Investment trusts are companies that invest money in other companies, both listed and private, and/or other assets like bonds, property and private equity. They are in the business of trading and holding these assets for profit.
The particular kind of assets an investment trust holds depends on the mandate of that trust.
For instance, a trust may specialise in smaller companies, fixed income, overseas stocks, or one of a host of other themes, enabling investors to take interesting positions on the market.
There are also specialised property investment trusts that get tax breaks called Real Estate Investment Trusts (REITS). These deserve a future article in themselves.
The first investment trust, the Foreign & Colonial Investment Trust, was launched way back in 1868:
“to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk of spreading the investment over a number of stocks”
The F&C trust is still going strong today, as the largest global growth trust in the world.
Investment trusts differ from unit trusts and mutual funds in two important ways:
- Investment trusts are listed on the stock market and so are owned by their shareholders.
- There are a finite number of shares in issue; they are closed-ended funds. This is in contrast to open-ended funds such as unit trusts, whose managers can create or destroy shares on demand (subject to reserves) as the money comes and is withdrawn by the fund’s investors.
Investment trusts are very popular in the UK – much more so than the U.S., with the notable exception of REITS – and until Exchange Traded Funds they were the main way to put money into collective funds via the market.
Investment trust basics
In most ways investment trusts are just like any other listed company: you buy and sell them for a quoted price via your broker, and some pay dividends.
However there are some extra terms you must be aware of:
- The Net Asset Value (NAV) of an investment trust is (in theory) the value of all its investments, and so gives an indication of what the trust would be worth if it were closed today and all its assets sold off.
- The premium or discount to the NAV expresses as a percentage how the share price compares to the NAV.
For instance, you might have the fictitious Monevator Investment Trust trading at 90p per share, with an estimated NAV of 100p. This trust is therefore trading at a discount to NAV of 10%.
Extreme discounts usually narrow over time. In the 1970’s bear market, discounts approached 50%, for example. Due to the fear in the market, the shares simply became illiquid. When normality returned the discount narrowed closer to what the assets were actually worth, enabling brave investors who bought at the bottom to pocket an effortless gain.
In late 2008 there were equity income investment trusts trading at unusual discounts, too.
However discounts may correctly anticipate reductions in NAVs that haven’t been worked into the official estimate yet.
As of mid-2009 there are many private equity and commercial property investment trusts trading at very steep discounts, for instance. In this case the discount may fairly reflect the fact that the assets are worth a lot less than the NAV indicates.
Even with big investment trusts like the £1 billion RIT Capital Partners that I hold, there’s an element of guesswork in official NAV estimates. That’s because the trust holds private companies, such as 50% stake in The Economist. You can never really tell what assets like that are worth until they’re sold.
In contrast, the portfolios of investment trusts that invest entirely in listed companies can be accurately modeled, both by the trust itself and by external companies who estimate NAVs between official updates.
Why would a trust ever trade at a premium to the NAV? It seems illogical to pay more than you know the trust is worth, after all, but it sometimes happens, especially in bull markets.
Usually premiums arise because investors rate the management very highly, and believe they can skillfully buy undervalued assets or sell over-priced ones for a profit that will reveal itself in the fullness of time.
Buying investment trusts at a premium to the NAV is risky, however. The premium is more likely to evaporate with a share price fall.
Other investment trust quirks
There are a few other things to be aware of with investment trusts.
- Warrants There may be warrants (a kind of share option) in issue, given the holder the right to buy shares in the trust at some pre-determined price. The NAV of the investment trust is given as ‘fully diluted’, to take into account the fact that outstanding warrants that are profitably ‘in the money’ will reduce the assets available to other shareholders. Normally this makes a very small difference to NAV, but it’s worth checking the details for any trust you buy.
- Debt Investment trusts can borrow money to invest. This debt will have a market value (what it would cost to repay today) and a par value (nominal) value. If an investment trust were to be wound up, any debt would have to be repaid at the market value. Investment trust updates to the market usually give NAVs with debt accounted for in both ways. Normally you don’t expect the trust to be wound up – it’s all about downside protection. And some trusts have no debt.
- Costs and expenses Again, if the trust was wound up, lawyers, brokers and accountants would all get a piece of the pie. This could devour 3-5% of the NAV, especially if the trust is small.
Investment trusts definitely give you some interesting ways to put your money to work, and the opportunity to bag a bargain if you spot a trust trading at an unwarranted discount.
If you’re new to the markets though, you’re best starting off with Exchange Traded Funds, which have far fewer of the extra complications (and risks) of investing in investment trusts.