Investment Trusts: Weighing up the Pros and Cons
A comprehensive guide to the intricacies of investment trusts, how they function, and the potential value they might bring to an attentive investor's portfolio.
Investment trusts date back to the 19th century, when the F&C Investment Trust was launched in 1868. There are 23 investment trusts that have been around for over a hundred years, surviving both world wars, the Spanish flu pandemic and many market crashes. Michael Born, Senior Investment Analyst at EQ Investors, offers Finance Monthly an in-depth look at what these investment trusts have to offer.
What are investment trusts?
Unlike open-ended funds, investment trusts are listed companies, and are traded on stock exchanges like the London Stock Exchange (LSE). ‘Closed-ended’ structures are so-called as the number of outstanding shares is fixed, unlike in an open-ended product which requires that investors can tender (redeem) their shares to the manager in order to get their cash back on a daily basis, so the number of shares changes from day-to-day.
Instead of trading with the fund manager, investors in investment trusts will trade with each other throughout the day. This means that the “price” of an investment trust can float independently of its net asset value (“NAV”) the fair valuation of the shares underlying value.
Buying portfolios at a discount
When investment trust prices move above the NAV (as investors clamour for shares, and demand outweighs supply) the trust is said to be on a “premium”, and when the price is below the NAV, a discount.
One of the key advantages for investment trust investors here is the potential to buy a portfolio at a discount, and then sell at a premium, which adds to investors’ returns. However, a negative swing in sentiment can exaggerate losses through down markets and if we are in an environment where most investment trusts are on a premium, this means that investors will have to pay over the odds for popular strategies.
As with most types of investing, it pays to be patient and wait for opportunities.
One of the key advantages for investment trust investors here is the potential to buy a portfolio at a discount, and then sell at a premium, which adds to investors’ returns.
Whilst open-ended funds offer investors liquidity on a daily basis, as investment trusts are listed companies, investors can trade in and out at any point when the LSE is open. This allows investors to reposition their portfolios in response to real time newsflow, whilst open-ended investors have to wait for their books to clear.
Not constrained by liquidity
As the managers of an investment trust are not bound to offer investors daily liquidity, they can invest in assets which are not manageable in an open-ended strategy, like assets which are not publicly traded such as property, infrastructure and private equity. These investments, which do not have “mark-to-market” risk (when values are determined by supply and demand on the open market) add considerable diversification benefit as they will not necessarily fall on bad news.
In addition to being able to invest in less liquid assets, managers of investment trusts do not have to hold a cash buffer to manage liquidity, which is essential if you have flows in and out of the product on a daily basis, so the cash “drag” resulting from the portfolio not being fully invested is minimised. Similarly, there is no obligation for managers to sell assets at unfavourable prices to provide daily liquidity.
One of the unique features of investment trusts is the ability to gear the shares, where trusts borrow debt and then leverage their returns. Although this certainly increases the potential for upside, losses can also be magnified by gearing, and one of the attributes of a manager is their ability to know when to deploy debt.
Legally, investment trusts are required to have a board who oversee the investment manager as well as interacting with shareholders via the annual general meeting (AGM). The board has the ability to fire and replace the manager if they determine the company is not being run in the interests of shareholders (e.g. for poor performance) in addition to making key decisions on strategic areas like share buybacks (to tighten the discount) and dividend policy. As a listed company, there is a higher burden of disclosure required for investment trusts as compared to their open-ended cousins.
A constrained universe
Like stocks, investment trusts must go through an IPO process, so the costs of bringing a product to market are considerably higher than for the open-ended space, which results in a much smaller universe. Many sectors only offer 4-5 choices with regard to strategy or manager and there are strategies which are not covered at all by the investment trust market. This also means that it is not possible to deploy large amounts of money in the investment trust space, as the premium would be driven up significantly. This is one of the main reasons that the investment trust market remains niche and is often overlooked by institutions.
Relative value opportunities
There are several managers who run both investment trust and open-ended versions of their products, which provides investors with the opportunity to choose between the two, as well as trade them if valuation opportunities open-up. However, investors should also be aware of the differences between “versions”.
Although strategies may be run pari-passu (side-by-side), the freedom of the manager from liquidity constraints can often result in the investment trusts running a longer tail and being closer to the manager’s “ideal” portfolio.