend to keep aside some money to be able to do this if necessary.
Due to the closed-ended structure of investment trusts, when an investor wants to pull out, the money comes from the sale of their shares rather than coming out of the fund itself.
As a result, a trust is generally more fully invested than an OEIC.
This is a particular advantage when investing in an illiquid asset such as property.
"The great positive for the closed-ended property funds is they don’t suffer from a cash drag – so they can run a vehicle fully invested whereas a property fund may have to keep as much as 20 per cent in cash," Cockerill said.
Being fully invested allows trusts to make bigger returns when investments pay off, but also bigger losses when they do not.
The management structure can also seem complicated, as trusts have a board that is independent of the management team.
However, this is simpler than it looks. The board is simply charged with safeguarding investor interests and making sure that the management is working to achieve this.
The board can even award the management contract elsewhere if they are unhappy with performance, although this is a rare event.
Jemma Jackson, a spokesperson for the Association of Investment Companies (AIC), says that the independence of the board is one of the key advantages of trusts, along with the freedom they have to gear and the stability that the closed-ended structure provides.
She adds that the existence of discounts to NAV is often seen as problematic for some investors, but the opportunity to pick up trusts for less than they are worth can also be an advantage.
"Discounts could be seen as negative but some income investors love them as you’re getting more bang for your buck," she said.
Jackson explains that if investors buy £100 of assets on a discount of 10 per cent then they pay £90, and if those investments are income-paying, they receive the income that would be due to someone who had invested £100 in the underlying assets.
Another issue that worries investors is the ability to sell when they want.
Mona Patel, head of communications at the Investment Management Association (IMA) lists this flexibility constraint as one of the key disadvantages: unit trusts can be sold at any time, but owners of investment trust shares need to find a buyer.
Cockerill points out that this should not be a problem for people who are investing sensibly in large, well-traded trusts.
"If you are trying to sell when the market is volatile, you may find the discount widens. For most investors liquidity isn’t a big issue in that you will get your money back," he said.
"The question is how much you are going to get back."
"If you are holding something sensible like Invesco Income Growth or Bankers Investment Trust, they are not going to have any problems at all, but the smaller specialist trusts could give you an issue."
Cockerill says that the wealth of specialisms on offer in the investment trust universe is another one of its attractions.
Anyone who wants access to niche areas such as private equity, infrastructure and even timber will find trusts to fill these requirements, while less specialised investors will find plenty of straightforward, well-traded trusts in the UK Growth & Income sector.