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Investment Trusts

What is an Investment Trust?

An investment trust is a type of fund set up as a public limited company (PLC), so its shares can be bought and sold on a stock exchange.

They aim to make money for their shareholders by investing in a portfolio of shares, property or other investments, chosen and run by the investment manager. When you buy a share, you are buying a slice of the trust’s underlying portfolio.

What are the main features of an Investment Trust?

Investment trusts are set up as companies and traded on a stock exchange.

Like any other company listed on the stock market, investment trusts have to publish an annual report and audited accounts. They also have a board of directors to hold the investment trust manager accountable. When you invest in an investment trust, you become a shareholder in that company.

They have a fixed number of shares, so they’re known as ‘closed-ended’, meaning they don’t have money flowing in and out unpredictably. This gives the portfolio manager a high level of control and the flexibility to build a long-term strategy, as the managers are able to invest and sell when they feel the time is right.

Because they’re a listed company, they should be easily tradable during market hours, and you can quickly establish a price that you can buy and sell for.

With open-ended funds on the other hand, like unit trusts or OEICs, fund managers have to buy and sell the underlying investments to accommodate people buying and selling units in the fund. This could mean the fund manager has to buy or sell the investments within the fund for a price they might not be happy with.

What is net asset value (NAV)?

The value of the investments held in an investment trust is called the net asset value (NAV). It’s usually indicated as pence per share. If a trust has £1m worth of assets and one million shares, the NAV is 100p.

With unit trusts, the price of the units you hold directly reflects the value of the assets held by the trust.

With investment trusts, just like with securities, the price of the share is based on supply and demand. That means the value per share in the investment trust could be higher or lower than the NAV.

What are premiums and discounts?

If a trust is trading at a price lower than its NAV, it's trading at a discount.

If a trust is trading at a price higher than its NAV, it's trading at a premium.

A lot of the time, investment trusts trade at a discount. This could look like a good deal, for example, if you pay less than £100 for £100 worth of assets.

There’s no guarantee though that any discount will have narrowed by the time you come to sell. If the discount widens, you'll lose out in relative terms, whatever happens to the NAV of the trust.

Occasionally trusts trade at a premium to NAV. This means you're paying more than £100 to own £100 worth of assets. You might be prepared to do this for reasons like the skill of the fund manager. But you’ll need to ask yourself whether this type of performance is likely to last.

Why do investment trusts use gearing?

Investment trusts can borrow money to buy investments – this is called gearing. It’s a method that could help to improve the performance of the investment trust, but could make it more volatile.

Because investment trusts are listed companies, they operate within company law just like any other business, so can borrow money based against their assets.

It can amplify the performance of the trust, but this happens whether its value goes up or down, so it can boost gains or increase losses.

Remember, the interest will have to be paid on the borrowed money, whether or not the trust makes a profit on the loan.

Gearing example

Let’s say you have £2,000 invested in investment trust X, and the manager gears by 10%. That means you essentially have £2,200 working for you.

Things have gone well and investment trust X doubles in value to £4,400. The manager then pays back the £200, plus, for example, 2% interest. That leaves you with £4,196.

If, on the other hand, the same investment didn’t do so well and halves in value to £1,100, the manager still has to pay back the £204. This means your losses are greater, leaving you with £896 instead of the £1,000 if the manager hadn’t geared.

Managers should only be using gearing where they think they can make more than the cost of paying back and servicing the debt. So, they've got to be pretty confident that their investments will perform well for their shareholders and make up for the increased risk.