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Investment trusts 101 - what are they?

Investment trusts are often popular among investors during turbulent times, but what are they exactly?

The Association of Investment Companies -
Unlike 'open' funds, investment trusts are stock market listed

Investment trusts allow individuals to deploy their money across a broad range of assets and spread risk.

Investors can outsource granular investment decisions and avoid the micromanagement of holdings in underlying assets.

For instance, an investment trust in the property sector may own stakes in different buildings worldwide, while others may be minority shareholders of listed companies, and they may buy or sell shares.

Quoted on stock exchanges, investment trusts have a finite number of shares. That is why they are called “closed-ended”.

So, there is only a limited amount of shares available on the market. For every buyer, there is a seller. Each investor in the company is a shareholder.

This is where they differ from other collective investment vehicles, such as unit trusts and open-ended investment companies (OEICS) which expand or contract in size depending on cash inflows and outflows.

For investment trusts, value and pricing is defined in the market. As a result, investment trust valuations can deviate from the underlying asset valuations.

Investment trusts tend to have better long-term performance than unit trusts and OEICS, according to Money Observer.

However, investment companies can also come with greater risk as they engage in gearing to improve their performance.

Geared for success, or indeed failure

Gearing - borrowing money against owned assets, in hope of a profit after covering servicing costs - can deliver more gains if the market is doing well, but in a moment of crisis, the losses can potentially be greater.

As the Money Observer puts it: “If the manager borrows X to invest and the trust grows, the manager has to repay X plus interest but retains the investment growth as part of the trust's NAV.

So if you have £1,000 invested (let's assume a constant share price for now) and the manager gears by 10 per cent, then there is effectively £1,100 working for you.

Now, if that doubles in value to £2,200, the manager pays back the £100 plus, let's say, 1 per cent interest. That leaves you - the investor - with £2,099. If the manager had not geared, you'd only have £2,000.

Conversely, if the same investment halves in value to £550, the manager still has to pay back £101. This magnifies the losses, leaving you with only £449 instead of the £500 you'd have without gearing.”

According to the Association of Investment Companies (AIC), the average gearing as of January was 7% of the companies’ capital.

Who runs them?

As with any listed company, investment trusts have an independent board of directors. The board’s responsibility is to set out the investment strategy, outline how money should be invested, and mandate how much risk should be taken on.

They elect a fund manager who chooses how to deploy capital, when to buy or sell assets.

Like a chief executive or managing director they may be sacked by the board if the performance is not satisfactory.

A study by the AIC published last summer shows that half of its investment companies have been managed by the same person for a decade or more, while 10% of companies have had their managers for over 20 years.

“Investors are often told they should be thinking long-term, so it’s reassuring to see that so many investment companies have managers with impressively long records,” commented Annabel Brodie-Smith, communications director at the AIC.

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