Investment trusts – how they work and the opportunities

In part one of our two-part series on investment trusts, we looked at what investment trusts are, how they started and what investors need to know.

In part two, we take a closer look at the board of directors, the potential benefits to income investors and what to think about when analysing investment trusts.

Investment trusts can sometimes invest in specialist areas like smaller companies and unlisted (private) companies. Lots also use derivatives and gearing (borrowing to invest) which adds risk. Investors should only invest in them if they have the time and knowledge to carefully select and monitor them, and as always, they should be held as part of a diversified portfolio.

This article isn’t personal advice. If you’re not sure an investment or course of action is right for you, ask for financial advice.

The role of the board

In line with other public companies, investment trusts have oversight from an independent board of directors (the board). This usually includes a chairperson, an accountant, and several other directors with a variety of different skills and experiences.

The board has a legal responsibility to make sure the manager of the trust acts in the best interests of shareholders. This involves regular meetings and ongoing monitoring of performance to make sure the trust’s objectives are being met.

The investment trust manager is in charge of the day-to-day running of the trust and decides where to invest the money held. Managers are scrutinised by the board on their investment decisions and are challenged on why they’re doing what they’re doing.

If the board’s unhappy with the current investment manager, it can replace them. Decisions like this aren’t taken lightly and it can be unnerving for investors if the newly appointed manager is less well-known or adopts a slightly different approach to investing. That said, the hunt for a new manager is a competitive process.

Taking action

The board has plenty of other responsibilities too. It needs to be mindful of costs and whether the trust’s charges reflect good value for shareholders. With lots of trusts well-known for their heritage, directors need to keep one eye on the future too.

Another key responsibility is closely monitoring the trust’s discount/premium to net asset value (NAV). If the share price is above the NAV it costs more to buy the shares than the underlying investments are worth. When the share price is below the NAV it is trading at a discount.

When a trust trades at a discount, it can signal opportunity since the shares can be bought at a lower value than the worth of the underlying investments. However there are often reasons why the trust is trading at a discount which should be considered and they can widen and fall further.

On the other hand, buying a trust that’s trading at a premium today means you could be paying over the odds. That’s because you’re paying more than the underlying assets of the trust are worth. Over time this premium could disappear which could set back your returns, even if the NAV is growing.

Over the long term, the hope is that the share price tracks the NAV. However, if you need to sell, and the trust is trading at a large discount, it can be a tough decision.

The board has several levers it can pull to try and combat a sustained and material discount or premium. For example, it could decide to buy back shares at a discount, or issue new shares at a premium, to help close the gap.

Income smoothing

Managing the income is another important consideration for the board and the manager. Their ‘closed-ended’ nature means investment trusts can be a great vehicle for investors looking for income.

Their ability to borrow, known as ‘gearing’, can help boost income, although gearing can also add risk. Equally, they aren’t limited to paying out a dividend from only the income they receive from their underlying investments. If needed, they have the flexibility to use the profits they make from buying and selling investments. However, this could eat into capital and being able to generate income in the future.

Investment trusts can also hold back up to 15% of the income their investments generate each year. It’s put in a pot called the ‘revenue reserve’. If dividends fall in any year, the manager can dip into the reserve to make up any shortfall. This means investment trusts can smooth out the dividends they pay.

Some trusts have used the revenue reserve to great effect and have increased the income paid out for a number of years in a row. There are trusts that have grown their dividend every year for 40 or 50 years. Although it’s worth noting that growing income could come at the expense of capital growth.

You can see an investment trust’s recent dividend history on the ‘Dividends’ tab on the factsheet. Remember past dividends aren’t a reliable indicator of what you might get in the future.

Not all investment trust managers hold back income though. Some are more focused on growth and place less importance on dividends. You’ll find the trust’s objective on its ‘At a glance’ page.

Open-ended funds (unit trusts and OEICs) have to pay all the income they generate to investors or reinvest it back into the fund if investors select the ‘accumulation’ units. They can build excellent long-term track records of dividend growth, but don’t have the same flexibility to potentially deliver growth year in, year out, as investment trusts.

Dividend heroes

The Association of Investment Companies (AIC) labels investment trusts that have consistently increased their dividends for 20 or more years in a row as ‘dividend heroes’. Here are the investment trusts that have done this for at least 50 years:

Source: AIC as at 28 February 2022. Trusts listed in alphabetical order.

Remember, past performance isn’t a guide to future returns. The value of an investment, and any income it produced can fall as well as rise and isn't guaranteed.

Are investment trusts right for you?

Like funds, investment trusts can invest in lots of different areas. Whether that be companies with an international footprint, or focused on specific regions like Europe, Asia, or Latin America. Some specialist investment trusts even focus on individual sectors, like technology, healthcare or property.

An investment trust manager usually has a fixed amount of money to invest, regardless of how many investors are buying or selling the trust’s shares. Fund managers, however, could be forced sellers if lots of investors want their money back at the same time, and that could negatively affect returns. This lets investment trust managers access less liquid – harder to sell – investments like private equity, property, and infrastructure. Essentially, nothing is off the menu for an investment trust.

Investment trust managers can focus solely on investing, without having to manage the inflow and outflow of investor money. It also means they have tended to hold less cash – which would be used to pay withdrawing investors – so they can have more money invested at any one time.

The investment trust structure has plenty of attractive features that can serve those looking for income, growth, or both. But they also have their risks. Investors need to consider the potential risks including gearing and navigating investment trust premiums and discounts and the focus should be on the long term.

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