Investment Trusts

What is an investment trust?

An investment trust is a collective investment fund which pools together money from hundreds or thousands of investors. This pool of money is structured as a company with shares quoted on the stock exchange.

A professional fund manager is employed to invest the funds in the shares of a wider range of companies than most people could practically invest in themselves. There are more than 300 investment trusts responsible for the management of billions of pounds' worth of assets on behalf of investors.

As a quoted company, an investment trust is a 'closed ended' fund with a fixed number of shares in issue. Conventional investment trusts issue only one class of ordinary share. These usually give shareholders a right to dividend distributions and offer the opportunity of capital growth to increase the value of their investment.

Some investment trusts are structured to offer high income while others focus on growth or a mix of growth and income. Some specialise in certain countries or regions. Others target specific industry sectors .The price you pay for shares in an investment trust will vary, depending on how popular the trust is. Too few buyers will mean the share price will drop however well the individual holdings of the trust are doing.

Each investment trust sets out its investment policy when it is launched and this will be reiterated each year in its annual report. A trust can ask shareholders to agree a change in investment policy. Some specify a date on which they will be wound up and the proceeds from the sale of investments returned to shareholders. Others hold a vote at regular intervals to decide if the trust should wind up or carry on.

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What do investment trusts invest in?

All investment trusts invest in other companies. What varies between different investment trusts is what those other companies are, where they are based and what they do. When you are deciding which investment trust to invest in, the first thing you need to do is consider your investment objectives and the investment objectives of the investment trust company what and where it is invested in and whether their aims are the same as your aims.

There is a wide range of investment trusts with exposure to different industries and regions of the world. Their objectives also vary. Investment trusts are grouped by the Association of Investment Companies AIC into sectors. The classification of each is based on a combination of the regional or industries focus of the portfolio combined with the trusts investment objectives. The AIC classifies investment trusts into 36 different sectors:

• Country Specialists: Europe
• Country Specialists: Asia Pacific
• Europe
• European Emerging Markets
• European Smaller Companies
• Asia Pacific excluding Japan
• Asia Pacific including Japan
• Global Emerging Markets
• Global Growth
• Global Growth & Income
• Global High Income
• Global Smaller Companies
• Hedge Funds
• Japan
• Japanese Smaller Companies
• Latin America
• North America
• North American Smaller Companies
• Overseas Growth
• Private Equity
• UK Growth
• UK Growth & Income
• UK High Income
• UK Smaller Companies

Sector Specialists:

• Biotechnology / Life Sciences
• Endowment Policies
• Environmental
• Financials
• Liquidity Funds
• Commodities & Natural Resources
• Property
• Securitised Debt
• Smaller Companies Media Communications & IT
• Technology, Media & Telecommunications
• Venture Capital Trusts
• Zero Dividend

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How do I choose an investment trust?

The first thing to consider is why you are investing. If your aim is to build up a nest egg for later in life, then you should look at trusts which are designed to produce capital growth. But if you are looking for a fund that pays out income, you may focus on the group of trusts which do just this.

Will you be investing a lump sum or on a regular savings basis? One of the advantages of regular saving is pound-cost averaging: you avoid the risk of buying all the shares in one go when the price may be high and your average purchase price may actually work out to be lower than the average price over the period in which you buy your shares its a mathematical quirk resulting from the fact that you buy proportionately more shares when the price is lower.

Next, think about risk and how well a particular trust would fit in with your existing investment portfolio. Broadly speaking, the level of risk you are prepared to accept will depend on how long a view you are prepared to take.

With a UK fund, for example, you are not taking on any currency risk the risk of your investment changing in value due to fluctuations in overseas exchange rates. Also the more broadly-based an investment trust, the lower its risk profile. Very focused trusts, for example those which invest in just one country or sector are higher risk.

However, there's more to risk than that with investment trusts. Although they have a finite number of shares and thus a finite amount of money to invest, trusts are allowed to borrow to buy more assets this is known as gearing. The profit they make on these extra assets is intended to cover the interest on the loan, and leave an additional profit for investors. But, the more an investment trust borrows, the more risky it is. What if the extra assets perform badly?

One measure you will see discussed many times in relation to investment trusts is volatility. The aim of this is to provide a yardstick of the historic performance of the trust's shares and offer a method of assessing the uncertainty around the future expectations for your investment, i.e. how risky is it?

There are several ways to measure volatility, but the most commonly used is the standard deviation. Standard deviation measures historically, the percentage movement around the trust's own averaged performance for the period under measurement.

Although often used as part of an assessment of risk, volatility must be considered in conjunction with other factors and is not by itself an indication of how well your investment will perform in the future.

Never buy an investment trust purely on the basis of past performance. However, that doesn't mean you should ignore it either. Some star performer fund managers have a substantial following among investors. What happened in the past is no guarantee of success in the future but if a trust has performed consistently well, the chances are that it has a skilled manager or team whose investment strategy is working well.

What you should not do without investigating further is pick last year's top performer: it may be that the particular sector or area in which the trust invests just happened to be the right place to be over that period. But those good short term results could mask a disastrous longer term record. Be prepared to keep an eye on your investment trust - you may track investment trust shares with Moneyextra.com's portfolio tool.

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Why do investment trusts trade at a discount?

Investment Trust shares tend to trade at a discount. This means the share price of the investment trust company is lower than the value of the underlying assets held by the trust. The latter is expressed as the net asset value NAV per share. There can be a number of reasons why this is so.

The first is a simple structural point - in theory you could buy the same portfolio of shares yourself directly in the market without having to pay the trusts fees / management charges, so the discount first of all reflects this extra cost that you pay.

The other major factor affecting the size of the discount is the popularity or otherwise of the investment trust in question. Given that, as a closed ended fund there is a finite number of shares available, the more demand there is for the trust's shares, the smaller the discount will be perhaps to the point where the shares actually trade at a premium to the NAV making the trust's shares worth more than the underlying assets!

Investment trust share prices are set by supply and demand and the relationship to the value of the underlying assets can be elastic. It is worth remembering that a discount can be useful to you. A 10% discount would allow you to purchase 100p worth of assets for 90p; meaning more assets working for you to provide dividend income and potential capital growth.

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How do I invest in an investment trust?

Investment trust companies' shares are listed on the stock exchange. This means you may buy shares in an investment trust through a stockbroker or execution only dealing service. You may hold the shares in your own name or through your broker or dealers nominee account service.

You may invest in an investment trust through an Individual Savings Account ISA. This would mean that any capital gains you make are free of income tax and you would, if you are a higher rate taxpayer, have no further tax to pay on any dividend distributions received from the ISA.

Several investment trust management companies offer a 'wrapper' option of buying investment trust shares without having to use a stockbroker. Using this option you may invest a regular amount each month or a lump sum. Most investment trust shares are available through such schemes.

You may make your investment decisions without recourse to financial advice. However, you may find it useful to go to a professional independent financial adviser, who will give you advice on what to invest in either via direct shareholdings, or via a regular savings scheme.

If you decide to select your own investment trust you may choose whether to go direct to a stockbroker or an execution only dealing service to buy the shares for you the direct holdings route, or to approach a fund management group to invest via a wrapper product.

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Are investment trusts better than unit trusts?

They are certainly different! Both are collective investments, but investment trusts are closed ended. That is to say the number of shares in issue is fixed. As a consequence, the price may go up and down not in direct relation to the value of the underlying assets, unlike a unit trust where the unit price fluctuates directly depending on the value of the investments held by the trust.

Moreover, an investment trust may borrow money to invest on behalf of its shareholders. This can provide a boost to investment performance when markets are rising. However, equally, when they're falling, the falls may be exaggerated. Another difference is that investment trusts are permitted to invest in unquoted shares which again can add to the risk for investors, even if the potential rewards might be greater.

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Is an investment trust like an ISA or a PEP?

Let's not get confused. An Individual Savings Account ISA and its predecessor the Personal Equity Plan PEP are nothing more than umbrellas that allow you to benefit from investments in a tax-advantaged manner. An investment trust may be bought and then held within an ISA so as to maximise the tax benefits from holding it. In other words, an ISA is a tax efficient way of holding investments.

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What's the tax situation with investment trusts?

What's the tax situation with investment trusts?

Do remember, if you have invested in an investment trust via a stocks and shares ISA, you will not have to pay any further tax. Income from investments held within ISAs does not have to be declared on your tax return.

If you are investing in an investment trust outside an ISA and you receive a dividend distribution, you will receive a tax voucher from the fund manager showing both the amount that you are getting and the amount of tax on the distribution that has already been paid by the manager. Dividend distributions are paid net of 10% tax.

The information on all the tax vouchers you get during a tax year should be recorded in your tax return. If you have not received a tax voucher, you should ask your fund manager to supply one.

How much, if any, tax you will then have to pay will depend on your status - non-taxpayers may not reclaim the tax paid on dividends, basic rate taxpayers will have no further tax to pay but higher rate taxpayers will face a further tax bill.

On the sale of an investment trust there may also be a Capital Gains Tax liability. Subject to the annual exemption, £9,200 for the 2007 / 08 tax year, and any taper relief, the gain would be added to your income and taxed at the appropriate rate. However, an investment trust held within an ISA would be sheltered from any further tax liability.

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What went wrong with split capital investment trusts?

In 2004 the Financial Services Authority claimed of the row over split capital investment trusts sometimes simply referred to as splits that 'the misconduct in this case and especially the impact it has had on the financial services industry as a whole, to have been the most serious it has seen.' Source: Daily Telegraph 09/05/2004 Around 50,000 investors lost at least £620 million in up to 40 trusts.

Problems arose partly out of the complex nature of split capital investment trusts. Splits are companies with a portfolio of investments just like ordinary investment trusts, but they issue different types of share, each of which carries different rights to participate in the income and capital returns from the trust's portfolio.

A simple split trust might, for example, have two types of share, one offering only the income stream from the dividends and the other offering no income but the capital growth of the underlying assets, to be realised at a set date in the future. These structures became more complicated and this, together with an unnerving tendency of split trusts to invest into other splits in a dangerous merry-go-round, led to the inevitable crunch as the stock market itself slumped in the early years of the new decade.

So complicated did the split capital trust industry become that few investors really understood what they were getting into, forgetting the old investment rule: if you dont understand it, don't invest in it!

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Where can I get more information on investment trusts?

The Association of Investment Companies AIC is the trade body for the investment trust sector. It was formed in 1932 - investment trusts are the oldest type of collective investment - and offers a range of introductory literature on its website or available in hard copy.

Most investment trusts themselves will have product literature, although, if you are not used to investing, you may find some of the terminology confusing. Stockbrokers and independent financial advisers will also be able to tell you more and explain the advantages and pitfalls of investing in investment trusts.

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2009-02-17 00:00:00 © Moneyextra.com