What is permanent capital in investment trusts?

Managers of open-ended funds have to deal with flows – investors buying into, or selling out of, the fund. When an investor wants their money back, the manager has to sell investments to free up cash.

Investment trusts don’t have that problem. They’re traded on a stock exchange, so when you sell your investment, you’re selling the shares to another investor. The money managed by the trust doesn’t change and the managers don’t have to worry about selling underlying investments.

So, we’re looking at two benefits of this ‘permanent capital’.

This article isn’t personal advice. All investments and any income from them can rise and fall in value, so you could get back less than you invest. Past performance isn’t a guide to the future. If you’re not sure an investment is right for you, ask for financial advice.

What is gearing?

A relatively stable level of capital means trusts can borrow money against their assets – known as gearing. This can provide the manager with more cash to invest if they spot opportunities they think could provide a return greater than the cost of borrowing. It can also be used to boost income by investing in companies that pay dividends greater than the interest on the borrowed cash.

This can all increase returns but will also magnify losses if the market falls or the manager invests in companies that don’t perform well. That makes gearing higher risk.

The maximum level of gearing a trust can use is set by the board. Managers will typically work with the board to decide what level of gearing is appropriate. The current cost of borrowing and market conditions will both factor into it.

Why investment trusts use private companies

Private companies are often younger than listed businesses and so could have the potential to grow faster than more established companies. They can be at the forefront of innovation in their industries, or even the centre of newly formed industries.

Some investors also argue that being private gives companies more flexibility, helping them to make better long-term decisions.

However, because they’re not listed on a stock exchange private companies are typically harder to buy and sell than public ones, meaning they’re a higher risk investment. Without constant buying and selling on a stock exchange it can also be harder to value private investments.

Both of these factors mean private companies are well suited to investment trusts. Managers can invest in private companies without the worry of having to sell at short notice, and possibly at a poor price, to return cash to investors.

2 trusts that use permanent capital

We’ve highlighted two investment trusts that take advantage of the trust structure, and we think have long-term potential. But investors in closed-ended funds should be aware the trust can trade at a discount or premium to Net Asset Value (NAV).

Investing in these trusts isn’t right for everyone. Investors should only invest if the trust’s objectives are aligned with their own and there’s a specific need for the type of investment being made. You should understand the specific risks of a trust before investing and make sure that any new investment forms part of a diversified portfolio.

Both investment trusts use gearing and can use derivatives, which increases risk. They also invest in smaller companies and those in emerging markets, both of which are higher risk.