What is an investment trust?

Investment trusts (also known as investment companies) are closed-ended vehicles, which means they have a set number of shares in issue and can be traded on the stockmarket. This sets them apart from open-ended funds, also known as open-ended investment companies (OEICs) or unit trusts, which will create new units whenever investors want to buy them and cancel them when existing holders want to sell.

Pros and cons of investment trusts

Pros 

• Ability to borrow money to boost long-term returns (known as gearing) 
• More suitable than open-ended funds for investing in illiquid assets 
• Run by an independent board working in shareholders’ interests 

Cons 

• Can be more volatile than open-ended funds in the short term 
• The ability to borrow money can amplify negative returns as well as positive ones 
• Platform fees and stamp duty reserve tax (SDRT) are usually charged when you buy or sell units 

Advantages of the closed-ended structure

 A set number of shares in issue means investment trusts have a fixed pool of capital: someone can only buy shares if an existing holder is willing to sell. 

Why is this an advantage? Because open-ended funds always create new units when there is demand, large inflows can result in more money flooding into the underlying assets than the managers may have anticipated.  

If the underlying assets are illiquid, such as property or very small companies, this can push up their prices in the short term, but leave the fund trapped with no one to sell to; if there are then large outflows from the fund, the managers will have to sell these assets at a knockdown price to meet redemptions. They may even be forced to close until sentiment improves, which used to be a regular occurrence for open-ended property funds. 

Because investment trusts don’t automatically buy and sell the underlying assets on the back of inflows and outflows, they are better suited to holding illiquid assets. 

However, investment trusts can be more volatile and fall further than open-ended funds in the short term due to the impact of gearing and the movement from premiums to discounts (for more information on these characteristics, see below). 

What is gearing?

Gearing refers to investment trusts’ ability to borrow money to invest. This is an advantage if the rate of return they can get from an investment is higher than the interest they need to pay on the loan used to buy the assets.  

Investment trusts tend to take loans for long periods of time, at a lower interest rate than the end investor would be able to borrow at. 

Gearing is one of the reasons why investment trusts tend to outperform open-ended funds when the stockmarket is rallying (going up quickly). However, if the stockmarket unexpectedly falls while an investment trust is heavily geared, this can lead it to perform worse than an equivalent open-ended fund. 

Discounts/premiums

Because an investment trust is a closed-ended vehicle with a set number of shares in issue, its share price can trade at above (a premium) or below (a discount) the value of the underlying assets (known as the NAV or net asset value, which is calculated after removing any liabilities such as debt), depending upon demand. Another useful term is the ‘market capitalisation’, which is the number of shares in issue multiplied by the share price.  

Investors buy and sell the trust at its share price. However, demand for shares is usually driven by the performance of the NAV, which the fund managers have more control over.  

If you buy an investment trust on a discount and it moves to a premium, you may be able to sell at a profit, even if the NAV hasn’t changed (and the gain is higher than the cost of buying and selling the trust). Unfortunately, if it moves from a premium to a discount and the NAV hasn’t risen, you will lose money if you sell.   

If shareholders vote to wind up (close) the trust, the underlying assets are sold off. Assuming these assets are liquid (such as shares traded on a mainstream stockmarket), the shareholders will receive their money back at a price that closely reflects the investment trust’s NAV. This means that if you invest in an investment trust at a discount shortly before it is closed, you are likely to receive more money back than you put in, assuming the underlying assets don’t fall in value.  

It is rare for a trust to be wound up if it is trading at a premium, although if this did happen, it would mean losses for investors who bought in at this level and received their money back at a price that closely reflected the NAV (assuming the underlying assets hadn’t risen in value after they bought in). 

What’s the difference between open-ended funds and investment trusts?

Open-ended funds

• Trade at price of underlying assets                                       
• Priced once a day
• Not typically allowed to borrow money for investment purposes (but may use other forms of ‘leverage’ for example via derivatives) 
• Must pay out all dividends from underlying holdings
• Do not have an independent board 
• No stamp duty payable on trades

Investment trusts 

• Can trade at a premium or discount to net asset value 
• Prices change constantly while the stockmarket is open 
• Allowed to borrow money for investment purposes using a process called ‘gearing’ 
• Allowed to hold some dividends in reserve  
• Have an independent board 
• Stamp duty payable when you trade 

Taxes, charges and pricing

Because investment trusts are traded on the stockmarket in the same way as individual shares, you will also pay the same stamp duty reserve tax (SDRT) when you buy or sell their units. This will usually amount to 0.5% of the value of the transaction.  

Most platforms will also charge the same transaction fees to trade in and out of these vehicles as they would for shares. This is another difference between investment trusts and open-ended funds: buying and selling units in the latter type of vehicle won’t incur stamp duty, and most platforms won’t charge you trading fees, either. 

However, some platforms will charge a type of annual ongoing fee on your holdings in open-ended funds, but not in shares or investment trusts. Although this fee will be a relatively small percentage, it can represent a substantial sum if you have a large amount of money invested. Please check the details of the platform you invest with for more information. 

One similarity between investment trusts and open-ended funds is that any realised capital gains or dividends you receive from either type of vehicle are taxable, unless held in a wrapper such as an ISA. 

Open-ended funds are priced daily. The share prices of investment trusts will change constantly while the stockmarket is open. 

What roles does the board play?

Investors in investment trusts have the same rights as any other shareholder in a publicly limited company. That’s why every investment trust will have an independent board of directors with a duty to act in their best interests.  

One of the board’s main responsibilities is appointing fund managers to invest shareholders’ money and replacing them if their performance falls below expectations.  

They also have some control over the trust’s share price and can decide to buy back shares to close the discount if they think it is trading too cheaply, or issue more shares if it is on a premium that they regard as excessive.  

The directors answer to shareholders, and you can vote to replace them if you are unhappy with their performance.  

Dividends

While open-ended funds must immediately pay out all of the dividends they receive from the underlying holdings, investment trusts have the option to hold some back. They can then use these reserves to boost the dividends they pay out in future when those from the underlying holdings fall. This technique, known as ‘smoothing’, has allowed some investment trusts to raise dividend payments for more than 50 years in a row.