Four key benefits of investment trusts vs open-ended funds

Having been around for more than 150 years, investment trusts have often been considered one of the best kept secrets in the financial services industry.

An investment trust at its rawest form is another pooled investment, like a unit trust or Open-Ended Investment Company (OEIC). However, unlike the others, an investment trust is a quoted company and listed on the Stock Exchange.

Effectively its role is to invest on behalf of investors – meaning you are not just a small part of a big wheel but more of an active participant as a shareholder.

Like many funds, investment trusts can also invest across various themes and geographies, but the critical difference between them and the likes of unit trusts and OEICs is they are closed-ended — this means if you try to buy a trusts’ shares after it launches you can only do so if an investor wants to sell their shares.

Contrast this with a unit trust or OEIC, where the manager makes it possible to invest by creating new units and then invests this new money. However, when investors want to sell in an open-ended fund, a manager may have to sell investments to facilitate this. There have been examples in the past where this has been to the detriment of a fund, with managers having to sell good investments to give their fund the liquidity to return money promptly to selling investors.

A good example would be the property sector, where we’ve seen a number of liquidity mismatches in the past couple of decades, often to the detriment of investors. Essentially, if we see volatile markets (such as the Global Financial Crisis or Brexit) they often result in investors looking to pull money in large quantities. The problem is that fund managers can’t dispose of assets fast enough to satisfy investor redemptions during periods of elevated volatility. This leads to fund suspensions and can impact performance.

Closed-ended vehicles have no such pressure as they have a fixed pool of capital that’s not affected by investors either buying or selling.

A good example to consider is the TR Property Trust, which invests in the shares of property companies of all sizes, typically within Europe and the UK. Marcus Phayre-Mudge has a great track record and is one of the most experienced managers in the business. This trust also trades on an attractive discount of almost 10%*.

Discounts are our next point of difference.

As an investment trust is a company, market sentiment can also dictate its share price. This may move above or below the value of the assets, known as the Net Asset Value (NAV). When it is above those assets it trades at a premium, while below means it is trading at a discount. However, sentiment is not always correct, so if a trust is trading at a discount it could actually be a bargain, while one at a premium could easily be overpriced.

Amid the pressure of rising interest rates, the average investment trust was trading at a discount of almost 15% in late 2023. This has since tightened, but there remains a lot of dispersion across sectors.

With its differentiated approach of investing in both private and public equities, the Schroder British Opportunities Trust (SBOT) was one the few products launched in response to the Covid-19 pandemic – as it sought to back a number of exciting opportunities in the UK small and mid-cap market.

Investing in roughly 30-50 holdings, SBOT targets two specific businesses; ‘high growth’ firms which are set to benefit from the rapid change in corporate and consumer behaviour; and ‘mispriced growth’ companies which offer products and services with long-term structural growth drivers. Although performance has held up well relative to its peers**, sentiment has been hit hard, with the trust at a near 35% discount*. A catalyst for change can see this evolve fast.

Investment trusts can also borrow money to invest more. This is known as gearing and is often used when a manager sees a rise in a certain stock or sector. If that stock or sector rises in value it can boost returns for the trust, but should they fall it can easily make the losses greater. Even modest gearing of 5% to 10% can really boost returns over time if a fund manager gets it right. Of course, this is a double-edged sword as it can also make losses larger if they get it wrong.

Experienced managers with excellent track records who use gearing include the likes of Fidelity Special Values, which aims to achieve capital growth by investing primarily in unloved UK companies and waiting for them to come back into favour. Manager Alex Wright currently uses 5% gearing, with the trust typically ranging between 6-14%***. Another would be the BlackRock World Mining Trust, a specialist trust offering exposure to mining and metals companies globally. Co-managed by Evy Hambro and Olivia Markham, the trust currently uses 13% gearing within the portfolio***.

A final point to highlight is dividend cover – this is almost like saving for a rainy day.

Investment trusts can retain earnings (up to 15% in each accounting period), which open-ended funds cannot do. This means that an investment trust can smooth income payments by retaining earnings during better years, in order to make up payments in weaker times. Think of times like Covid, when many income funds cut or suspended dividends.

This income “buffer” has helped some trusts to increase dividends annually for many decades. Examples include the City of London Investment trust (which yields over 5%*** and raised its dividend consistently for 57 years). Another to consider here is the Schroder Income Growth fund (which has raised dividend for 28 years and currently yields 5.2%)****.

*Source: Association of Investment Companies, figures at 16 May 2024

**Source: FE fundinfo, figures in pounds sterling, 19 May 2021 to 19 May 2024

***Source: fund factsheet, 31 March 2024

****Source: AIC/Fidelity, at 10 April 2024

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.

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