An investment trust is a complicated way of describing a company which will invest your money for you. Most investment trusts will have a clear mandate to target a sector, asset class or foreign portfolio investment. Some investment trusts will be even more specific, targeting income or capital preservation.
What is an investment trust and how its structure works
Understand the investment trust premium and discount
Learn what risks you should look out for
An investment trust is a company in its own right which has a fixed number of shares in issue. This means it is a close-ended structure, i.e. it does not need to issue new shares to meet demand. This has the advantage of increased liquidity in their shares.
A board of directors oversee the investment trust. These directors will decide who invests the company’s funds. A separate company will bid for the mandate of investing the funds. In cases where the investment performs badly, the directors can remove the mandate, i.e. fire the portfolio manager, and assign it to someone else.
Investment trusts have the ability to issue debt. Used properly debt can increase returns . If a market rally has cooled and leads to a violent stock market sell off, opportunities will arise.
A sell off will also negatively impact the price of strong companies. An investment trust manager can take advantage of this to top up their favourite holdings, using debt which can be repaid later. This will boost returns to your advantage.
Investment trusts have a mechanism where you can buy the trust at a discount (or premium) to its Net Asset Value (NAV). The NAV of a trust is the total value of its assets minus any liabilities. Therefore a trust’s share price can trade at 90p, whereas the NAV of the trust is worth 100p. This gives opportunities for savvy investors to buy the investment at a discounted price. Investors should be aware that a trust trading at a discount could be highlighting a problem which is keeping investors from buying.
Take advantage of a discount to buy on the cheap.
Just as much as a trust can trade at a discount, it can also trade at a premium, where the shares of the trust trade at 110p, but the NAV is 100p. This will be driven by the trusts strong performance and because it is in a topical area, often backing a thematic investment.
Investment trusts which are income focused have the ability to retain some of the profits from their investing activities. This is called revenue reserves. For investors whose focus is dividend income, the build up in revenue reserves, can ensure the income is still paid even in bad years!
Scottish mortgage investment trust is perhaps the most famous UK investment trust off the back of its outstanding performance. Scottish mortgage is also considerably cheaper than it’s rivals. It’s cost is actually similar to that of an ETF.
Attractive companies are listing later. Funding rounds are becoming the only way of accessing privately held companies. Investment trusts are well suited to holding illiquid investments. Their close-ended capital structures mean they do not need to be sold to meet investor redemptions – ensuring they are sold at the right time.
Augmentun Fintech is an example of such a trust which holds positions in Interactive Investor, the do-it-yourself investment platform, and Revolut, the lower cost foreign currency exchange app.
Downside risk is never far away, even for an investment trust. Some investment trusts hold concentrated positions, up to 10% in one holding. This is poor diversification if things go wrong, with little margin of safety. Some trusts are clear they prefer to hold a smaller amount of concentrated holdings. This ensures they can spend more time understanding them.
The biggest risk is volatility. Bad news can lead to a violent response. Remember even if the underlying share prices of the stock portfolio are performing well, this will not stop the trust’s share price from collapsing if investors believe world events will turn against the trusts investment strategy.
As with any investment, investment trusts have their advantages and disadvantages. For investors who prefer simplicity, a mutual fund may be best. The net asset value of a mutual fund defines its value. For investors who are comfortable with increased volatility, the opportunity that buying at a discount presents is compelling.
Either way some investments, especially illiquid ones, are best held in an investment trust as the Woodford saga demonstrated. An investment trust will appeal to investors who do not like single stock risk or the lack of liquidity of a fund.