Investment Trusts
What are they?
Investment trusts are companies listed on the stock exchange whose sole purpose is to trade as an investment fund. While they're effectively funds and may hold very
similar investments (e.g. shares) to unit trusts, there are fundamental differences.
Because they're listed on a the stock exchange, investment trusts have a share (not unit) price. However, unlike unit trusts this doesn't necessarily reflect the actual
value of the investments held within the investment trust (i.e. the 'net asset value' - NAV). If there's fewer buyers than sellers then the share price may trade below
the net asset value, hence the investment trust would be trading at a 'discount'. If the reverse was true it would be trading at a 'premium'. The majority of investment
trusts currently trade at a discount to their NAV.
This means you could make or lose money from share price to NAV movements alone, i.e. independently of actual fund performance!
Investment trusts can also borrow money to increase your investment exposure (known as 'gearing'). Suppose you invest £100, the investment trust might borrow a further
£25, giving you around 1.25 times more potential gains or losses than you'd get in a comparable unit trust.
These factors tend to make investment trusts riskier than an equivalent unit trust, although returns could be greater. Charges are usually lower because investment trusts
don't pay commission to financial advisers.
Investment trusts can also have more than one type of share (known as 'share class'). For example, it's possible for one share class to receive all the income from the
trust and for another share class to receive all the growth. These types of investment trust are known as 'split capital'.
How do they work?
There are several parties involved in the running of an investment trust, as follows:
Board of directorsFund ManagerRegistrarBank
The board of directors have a legal duty to uphold the interests of shareholders. This includes ensuring the fund manager is performing satisfactorily and meeting the
fund's objectives. The board has the power to replace a manager if necessary.
Appointed by the directors. The manager decides how to invest the fund's assets, making all of the investment decisions.
The registrar keeps up to date details of all shareholders.
The bank lends money to the trust for the purpose of 'gearing'.
Investment trust charges
There are two types of charges you'll face as an investment trust owner: dealing costs when buying or selling and annual charges while you own the shares.
Dealing CostsAnnual ChargesISA Charges
You'll normally need to buy or sell an investment trust through a stockbroker, for which they'll charge a dealing fee. Online and telephone brokers are usually the
cheapest, with fees of around £6 - £15 per trade. Because this is not cost effective for a monthly saving, a few investment trusts offer a savings plan with lower fees.
There may also be a difference between the buying and selling price of the shares called a 'bid-offer spread'. This is created by stock market middle-men and not the
trust itself. While the spread tends to be small (2% or less) in the normal course of events, it can widen significantly if a trust is especially popular or unpopular.
For as long as you own an investment trust you'll pay an annual management charge, typically between 0.25% - 1% of either the price of your shares or their NAV.
It's used to pay for the management of the trust.
Whether the annual charge is based on the share price or NAV can be very important. Given many investment trusts trade at a discount to their NAV, charges based on
share price (i.e. market capitalisation) are preferable. This also incentivises the trust's manager to try and avoid their trust falling to a wide discount.
In addition to the management charge there are the other costs incurred in running the company. These include the directors' fees, auditor/custody fees and marketing
costs, typically adding an extra 0.3% or more to overall annual costs. These additional costs are partially fixed, so they make a bigger difference to smaller funds.
The total costs can be summarised as a 'ongoing charge figure' (OCF). This is the best figure to use when looking at annual investment trust charges,
as it shows the true costs you'll pay (normally as a percentage of the trust's NAV).
Whereas most unit trust managers (and fund supermarkets) throw in an ISA wrapper free of charge, investment trust companies do not. To hold an investment trust within
an ISA you'll need to use a stockbroker 'self-select' ISA wrapper, which could cost upwards of £20 a year.
What affects the premium / discount to NAV?
An investment trust's share price is affected by the number of buyers versus sellers, i.e. their popularity. If sellers are trying to sell more shares than buyers are
willing to buy at the current price, the share price will fall until they're once again in balance. If the reverse is true the share price will rise.
So what affects a trust's popularity?
Less PopularMore Popular
Investment trusts tend to fall in popularity (i.e. the discount widens) when:
- Markets are falling - some investors will naturally sell and investment trusts with gearing are usually the least popular because the gearing compounds losses.
- Underlying investments out of favour - suppose a trust invests in property and investors are steering well clear of that sector, there'll be few buyers and the share
price will suffer.
- Poor relative performance - trusts that perform poorly versus peers are likely to fall out of favour and be sold.
Investment trusts tend to rise in popularity (i.e. the discount narrows) when:
- Markets are rising - investment trusts with gearing should do especially well, boosting investor demand.
- Underlying investments are very popular - if a trust's underlying investments are in a popular sector it'll probably increase demand for the fund.
- Strong relative performance - trusts that perform very well versus peers are likely to be in greater demand.
- Share buybacks - investment trusts can buy back their own shares in a bid to narrow a discount. They can either be held and subsequently re-sold if demand picks up, else
cancelled altogether.
What are split capital trusts?
Some investment trusts have more than one class of share, allowing them to offer different types of return to different investors. These are known as split capital trusts,
or 'split caps', and normally run for a fixed number of years before they wind up (when the underlying investments are sold and the proceeds returned to relevant shareholder
classes). A common scenario is for income shares to offer all of a trust's income while capital shares offer all the capital growth.
Mr Income buys £100 worth of income shares and Mr Growth £100 of capital shares in XYZ Investment Trust, with each receiving all of the trust's income and growth respectively.
Mr Income benefits from receiving an income equivalent to holding £200 worth of conventional shares and Mr Growth likewise re: capital shares.
However, this also increases their risk as they're more exposed to movements in income and capital value.
There are several possible share classes:
ZerosIncome SharesCapital SharesOrdinary Income Shares
Zeros offer no income but a pre-determined capital return at wind-up. They usually rank ahead of the other share classes in terms of receiving proceeds when a trust is
wound up, but there's no guarantee there'll be enough in the pot to pay the expected return. Although less risky than the other share classes, there's still a risk of
losing some, or even all of your money.
Income shares come in various flavours, but the most common give you the right to all of the income produced by the trust and the return of your original investment at
wind up. Variations include a pre-determined target income, some entitlement to capital growth and a very high income at the expense of your original investment.
Capital shares have no pre-determined value, but receive all the trust's proceeds at wind up after the other share classes have taken their entitlement.
This gives rise to a natural 'gearing' effect. Provided obligations to the other share classes are covered, any increase in a trust's value will pass to the capital
shareholders at wind up. So, even though the capital shareholders only own part of the trust, they'll receive all of that increase. Of course, this also means more risk,
so be careful.
Ordinary income shares are a mix between income and capital shares. As well as receiving some, or all of a trust's income, they also have an entitlement to the
trust's capital after the other share classes have taken their share. The exact pecking order of the share classes varies between trusts, but ordinary income shares tend
to be at the bottom of the pile.
These are potentially high octane investments, so be very careful!
When buying any of these share classes it's important to determine what average annual (trust) performance is required to be confident of receiving the expected return
at wind up, known as a 'hurdle rate'. You should also check the extent that a trust's assets currently cover the expected return, known as a 'cover ratio'.
The split capital investment trust scandal took place between 2000 - 2002, during which an estimated 50,000 investors were believed to have lost about £700 million.
The problem was two-fold.
- Thanks to rising markets and low interest rates, many split caps borrowed heavily to increase their gearing (in some cases to around 100% of the trust).
- A number of split caps invested in each other, a so-called 'magic circle'. These 'cross-holdings' increased demand for each other's shares, pushing up the price.
This cosy arrangement worked well in rising markets, but fell to earth with an almighty bump when markets plunged during 2000. The high level of gearing accelerated losses
and the cross-holdings meant that some trusts collapsed like a house of cards.
Amongst those hit were investors in zero dividend shares ('zeros'), previously viewed as a relatively safe investment and favoured by/sold to cautious investors. This led
to an uproar and a massive subsequent investigation by the Financial Services Authority (FSA). Compensation totalling £143 million (funded by 18 of the offending companies)
was finally paid out to 25,000 investors in 2006, representing 40% of the money they lost.
How quickly can I get my money back?
Because investment trusts are traded on the stock market you should be able to sell shares easily and receive your money within days. However, less popular investment
trusts may struggle to find buyers, which could mean a slow sale and/or a poor bid price.
What happens to income?
An investment trust might receive income from its underlying investments at various times throughout the year. The trust will combine the various incomes and pay it out
as a dividend on pre-determined dates, usually twice yearly. Unlike unit trusts, an investment trust can retain up to 15% of its annual income as reserves, providing a
potential buffer to help boost income in lean years.
What are warrants?
Warrants give you the option (but not obligation) to buy shares in an investment trust at a fixed price on either a fixed date or range of dates in the future. They're
often given away when an investment trust first issues shares, after which they may traded on the stock market.
They effectively provide a geared exposure to the trust they're linked to, making them more volatile, hence higher risk.
Mr Optimistic buys 100 warrants for £20, entitling him to buy 100 shares in Investment Trust A in five years time at 120p per share, the current share price is 100p.
After five years the share price has risen to 200p. Mr A can buy 100 shares at 120p and immediately sell them at 200p, netting him a £80 profit on his £20 stake.
However, were the share price at expiry 120p or less the warrant would be worthless, as it would be cheaper to buy the shares directly.
Can I invest in an investment trust for my (grand)child?
Yes, it's very straightforward. Read the section on investing for children to find out more. Some investment trusts have set
up specific savings schemes for this purpose.
Investment trust sectors
To better help you compare like for like, the Association of Investment Companies (AIC) has created a range of investment trust sectors. When looking at a trust you can
check it's AIC sector then easily compare it will similar rivals. However, some sectors have fairly broad investment guidelines, so trusts within a sector can sometimes vary
quite markedly.
How can I buy investment trusts?
There are normally two routes to buying investment trust shares:
StockbrokerDealing Scheme
Buying through a stockbroker incurs a dealing fee when you buy or sell an investment trust. Online and telephone brokers are usually the cheapest, with fees of around
£6 - £15 per trade. Bear in mind that if you wish to save on a monthly basis then the dealing fees may become uneconomic. For example, a £10 dealing fee on a £100
investment is equivalent to a 10% initial charge!
Beware that if you wish to hold the investment trust within an ISA you'll need to buy a 'self-select ISA wrapper' from your stockbroker, which is likely
to cost upwards of £20 a year.
Some investment trusts offer their own dealing schemes, in a bid to offer lower dealing costs than stockbrokers. While some succeed others end up being more expensive than
the cheapest stockbrokers, so always compare costs. You might also find restrictions, such as dealing only taking place once a week.
Such savings schemes are usually the only cost effective option if you wish to save on a monthly basis.
Tax
Investment trusts pay income as dividends. There's no tax within the fund on any gains when the manager buys and sells investments, but any gains you make on selling the
fund will be liable to capital gains tax. The returns from zero dividend shares are also subject to capital gains tax.
Jargon
The world of investment trusts is full of jargon. Here's some of the more common terms you might come across:
| AIC | The Association of Investment Companies, the trade body for investment trust companies. |
| Asset Cover | Measures the extent that the assets in the zero and income share classes of a split capital investment trust currently cover the expected return at redemption. |
| Capital Shares | The part of a split capital investment trust that usually gives you the right receive all the trust's proceeds at wind up after the other share classes have taken their entitlement. |
| Discount | When an investment trust's value based on it's share price is lower than the actual value of the underlying assets. |
| Hurdle Rate | Measures the average annual performance required for the zero and income share classes of a split capital investment trust to receive the expected return at redemption. |
| Income Shares | The part of a split capital investment trust that usually gives you the right to all of the income produced by the trust and the return of your original investment at wind up. |
| Investment Trust | A company listed on the stock exchange whose sole purpose is to trade as an investment fund. |
| NAV | Net asset value. The actual value of underlying investments within an investment trust, often differs from the value based on the trust's share price. |
| Ordinary Income Shares | The part of a split capital investment trust that usually receives some, or all, of a trust's income and has an entitlement to the trusts's capital after the other share classes have taken their share. |
| Premium | When an investment trust's value based on it's share price is higher than the actual value of the underlying assets. |
| Warrant | The option (but not obligation) to buy shares in an investment trust at a fixed price on either a fixed date or range of dates in the future. |
| Zeros | Zero dividend preference shares. The part of a split capital investment trust that offers no income but a pre-determined capital return at wind-up. |