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What are investment trusts and how do they work?

October 2017


Tags: First Time Investors

Investment trusts are popular with private investors because they allow you to gain exposure to a large portfolio of investments, even if you have a relatively modest sum at your disposal.

Because you pool your money with other investors you benefit from added scale, diversification and the skill of the fund manager in selecting investments.

 

How do they work?

An investment trust is the same as any other company listed on the stock market, but rather than making or selling something, it invests in other businesses. The money invested into the fund is pooled and the fund manager uses this money to buy and sell a wide range of shares, bonds, property and other assets, with the aim of increasing profits. Investment trusts can invest in almost anything, but many focus on a particular region, sector or investment style. You can find investment trusts that focus on everything from dividends to UK small cap companies and high-risk emerging markets. 

You will often hear investment trusts referred to as closed-end funds (see Jargon Buster). Due to this closed-end nature, and because shares in the trust are traded on the stock market, the price of the shares can go up and down. When looking at an investment trust’s shares you have to take into consideration both demand for the shares and also the value of its underlying assets. 

Find out more about Investment Trusts

 

Valuing investment trusts

The underlying value of the trust is worked out by calculating the net asset value (NAV) of the investment trust. To get this you divide the total net assets of the investment trust by the number of shares available in it. This gives you the NAV per share. Because you have these two factors to take into consideration, you will often hear shares in an investment trust described as either trading at a discount or a premium. If they are described as trading at a discount, that means the share price is less than the NAV per share. Conversely, if the shares are trading at a premium, the market price is higher than the NAV per share. It’s not necessarily a bad thing for an investment trust’s shares to trade at a premium. It could indicate that the market, i.e. investors, have faith in its management and see prospects for growth.

If the shares are trading at a discount that might suggest the market expects the value of the assets held by the investment trust to fall. Or it could just happen to be that the sector it invests in isn’t particularly popular with investors at that time or is hampered by economic concerns.

On the whole though, investment trusts tend to trade at a slight discount to NAV. Over the long-term, discounts and premiums typically to average out, which is why the shares should be held for at least five years, but some investors like to keep an eye out for trusts trading at an unusually large discount, as this can mean the eventual return on their investment is greater.

 

Investment trusts for income

One thing to remember about investment trusts, and where they differ from other types of fund, is that the fund manager can borrow money to build a bigger portfolio. Many fund managers successfully use this gearing or leverage, as it is known, to manage their portfolios more efficiently. The danger with gearing is that if a fund manager does make a bad decision when investing this borrowed money, the investment trust’s returns will be even worse than they could have been without the borrowing.

Managers of investment trusts can also retain cash to help smooth out dividend payments and reliable income is a key appeal of this type of fund. In March 2017 the body which represents investment trusts – the Association of Investment Companies (AIC) - published a list of dividend heroes. All the constituents – shown in the table below - have increased their dividends each year for at least two decades.

Three investment trusts have reached the impressive milestone of 50 years of consecutive dividend increases. They are City of London Investment Trust (CTY), Bankers Investment Trust (BNKR), and Alliance Trust (ATST).

 

Dividend Heroes

Company

AIC sector

Number of consecutive years dividend increased

City of London

UK Equity Income

50

Bankers

Global

50

Alliance Trust

Global

50

Caledonia

Global

49

F&C Global Smaller Companies

Global

46

Foreign & Colonial Investment Trust

Global

45

Brunner

Global

45

JPMorgan Claverhouse

UK Equity Income

44

Murray Income

UK Equity Income

43

Witan

Global

42

Scottish American

Global Equity Income

37

Merchants

UK Equity Income

34

Scottish Investment Trust

Global

33

Scottish Mortgage

Global

33

Temple Bar

UK Equity Income

33

Value & Income

UK Equity Income

29

F&C Capital & Income

UK Equity Income

23

British & American

UK Equity Income

21

Schroder Income Growth

UK Equity Income

21

Source: AIC using Morningstar

 

The AIC regularly updates the list of dividend heroes - the table above is from the latest one in March 2017. For more information is the AIC website: http://www.theaic.co.uk/

If you are interested in the dividend yields for individual investment trusts then the AIC website can also provide this information: http://www.theaic.co.uk/aic/find-compare-investment-companies

 

Jargon Buster – Closed-end funds

A closed-end fund has a fixed number of shares. Unlike open-end funds, new units cannot be created or existing units bought back to reflect investor demand. This means it can trade at a discount or premium to the value of its underlying investments.

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Selftrade does not provide investment advice. This article is the authors view and is not the view or opinion of Selftrade and Selftrade accepts no liability for any loss caused as a result of the use of this information. The opinions expressed are those of the author at the time of writing and should not be interpreted as investment advice.

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