Investment trusts explained

What is an investment trust?

Investment trusts allow you to pool your money with that of other investors to get exposure to a range of assets through a single investment, in the same way as investment funds.

They are set up as companies and traded on the London Stock Exchange. When you invest in an investment trust, you become a shareholder in that company.

Here we explain how they work, and whether they're right for you.

Please note: the content contained in this article is for information purposes only and does not constitute financial or investment advice.

What's the difference between a trust and a fund?

Investment trusts are 'closed-ended' investments, meaning they issue fixed number of shares when they're set up, which investors can buy and sell on the stock market. 

This means investment trust managers always have a fixed amount of money at their disposal, and won't have to buy and sell to meet consumer demand for shares. This can add a degree of stability to investment trust management that a unit trust manager won't have.

Funds are 'open-ended' investments and can issue or redeem units at any time to satisfy investors who want to buy into the fund or sell their stake. This may cause problems, as the manager may have to sell assets at a low point to pay investors who want to sell units.

Most investment funds are unit trusts, though some are exchange-traded funds.

• Find out more: Investment funds explained

Investment trust prices

The value of the assets held by an investment trust is called the net asset value (NAV), usually expressed as pence per share. If a trust has £1m worth of assets and one million shares, the NAV is 100p.

With unit trusts, the price of the units you hold directly reflects the value of the assets held by the trust.

With investment trusts the price of shares is determined by supply and demand in the stock market. This means the price you pay will almost invariably differ from the NAV.

Trading at a discount

If a trust is trading at less than its NAV, it's said to be trading at a discount. If it's higher than its NAV, it's trading at a premium.

Often, investment trusts trade at a discount. This looks like good value, as you pay less than £100 for £100 worth of assets. 

However, there is no guarantee that any discount will have narrowed by the time you come to sell. If the discount widens then you'll lose out in relative terms, whatever happens to the NAV of the trust.

Trading at a premium

Less often, trusts will trade at a premium to NAV. This means you're paying more than £100 to own £100 worth of assets. 

You might be prepared to do this, for example, because of the skill of the fund manager. However, you need to ask yourself whether this type of out-performance is likely to last.

• Find out more: how to invest money - our portfolios

Where do trusts invest?

Like funds, investment trusts are grouped by the geographical area and type of investment with which they are involved.

The Association of Investment Companies (AIC), the trade body that represents investment trusts, lists more than 30 different sectors, including:

• UK Growth
• Global Growth
• Europe, Asia Pacific Infrastructure
• Property
• Private Equity

The level of discount or premium tends to vary by sector and changes with market sentiment.

Where and in what a trust invests will partly determine how risky it is. You can also invest in ethical investment trusts.

• Find out more: Ethical investing explained 

Investment trust performance

Investment trust shareholders often invest because they believe trusts will outperform similar 'open-ended' funds, such as unit trusts and Oeics.

When investment trusts do out-perform their open-ended rivals, as they frequently have in the past, it can sometimes be explained by a combination of lower costs (although that advantage has narrowed in the last few years), the closed-ended structure of the trust and the effect of 'gearing'.

Because investment trusts have a limited and constant number of shares, and are governed by a board of directors, they can arguably take a more genuine long-term view than their open-ended counterparts. They don't have to buy or sell the underlying investments until the board really thinks it's the best time to do so.

With open-ended funds on the other hand, fund managers have to buy and sell shares to accommodate investors joining and leaving the fund. This can mean managers might be forced to transact at inopportune times - selling when the market is low and buying when it's high, for example.

Of course, as every investment professional is duty-bound to tell you, past performance is definitely not an indicator of future returns.

Dividends can play a powerful role in generating an income from investment trusts.

What is gearing?

Investment trusts can borrow money to invest, known as 'gearing', which can have a dramatic effect on the value of your investments.

When stock markets are rising, gearing is useful because it magnifies any gains you make. But when markets are falling, gearing will increase your losses.

This means the more borrowing a trust has, the greater the capital risk you face, but you also have the potential for higher returns. The combined effect of gearing and the discount means investment trusts are likely to be more volatile than equivalent funds.

This means if you invest in investment trusts you should be prepared for a rockier road with bigger ups and downs.

The AIC publishes details of each trust's gearing policy - a gearing rating of 100 means the trust has no borrowing, a rating of 110 means your gains or losses will be magnified by 10%, etc - in other words, the trust has gearing of 10% of total assets.

Are investment trusts expensive?

As most investment trusts are actively managed, they tend to have higher charges than tracker and index funds.

Trusts may have similar costs to actively-managed open ended funds, though the former enjoys some advantages. 

Trusts have less admin to pay for because they don't have to deal with money coming in and out and have independent boards of directors representing the interests of shareholders - as such they will often negotiate lower annual charges as trusts grow.

They also have a notable disadvantage: trusts are treated by investment platforms in a similar way to shares. This means you'll likely have to pay one-off fees when you buy and sell trusts, even if fund trading is free.

• Find out more: Compare investment platform fees and charges

How to choose an investment trust

There are a few things you should consider when choosing an investment trust:

• Check to see what level of gearing it has - higher borrowing will boost your returns if the fund performs well, but will hit you hard if it falls in value.
• Check on charges - now that open-ended funds don't pay commissions, many have cut their fees.

In the end, there is no definitive answer to whether investment trusts or open-ended funds are better. The former have advantages, particularly when you want exposure to more illiquid assets, but they're not guaranteed to outperform - and they may be more volatile over short-term periods.

You should only be investing if you can take a long-term approach - and all collective investment funds can fall in value as well as rise.

• Find out more: are you ready to invest?