In this series, FE Trustnet has been taking first-time investors through what they should know when entering the world of investments by asking experts for their best piece of advice.
Having looked at the broad world of open-ended funds, this week we looked at the more specialist area of closed-ended funds, otherwise known as investment trusts.
There are fewer closed-ended funds than open-ended funds out there, with 403 in total according to the Association of Investment Companies (AIC), the trade body that represents investment trusts.
However, trusts have been around for longer and, where there are appropriately comparable sectors, generally produce better returns over the long term than their open-ended counterparts, despite being less well-known.
Indeed, the below chart shows two sectors that have outperformed their Investment Association (IA) counterparts, however, there were many other sectors that achieved this.
Performance of trust vs fund sectors over 10yrs
Source: FE Analytics
Trusts have some unique characteristics, which can make them more complicated to understand but also particularly appealing to investors that do understand them, according to AJ Bell personal finance analyst Laura Suter.
Examples of these attributes covered below include the difference between open- and closed-ended products, manoeuvring the discounts/premiums and how they employ gearing, alongside tips on how to choose a trust.
What does ‘closed-ended’ mean?
“[An] attribute of investment trusts that some professional investors prefer is that the fund manager is not at the whim of investor redemptions,” Suter said.
“Because investment trusts are ‘closed-ended’ and so raise a certain amount of capital to invest, investors can only sell by selling the shares to another investor.”
Indeed, investment trust shares are listed on the stock market and should be treated the same as shares of an individual company, and like publicly-listed companies have a board of directors who oversee the management team.
This is different to open-ended funds, where investors buy units from the fund group, which has an obligation to buy them back when investors want to sell their units. This essentially means that investors can both add capital to and withdraw money from a fund at any time (known as inflows and outflows).
As such, with only a finite amount of shares in existence, for every buyer of a trust there must also be a seller. This means that the price is therefore set by the forces of supply and demand.
This mechanism for buying investment trusts typically means that the managers take more long-term views than open-ended funds, said Annabel Brodie-Smith, communications director of the AIC.
However, AJ Bell’s Suter added that this way of investing means that the price you pay for the shares not only depends on the performance of the underlying investments in the fund, but also investor sentiment on the trust, which leads us to our next point.
Watch out for the discount or premium
Investment trusts have a net asset value (NAV), which is the total value of the trust’s underlying assets, minus liabilities, divided by the number of shares in issue.
Because you purchase a trust at the price determined by the market and not the NAV price, there exists the potential for shares to trade at a discount or premium to this underlying value.
Put very simply, a premium is where you buy shares in the trust that have a higher value than the NAV and a discount is where you buy shares in the trust that have a lower value than the NAV.
Suter said: “Because of this ability for trust shares to drop to a discount, many investment trusts have a ‘discount control mechanism’.
“This means that if a discount reaches a certain level, the trust will undergo share buybacks in a bid to reduce the discount. This can help investors in a trust that is trading at a discount for a prolonged period of time.”
For the bargain hunters out there, she said buying well-run and strong-performing trusts on a discount is one way to increase the value of one’s investment, provided the trust at some point returns to its fair value.
On the other hand, she warned: “Clearly this can work in reverse and go against investors - the share price of a trust can fall regardless of how well its holdings are performing.
Difference between price and NAV of a trust over 1yr
Source: FE Analytics
“However, as long as investors are able to hold on to the investment for the long term, and not be a forced seller when the trust falls to a discount, they can usually ride this out.”
Gearing
Another unique aspect of investment trusts is their ability to use gearing, or essentially borrowing money to make additional investments.
The AIC’s Brodie-Smith said: “The idea is that the additional investments generate sufficient returns to meet the costs of the debt and make a profit on top.
“Gearing magnifies the performance of an investment company so if the performance is good gearing will be a boost, but if the performance is poor gearing will increase losses."
She added: “Whilst gearing does increase risk, over the long-term markets have increased in value and gearing has added to performance.”
Gearing, however, does not feature in all investment companies and those that do employ it have an average level of 7.6 per cent. Further information about gearing and discounts or premiums can be found on the AIC’s website.
Trusts are particularly useful for investing in illiquid assets
Brodie-Smith added that because of the way that investment trusts are traded, they are well suited to invest in illiquid assets that are difficult to buy and sell quickly, such as property and infrastructure.
This is because they are not obligated to buy back shares and are not affected by large swathes of outflows that can be a problem for open-ended funds investing in illiquid assets that are hard to sell.
AJ Bell’s Suter said the aftermath of the Brexit vote illustrated this difference between trusts and funds.
Many investors in open-ended property funds tried to withdraw their money after the Brexit vote, but the managers of the funds halted withdrawals and temporarily closed the funds because the assets they were invested in could not be sold quickly enough to meet such large redemptions, said Suter.
Inversely, she said that property investment trusts were not subject to these redemption requests and did not have to sell such holdings.
Although the share prices of the trusts plummeted and caused investors to sell at a large discount, they were still able to withdraw their money.
Steadier income generation for investors
Unlike funds, trusts that pay out an income, regardless of the assets they invest in, do not have to pay out all the income they receive in a year and can retain up to 15 per cent for a rainy day.
Trusts with 20+ consecutive years of dividend growth
Source: The AIC
Brodie-Smith said this feature, called dividend smoothing, enables them to “squirrel away money in good years to pay out in leaner ones”.
So how to go about choosing an investment trust?
When it comes to choosing how to invest in a trust, there are many similarities with open-ended funds.
“First, we focus on the investment proposition,” said Peel Hunt head of investment companies research Anthony Leatham.
“What does the investment company invest in, who is the manager and how long has he/she been at the helm, how is the money invested, how has the asset class performed, what additional/unique features does it offer e.g. access to illiquid asset classes such as property or private equity, is it offering to pay a dividend and how is that income generated?”
Second, Leatham said he looks at the performance, focusing on the NAV total return, which assumes that all dividends that shareholders receive are reinvested in the trust.
He added that he looks to compare the NAV total return of a trust against an appropriate index and relevant peers, which would typically be the other constituents in the trust’s sector.
Next, he said: “Once you are comfortable with how your investment is going to be managed and how it has performed, we focus on other attributes. What are the fees being charged, are they reasonable and proportionate?”
Lastly, Leatham reminded to take into account the price you pay for the trust in the market, its discount or premium.
He said: “Whilst we focus on NAV total return to judge performance, we buy shares in the market in order to gain exposure to this manager skill. The price of these shares is determined by the market.
“The 'trick' is to not overpay. As a value investor, I would far rather pay 90p for £1 of assets than the other way around.”