Why Investment Trusts Are Foolish

Published in Investing on 27 January 2010

Investment trusts often beat other types of funds over the long term.

Here at the Fool we frequently rail against managed investment funds, due to their high charges and the inability of most of them to match a simple index tracker over the long term.

But, when we do rail, we're usually referring to the large number of them that are structured as unit trusts or open-ended investment companies (OEICs). Not all funds fall into these groups though. There is a better way!

Units...

First of all, let's look at unit trusts and OEICs. These are open-ended, which means that they are open to new funds. Whenever an investor wants to invest new money in a unit trust, the trust creates new "units" whose cost depends on the current value of the fund -- the unit price goes up and down as the value of the trust's assets varies. 

New cash, apart from some short-term cash held to cover the short term buying and selling of units, is invested in whatever it is the unit trusts invest in -- shares, bonds, or other investments, depending on its stated strategy and objectives.

The fund's management makes its own profits from two sources -- from the bid/offer spread of the units themselves, and from annual management charges taken as a percentage of the fund.

A problem with unit trusts, and one of the reasons why so many Fools turn their noses up at them, is that a company that runs a unit trust is primarily in the business of enriching its shareholders, not its customers. There's nothing dodgy about that, it's just the way all companies work. A company, in fact, has a duty to its shareholders to do exactly that.

Or shares?

There is a different kind of pooled investment fund, known as an investment trust, whose loyalty is to its investors. An investment trust achieves this loyalty because its investors are also its shareholders.

Instead of being open-ended and taking new money from investors every time they want to invest (and paying it back to them when they want to sell), investment trusts are closed-end funds. What that means is that they take a fixed sum of money, raised by an initial public offering just like any other company, and then invest the money raised.

Each investment trust is a public limited company in its own right, with its shares quoted on the London Stock Exchange. There are about 300 of them at the moment.

From time to time an investment trust can grow, just as other companies do, by issuing new shares to new investors, thus growing the size of the investment pot. But again, investors' interests are represented by shares in the company, not by assets bought with deposited cash.

Open market

If you see an investment trust that takes your fancy, you invest in it by buying its shares on the open market rather than handing over cash to its managers. Instead of facing the bid/offer spread of a unit trust, you pay the market makers' spread and your broker's commission (plus 0.5% stamp duty).

As a shareholder rather than a customer, you still own the rights to the company's assets. But as public limited companies have to be run in the interests of their shareholders, you also get the directors' loyalty as with any other company you might have shares in, and that leads to the directors being obliged to aim for low costs.

There are other factors that improve the cost efficiency of investment trusts too. Generally, they are not allowed to advertise (and as they're not in the business of attracting new money from new customers, there wouldn't be much point anyway), so that's one source of costs eliminated. And they also don't have to manage money coming in and going out as investors buy and sell units -- they simply have a fixed sum of money to invest -- so that's a layer of management costs that they also don't face.

What all this leads to is the costs of running an investment trust getting proportionately lower as the trust gets bigger, and some of the largest have very low running costs indeed.

Transparency

The final bit of transparency you get with investment trusts is that you get to see a constant snapshot of what investors think of the performance of the company -- it's called the share price. Investment trust shares tend to trade at a discount to their net asset value (NAV), though on rare occasions they can trade at a premium, if, say, some exceptionally good performance is anticipated. The size of the discount tells you something about investors' assessment of the trust -- if the discount is wide, it suggests that investors are less attracted to the fund than if it is narrow.

There is one potential source of risk that investment trusts, but not unit trusts, attract, which we need to be aware of, and that is due to gearing. Investment trusts, like other public limited companies, are allowed to borrow money to carry out their business -- which, in this case, is investing.

But despite that risk (or perhaps partly because of the extra profits that can be made by gearing in good times), investment trusts regularly outperform unit trusts in the long term. They can, indeed, make for a very Foolish investment.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

jaizan 27 Jan 2010 , 9:19pm

The gearing is normally fairly modest, so not a problem.

In fact, you should be buying when expecting the trust to go up, therefore modest gearing is an advantage.

The gearing and the discount probably offsets the negative effects of management charges to some extent.

The only downside I can see is reduced choice of trusts compared with unit trusts. But there are enough out there

BarrenFluffit 28 Jan 2010 , 11:11am

IT's have to publish their accounts and news via RNS. There is a great deal of variety in what they invest in, what they charge, policies and capital structure. Need to read the accounts.

Jonesey12 28 Jan 2010 , 1:22pm

Harvey Jones here.
Well done Alan!
This is the best article I've ever read onthe differences between unit trusts and investment trusts. And better than anything I've ever written on the subject.

curedum 28 Jan 2010 , 1:43pm

For income seekers, investment trusts trading at a discount increase the net yield of the shares compared to the NAV. Also the "progressive dividend policy" which some trusts use tends to smooth out the rate of dividend growth - OEICS have to distribute all net income straight away but ITs can maintain a revenue reserve. Compare the Edinburgh Investment Trust with Invesco Perpetual Income fund, both run by Neil Woodford.

TMFBoing 28 Jan 2010 , 2:10pm

Thanks Harvey, that's very kind of you :-)

Cheers,
Alan

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