Investment trusts can be a good way to start investing as they allow individuals to deploy their money across a broad range of assets and spread risk.
First-time or relatively inexperienced investors may find themselves lost in the ocean of investment trusts: but picking the right one is not the herculean task it may seem.
There are several metrics that can help in understanding what investment company best suits one’s needs.
How risky is this going to be?
Before delving into research, investors need to ask themselves what risks they are willing to take.
“Generally speaking younger clients have a longer investment time horizon and can withstand stock market volatility,” said Paul Chilver, associate and financial planning manager at Birkett Long.
According to Chilver, millennial investors could choose investment trusts such as Pacific Horizon (LON:PHI), which has a diverse portfolio across the Asia Pacific region, while Edinburgh Worldwide (LON:EWI) has a view for long-term capital growth.
“Retirees are more likely to require an income from an investment,” he added.
“With that in mind, a suggestion would be Temple Bar (LON:TMPL) managed by Investec’s Alastair Mundy who is known for his contrarian investment approach which has been out of favour in recent years.”
Investment choice is often determined by proximity to retirement, with those later in years generally looking for lower volatility, income plays invested in blue-chip equities.
Many investors, however, are more interested in the blue-sky and ultimately higher-risk opportunities of a trust invested in developing smaller private firms, or a broader mix.
You might also want to refine your search further to focus on a particular industry or geography.
The power of returns
Income is often a big motivating force behind demand for trusts, which are allowed by law to set aside 15% of their annual income to pay dividends during leaner times.
This has allowed many of these venerable investment funds not just make payouts, but increase them over many decades like the 'dividend heroes'.
Key to understanding whether the income distribution from a trust is sustainable is the dividend cover figure, which simply tells the would-be investor how sustainable the income stream.
An analysis by Winterflood Securities found that the median level of dividend cover among dividend heroes was 129%, so enough to cover 1.29 years.
However, it’s important to bear in mind that a strong dividend history doesn’t necessarily mean there is a bright future ahead.
One key metric for investors is net asset value (NAV) total return, which shows the return of the underlying portfolio by reinvesting dividends, and doesn’t take discounts and premiums into account.
This metric is helpful to compare investment trusts with a benchmark, such as the FTSE 100, or other vehicles.
Discounts and premiums
Most investment companies' share prices currently trade at a discount to NAV per share thanks to the recent market correction. Before this, they had mostly traded at a premium.
Buying at a discount theoretically allows you to bag a bargain: but that disconnect between NAV and the market price may hint at distress. Also, it’s worth remembering trusts don’t like issuing additional shares at discount prices as it dilutes existing investors, which is frowned upon. More importantly, a lack of new capital into a trust will almost certainly impede its growth trajectory.
For quoted equities, NAV is usually an accurate yardstick. However, it is less so when the trust is invested in private companies, which are difficult to accurately benchmark (ask Neil Woodford), while property asset valuations are volatile at the moment, particularly in the retail sector, where portfolios have cratered.
In depressed markets, grabbing shares at a discount can be an opportunity, providing the company has had a manager for some time, Edison Investment Research’s managing director Rob Murphy told Proactive.
In more stable markets, discounts and premiums (when the share price is higher than the NAV per share) are based on supply and demand.
According to Nick Britton, head of intermediary communications at the AIC, the underlying portfolio and strategy of the company are always more important than the discount - it’s like buying something at the shop just because it’s on sale, even if you don’t like it.
How much debt?
Another potential tool in the pocket of investment trust managers that their unit trust cousins do not possess is the ability to take on borrowing money against owned assets, with the aim of increasing gains - especially when interest rates are so low.
It is usually favourable if the market goes up: the higher the gearing, the more potential in the long term, but is a potential risk factor worth bearing in mind.
Some companies provide a gearing range they would normally fall into, which shows investors what to expect.
“In the end of the day, if you’re not sure, choose a low-risk company,” Britton commented.
Investors may also want to look at charges and whether a company asks for performance fees on top of base fees.
It's not all about quantity
Last but by no means least, the strategy, investment manager and history of a company are important factors to check, as Murphy points out.
If a company keeps changing investment manager, there may be a reason, as usually they should be there for the long haul.
A study by the AIC published last summer shows that half of its trusts have been managed by the same person for a decade or more, while 10% of companies have had their managers for over 20 years.
Where to research
Performance data, the main holdings in the portfolio and other information can be found on the trusts’ reports and on online resources providing data, commentary and the opportunity for comparison.
The Association of Investment Companies (AIC), the industry trade body, covers around 300 trusts invested in all manner of sectors and with strategies to suit all tastes and risk profiles. Its website provides the basics on how these vehicles work as well providing data such as total assets, gearing and performance.
Morningstar, Trustnet and FE fundinfo are also a treasure trove of quantitative and qualitative information.
For commentary, there are several research houses analysing the industry or single trusts such as Shore Capital, Edison Group, Kepler Partners, Winterflood Securities, Killik & Co, Numis Securities and Stifel.