How to choose an investment trust

What is an investment trust?

Investment companies are a way to make a single investment in a range of assets. A type of collective investment, they let you spread your risk and access a variety of investment opportunities. Their shares are listed on a stock exchange, just like those of any other public company, and can be bought and sold in the same way.

How they work

• Investment trusts are ‘closed-ended’ which means they have a fixed number of shares in issue at any one time. You invest in an investment company by buying the shares on the stock market, and when you want to sell your shares, you sell them back the same way. It means anyone wanting to buy or sell shares in the trust has to find someone else willing to trade with them. Like shares in any other company the price therefore reflects supply and demand.
• This makes them very different to ‘open ended’ unit trusts and OEICs where the fund manager issues and withdraws units in response to demand as investors move their money in and out of the fund, and the number of shares in circulation varies. The price of the units is a reflection of the value of the assets the fund holds less that day’s portion of the investment management charge and other costs.
• Because of the way the funds are structured, the investments they can hold are sometimes very different. Open-ended funds must be ready to give investors their money back at any time. So, they normally invest only in assets which can be sold quite quickly. But investment trusts do not have the same restrictions. It means they can invest in illiquid securities (those that might be difficult to sell at short notice) and can use complex investment strategies to achieve their objectives.

Overall, investment trusts can be a bit more complex than funds, so here is a roundup of some the important things to consider when choosing an investment trust.

How to choose an investment trust

1. Check the asset class and holdings

What might pique your interest in a particular investment trust is the area it invests in. Investment trusts offer a particularly wide range of investment areas from the conventional ones such as equities (by geography, sector or type such as smaller companies), through to more specialist and hard-to-reach areas such as private equity, commercial property and infrastructure.

The objectives of an investment trust will tell you where it invests and how it will do so, and you can check this and the current composition of its portfolio, including the top ten holdings, on its factsheet, which is usually published monthly. More detailed information is presented in a trust’s annual and semi-annual report and accounts where a full disclosure of its investments (“positions”) is shown. These can all be found via the ‘key features and documents’ tab of the relevant product page of the Charles Stanley Direct website among other places.

Bear in mind that a trust’s portfolio can either be very concentrated in a small number of holdings, (which increases risk) or more diversified across a large number of holdings; usually dozens, and possibly hundreds. Some trusts even take a deliberately diversified approach across a large range of different assets to create a broader and more resilient portfolio.

2. Find out who manages the trust

It’s important for the investor to have confidence in the manager’s expertise in the area of investment they are targeting. One of the main features of investment trusts is that they are all actively managed with a named fund manager or managers, supported by a broader team. They are responsible for choosing when to buy and sell the investments. Investors tend to rate managers according to their experience, track record, and level of resource.

Most are managed by an external management group, which may manage several investment companies, and is chosen by the board of directors. The manager may change from time to time if there is widespread dissatisfaction from shareholders or if a key person moves on, which can in some cases mean a change in investment policy, too.

3. Decide if you want a trust that uses 'gearing'

Investment trusts can borrow money to make additional investments, which is known as ‘gearing’. The greater the gearing the riskier a trust becomes. The more the company borrows, the more profit it makes if the investments rise in value but the more it loses if they fall. This is one reason why investment trusts can magnify the ups and downs of markets compared to an equivalent open-ended fund which is not able to borrow money.

Not all investment companies use gearing and many that do only use a small amount. It’s a decision taken by the fund manager and the board of directors. However, some trusts have a high level, and things can go awry if a trust becomes encumbered with expensive debt and its investments don’t perform well.

A trust’s gearing policy, along with details of other risks involved, will be detailed in its Key Information document or ‘KID’. This can be found in the ‘key features and documents’ tab the relevant trust page on the Charles Stanley Direct website, and the current level of gearing can be found on the summary tab or, alternatively, on the AIC (Association of Investment Trusts) website.

4. Consider expected income and yield

If you want to generate income from your investments the investment trusts that pay regular dividends, usually bi-annually or quarterly, may be of interest. Meanwhile, others concentrate chiefly or wholly on capital growth, catering for those that simply wish to maximise their overall return.

The yardstick for how much an investment pays is yield. Like an interest rate on cash, it’s an annual figure expressed as a percentage. However, while interest on cash tells you what to expect going forward, the yield figure on most investments, including investment trusts, is more complicated. It is typically calculated as a percentage of the previous distributions divided by its current price. This is why income from investments is always variable and not guaranteed.

The yield on an investment trust, just like any share, is shown on the relevant page of the Charles Stanley Direct website. For further tools and resources for income-seeking investors the AIC’s useful Income Finder tool allows you to create a virtual portfolio of income-paying investment companies, track dividend dates, and calculate how much income you could receive over a year.

Investment companies have several advantages when it comes to delivering a high income, or income that grows over time. Investment companies can hold back some income in good times to pay it out in leaner ones, which means they can sometimes maintain or increase their dividends even in difficult times when underlying investments reduce or pause their payouts. They are also allowed to pay dividends out of capital, although this will reduce the capital growth of the trust.

5. Take care with discounts or premiums

Investment trust shares often trade at a discount, which means the shares can be bought at a lower valuation than the ‘net asset value’ per share. This is the value of the investment company’s assets after any liabilities, such as debt, divided by the number of shares.

When an investment company trades at a discount, it can be an opportunity to buy. However, it is not automatically a good thing. The price of investment trust shares depends on a whole range of factors. As well as sentiment towards the trust, its strategy, and the type of investments it holds, investors consider other things such as level and cost of debt, the charges and, in the case of less readily traded assets, the frequency at which they are valued.

There may be good reasons why shares trade at a discount, and a very large discount could be a warning sign. For instance, where the valuation of a trust’s assets is only calculated infrequently it can indicate that investors think it’s out of date and events have moved on. Alternatively, investors may be sceptical of the estimated valuations for assets that are not regularly bought and sold.

If you invest in an investment trust it should be for the long term, so changes in the discount shouldn’t make too much difference compared to the change in valuation of the underlying assets. However, they are an added factor that can work for or against an investor, so it’s well worth considering the current level and how that compares to history.

6. Understand the charges

Like all collective investments, there are various charges and costs associated with running and operating investment trusts. The lower the better for the investor, though some areas do involve higher costs due to their level of involvement, such as private equity, or the nature of the assets themselves, for instance property.

The most significant of these costs is the annual management fees taken by the fund manager. Often this is a straightforward percentage of assets under management each year, but sometimes it can be a little complicated if they are tiered according to different levels of assets, or if there is part of the fee that depends on performance compared to a relevant benchmark.

The AIC has a recommended methodology for calculating an Ongoing Charges Figure (previously Total Expense Ratios or TERs), which is a figure published annually by an investment company which shows the drag on performance caused by operational expenses. This doesn’t include performance fees, but a separate figure available on the AIC website does include this where applicable.

7. Consider the size of the investment trust

Investment trusts come in various sizes from tens of millions of pounds to multi billion. Size can matter a lot because it can define economies of scale in terms of running costs as well as the ‘liquidity’ – or ease of buying and selling – of the shares in the market.

Trusts below a certain size are arguably not viable as they will tend to suffer from prohibitive charges owing to its fixed costs being spread across a limited asset base. Meanwhile, a smaller number and variety of shareholders, and therefore more limited trading activity, can lead to a high ‘spread’ between the buying and selling prices of shares. These characteristics would tend to lead to a wider discount (see above) compared to a larger, more frequently traded investment trust.

8. Lookout for any buyback policies

An investment trust can repurchase its own shares if it has sufficient cash to do this. These ‘buybacks’ are one of the ways investment trusts try to reduce their discount to net asset value, and thereby dampen the share price volatility that comes from swings in investor sentiment.

Buyback programmes often involve the investment trust board setting a formal or informal discount level – when the discount reaches 10%, for example – at which point it will consider making purchases. Variations of this include regular ‘redemption facilities’ whereby investors can sell shares at a predetermined price with reference to the Trust’s net asset value rather than the trust buying its own shares in the market.

Share price discounts, or premiums, are in part a reflection of a mismatch between supply of and demand for shares in the trust. So in theory buybacks should help to reduce the gap and narrow a discount, pushing up the share price and boosting investor sentiment.

A buyback policy can therefore also offer some reassurance to investors that the discount won’t be allowed to drift. However, not all trusts have a buyback policy, and some boards and managers worry that reducing the number of shares in circulation can effectively make the trust smaller and possibly less ‘liquid’ and readily tradable in the future.

9. Check the life of the trust

Although some trusts are set up to run in perpetuity, others have built-in milestones where shareholders get to vote on the continuation of the company. For well-supported trusts these ‘continuation votes’ are often formalities to further the life of the company, but they can also be used by activist shareholders to voice dissatisfaction and prompt a wind-up of the company.

If this happens, the trust will usually sell its assets and distribute cash to shareholders, which can be a way of releasing value if a trust is at a persistent discount. Instead, shareholders may be offered a ‘rollover’ into another, similar trust. A trust can also choose to wind up because there is no longer demand for it, perhaps because the asset class it invested in now looks unattractive, performance has been poor, or it is no longer deemed to offer sufficient value for money.

10. Weigh up the risk and position size

As with any investment, before buying an investment trust you should consider whether it meets with the level of risk you are happy with and how it fits into your portfolio. Owing to the various complexities outlined above, investment trust shares can experience greater share price movements compared with a similar open-ended fund such as a unit trust or OEIC. Investors should therefore be comfortable with that typically greater volatility, which can be heightened in times of market stress.

It also important to reflect on appropriate position sizing with a wider portfolio of investments. More specialist trusts should generally be held in smaller sizes at the fringes of a portfolio whereas more general, diversified ones can be considered for larger, core positions.

Which investment trusts are popular with investors?

A wide range of the top investment trusts are available through our Charles Stanley Direct Online Investing. There are around 400 to choose from covering virtually any imaginable geographical area and asset class.

Looking for more investment ideas?

Explore a universe of more than 12,500 funds, trusts, ETFs and shares on the Preferred List, curated by our experienced Collectives Research Team.

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