Investment trusts were for many years the only way for individuals to gain access to a range of assets that would have been unattainable to the average investor.
Nowadays, the majority of funds under management in the collective investment industry are in unit trusts or Open Ended Investment Companies (Oeics). Figures from the IMA showed open-ended funds under management of almost £413bn as at the end of July 2009. By comparison, the Association of Investment Companies (AIC), the trade organisation for the closed-ended investment company industry, detailed total assets under management of £79bn.
Various reasons have been mooted for this imbalance, the perceived complexity of investment trusts and the lack of commission paid to IFAs being the most commonly cited, supported by the prolific levels of marketing undertaken by the open-ended fund industry.
However, the FSA’s Retail Distribution Review (RDR), which should be implemented by December 2012, may go some way to redressing the balance.
Advantages and disadvantages
There are a number of benefits to investment trusts that make them worthy of consideration by advisers.
Charges
Investment trusts tend to have lower charges than open-ended funds, in terms of both their Total Expense Ratios (TERs) and their savings schemes.
The AIC provides information on investment trust TERs, demonstrating their low levels:
- 34% of conventional investment trust companies have TERs under 1.0%
- 63% of global growth investment trust companies have TERs under 1.0%
- 70% of conventional investment trust companies have TERs under 1.5%.
- On average, Oeics and unit trusts have TERs of over 1.5%.
Performance
Although performance is important to investors and advisers alike, past performance cannot be taken as a guarantee or even an indication of future performance. That said, current medium to long-term figures show investment trusts with an advantage over their open-ended rivals. For example, over the five years to 31 August 2009, AIC listed investment trusts as a whole turned an initial investment of £100 into £156 on a mid to mid basis with dividends reinvested, comfortably beating the FTSE All-Share and FTSE All-World indices, while the Morningstar open-ended funds averaged £137 on a bid to bid basis with income reinvested. For a ten year term, the average investment trust grew to £164 whereas open-ended fund growth at £135 was lower than over five years.
Dividends
Investment trust companies have an enviable track record of dividend increases. This benefit is particularly relevant in the current climate of historically low interest rates where income is harder to come by.
Investment trusts can retain up to 15% of each financial year’s income from the underlying investments and transfer this amount to their revenue reserves – in contrast with most open-ended funds, which are required to distribute all their income each year. These revenue reserves may be built up in good years and can be used to boost dividends paid to shareholders in poorer years. The effect is that an investment trust can, to some degree, smooth out the payment of dividends over a period of time.
A handful of investment trusts have increased their annual dividends for over 40 consecutive years. 20% of conventional investment companies (with track records of ten years or more) have increased dividends each year for the last 10 years while 48% of Global Growth investment trusts (with records of 20 years or more) and 45% of UK Growth & Income investment trusts (with records of 20 years or more) have increased dividends year-on-year for 20 years.
Closed-ended
Another advantage of investment trust companies is that they are closed-ended – in other words the number of shares in issue does not increase or decrease according to investor numbers – the amount of money the trust raises to invest is fixed at the start by issuing a set number of shares. This closed-ended structure gives fund managers greater scope to invest for the long term without worrying about factors that affect open-ended funds such as outflows and inflows of investor money, sudden fluctuations in these flows and unpredictable requirements to buy or sell in unfavourable market conditions.
Discounts
One area seen as complicated and consequently can seem off-putting to potential advisers is discounts. Share prices depend on market supply and demand and, as a result, tend to differ from the underlying asset value of the investment trust company. The shareholders’ funds are the net value of all of the company’s assets after liabilities have been deducted. Where there is a discount or premium to NAV it means that the share price is trading either lower or higher than the NAV. The discount is shown as a percentage of the net asset value.
The existence of a discount can provide buying opportunities. A discount of 15% means that an investment of £85 is buying £100 worth of underlying assets – thus giving investors more bang for their buck. A wide discount may represent a good buying opportunity as if/when the discount narrows, there is the potential for enhanced returns. Of course, the discount can work to the disadvantage of the investor if it widens further. Discount widening is a risk for investors in investment trusts and indeed the discount or premium to net assets can vary considerably over time giving volatility to the share price. However, many trusts now actively seek to limit this volatility by discount control mechanisms using share buybacks to target a given level of discount.
The prices of Oeics and unit trusts are calculated depending on the value of their assets, so they can never be bought at a discount.
Gearing
Unlike open-ended funds, investment trusts have the potential to enhance returns through gearing (borrowing). Investment trusts can borrow money in order to buy more assets, ideally at appropriate and advantageous times, without having to sell existing investments to do so. Gearing is beneficial in a rising market but can be detrimental in a falling market. The employment of a degree of gearing means that the investor has more than their own capital working for them.
Independent boards
Another strength of investment trusts, and an advantage over open-ended funds, is in their corporate structure. Investment trusts are governed by independent boards of directors whose duty is to look after the interests of the shareholders (ie investors). These boards have the ability to move investment management contracts and change managers and over the past few years have shown an increasing willingness to do so if unhappy with the manager’s performance.
Information
A recurring complaint from IFAs has been the apparently limited amount of available information on investment trust companies. However, this is changing as an ever-increasing number of providers of financial data now offer detailed information on investment trust companies.
Summary
If investment trusts are to see an upturn in use by IFAs, now could be the time. With the RDR proposed move away from commission allied to the lower charges, the potential to out-perform open-ended funds over the long term and the increasing availability of data, there is the potential for investment trust companies to be given greater consideration by advisers for their client portfolios.
Sherry-Ann Sweeting is marketing manager of SIT Savings Ltd
