How to choose an investment trust

What is an investment trust?

Investment companies are a way to make a single investment in a range of assets. A type of collective investment, they let you spread your risk and access a variety of investment opportunities. Their shares are listed on a stock exchange, just like those of any other public company, and can be bought and sold in the same way.

How they work

• Investment trusts are ‘closed-ended’ which means they have a fixed number of shares in issue at any one time. You invest in an investment company by buying the shares on the stock market, and when you want to sell your shares, you sell them back the same way. It means anyone wanting to buy or sell shares in the trust has to find someone else willing to trade with them. Like shares in any other company the price therefore reflects supply and demand.
• This makes them very different to ‘open ended’ unit trusts and OEICs where the fund manager issues and withdraws units in response to demand as investors move their money in and out of the fund. and the number of shares in circulation varies. The price of the units is a reflection of the value of the assets the fund holds less that day’s portion of the investment management charge and other costs.
• Because of the way the funds are structured, the investments they can hold are sometimes very different. Open-ended funds must be ready to give investors their money back at any time. So, they normally invest only in assets which can be sold quite quickly. But investment trusts do not have the same restrictions. It means they can invest in illiquid securities (those that might be difficult to sell at short notice) and can use complex investment strategies to achieve their objectives.

Overall, investment trusts can be a bit more complex than funds, so here is a roundup of some the important things to consider when choosing an investment trust.

How to choose an investment trust

1. Check the asset class and holdings

What might pique your interest in a particular investment trust is the area it invests in. Investment trusts offer a particularly wide range of investment areas from the conventional ones such as equities (by geography, sector or type such as smaller companies), through to more specialist and hard-to-reach areas such as private equity, commercial property and infrastructure.

The objectives of an investment trust will tell you where it invests and how it will do so, and you can check this and the current composition of its portfolio, including the top ten holdings, on its factsheet, which is usually published monthly. More detailed information is presented in a trust’s annual and semi-annual report and accounts where a full disclosure of its investments (“positions”) is shown. These can all be found via the ‘key features and documents’ tab of the relevant product page of the Charles Stanley Direct website among other places.

Bear in mind that a trust’s portfolio can either be very concentrated in a small number of holdings, (which increases risk) or more diversified across a large number of holdings; usually dozens, and possibly hundreds. Some trusts even take a deliberately diversified approach across a large range of different assets to create a broader and more resilient portfolio.

2. Find out who manages the trust

It’s important for the investor to have confidence in the manager’s expertise in the area of investment they are targeting. One of the main features of investment trusts is that they are all actively managed with a named fund manager or managers, supported by a broader team. They are responsible for choosing when to buy and sell the investments. Investors tend to rate managers according to their experience, track record and level of resource.

Most are managed by an external management group, which may manage several investment companies, and is chosen by the board of directors. The manager may change from time to time if there is widespread dissatisfaction from shareholders or if a key person moves on, which can in some cases mean a change in investment policy too.

3. Decide if you want a trust that uses 'gearing'

Investment trusts can borrow money to make additional investments, which is known as ‘gearing’. The greater the gearing the riskier a trust becomes. The more the company borrows, the more profit it makes if the investments rise in value but the more it loses if they fall. This is one reason why investment trusts can magnify the ups and downs of markets compared to an equivalent open-ended fund which is not able to borrow money.

Not all investment companies use gearing and many that do only use a small amount. It’s a decision taken by the fund manager and the board of directors. However, some trusts have a high level and things can go awry if a trust becomes encumbered with expensive debt and its investments don’t perform well.

A trust’s gearing policy, along with details of other risks involved, will be detailed on its Key Information document or ‘KID’. This can be found in the ‘key features and documents’ tab the relevant trust page on the Charles Stanley Direct website, and the current level of gearing can be found on the summary tab or, alternatively, on the AIC (Association of Investment Trusts) website.

4. Consider expected income and yield

If you want to generate income from your investments the investment trusts that pay regular dividends, usually bi-annually or quarterly, may be of interest. Meanwhile, others concentrate chiefly or wholly on capital growth, catering for those that simply wish to maximise their overall return.

The yardstick for how much an investment pays is yield. Like an interest rate on cash, it’s an annual figure expressed as a percentage. However, while interest on cash tells you what to expect going forward, the yield figure on most investments, including investment trusts, is more complicated. It is typically calculated as a percentage of the previous distributions divided by its current price. This is why income from investments is always variable and not guaranteed.

The yield on an investment trust, just like any share, is shown on the relevant page of the Charles Stanley Direct website. For further tools and resources for income-seeking investors the AIC’s useful Income Finder tool allows you to create a virtual portfolio of income-paying investment companies, track dividend dates and calculate how much income you could receive over a year.

Investment companies have several advantages when it comes to delivering a high income, or income that grows over time. Investment companies can hold back some income in good times to pay it out in leaner ones, which means they can sometimes maintain or increase their dividends even in difficult times when underlying investments reduce or pause their pay outs. They are also allowed to pay dividends out of capital, although this will reduce the capital growth of the trust.

5. Take care with discounts or premiums

Investment trust shares often trade at a discount, which means the shares can be bought at a lower valuation than the ‘net asset value’ per share. This is the value of the investment company’s assets after any liabilities, such as debt, divided by the number of shares.

When an investment company trades at a discount, it can be an opportunity to buy. However, it is not automatically a good thing. The price of investment trust shares depends on a whole range of factors. As well as sentiment towards the trust, its strategy, and the type of investments it holds, investors consider other things such as level and cost of debt, the charges and, in the case of less readily traded assets, the frequency at which they are valued.

There may be good reasons why shares trade at a discount, and a very large discount could be a warning sign. For instance, where the valuation of a trust’s assets is only calculated infrequently it can indicate that investors think it’s out of date and events have moved on. Alternatively, investors may be sceptical of the estimated valuations for assets that are not regularly bought and sold.

If you invest in an investment trust it should be for the long term, so changes in the discount shouldn’t make too much difference compared to the change in valuation of the underlying assets. However, they are an added factor that can work for or against an investor, so it’s well worth considering the current level and how that compares to history.

6. Understand the charges

Like all collective investments, there are various charges and costs associated with running and operating investment trusts. The lower the better for the investor, though some areas do involve higher costs due to their level of involvement, such as private equity, or the nature of the assets themselves, for instance property.

The most significant of these costs is the annual management fees taken by the fund manager. Often this is a straightforward percentage of assets under management each year, but sometimes it can be a little complicated if they are tiered according to different levels of assets, or if there is part of the fee that depends on performance compared to a relevant benchmark.

The AIC has a recommended methodology for calculating an Ongoing Charges Figure (previously Total Expense Ratios or TERs), which a figure published annually by an investment company which shows the drag on performance caused by operational expenses. This doesn’t include performance fees, but a separate figure available on the AIC website does include this where applicable.

7. Consider the size of the investment trust

Investment trusts come in various sizes from tens of millions of pounds to multi billion. Size can matter a lot because it can define economies of scale in terms of running costs as well as the ‘liquidity’ – or ease of buying and selling – of the shares in the market.

Trusts below a certain size are arguably not viable as they will tend to suffer from prohibitive charges owing to its fixed costs being spread across a limited asset base. Meanwhile, a smaller number and variety of shareholders, and therefore more limited trading activity, can lead to a high ‘spread’ between the buying and selling prices of shares. These characteristics would tend to lead to a wider discount (see above) compared to a larger, more frequently traded investment trust.

8. Lookout for any buyback policies

An investment trust can repurchase its own shares if it has sufficient cash to do so. These ‘buybacks’ are one of the ways investment trusts try to reduce their discount to net asset value, and thereby dampen the share price volatility that comes from swings in investor sentiment.

Buyback programmes often involve the investment trust board setting a formal or informal discount level – when the discount reaches 10%, for example – at which point it will consider making purchases. Variations of this include regular ‘redemption facilities’ whereby investors can sell shares at a predetermined price with reference to the Trust’s net asset value rather than the trust buying its own shares in the market.

Share price discounts, or premiums, are in part a reflection of a mismatch between supply of and demand for shares in the trust. So in theory buybacks should help to reduce the gap and narrow a discount, pushing up the share price and boosting investor sentiment.

A buyback policy can therefore also offer some reassurance to investors that the discount won’t be allowed to drift. However, not all trusts have a buyback policy, and some boards and managers worry that reducing the number of shares in circulation can effectively make the trust smaller and possibly less ‘liquid’ and readily tradable in the future.

9. Check the life of the trust

Although some trusts are set up to run in perpetuity, others have built-in milestones where shareholders get to vote on the continuation of the company. For well supported trusts these ‘continuation votes’ are often formalities to further the life of the company, but they can also be used by activist shareholders to voice dissatisfaction and prompt a wind up of the company.

If this happens, the trust will usually sell its assets and distribute cash to shareholders, which can be a way of releasing value if a trust is at a persistent discount. Instead, shareholders may be offered a ‘rollover’ into another, similar trust. A trust can also choose to wind up because there is no longer demand for it, perhaps because the asset class it invested in now looks unattractive, performance has been poor, or it is no longer deemed to offer sufficient value for money.

10. Weigh up the risk and position size

As with any investment, before buying an investment trust you should consider whether it meets with the level of risk you are happy with and how it fits into your portfolio. Owing to the various complexities outlined above, investment trust shares can experience greater share price movements compared with a comparable open-ended fund such as a unit trust or OEIC. Investors should therefore be comfortable with that typically greater volatility, which can be heightened in times of market stress.

It also important to reflect on appropriate position sizing with a wider portfolio of investments. More specialist trusts should generally be held in smaller sizes at the fringes of a portfolio whereas more general, diversified ones can be considered for larger, core positions.

Which investment trusts are popular with investors?

A wide range of the top investment trusts are available through our Direct Investment Service. There are nearly 500 to choose from covering virtually any imaginable geographical area and asset class – but there are some perennial favourites among investors. The list below represents the top five (by number of client holdings).

Please note these are provided for your information and although certain funds have been popular with our customers, this does not imply that you should follow suit. Any investment you choose should meet with your own personal circumstances and objectives, taking into consideration your existing portfolio.

Scottish Mortgage

Scottish Mortgage is an adventurous investment trust targeting companies that harness technological change to create new markets or uproot existing ones, and thereby provide investors with substantial growth opportunities.

There is a particular focus on innovation among US companies, notably within Silicon Valley. Historically, the portfolio has been invested in internet platform companies with Amazon, Google (now Alphabet) and Facebook (now Meta) all backed from an early stage, but now areas as diverse as finance, energy, healthcare and transport are all important. Current top holdings include Tesla, ASML and biotech firms Illumina and Moderna.

Private investments have contributed significantly to the Trust’s returns over the years and perhaps represent the biggest ‘edge’ the managers possess. Just over a third of the current portfolio started off in the unquoted arena and increasingly the managers see non-listed investments – ones to which regular investors cannot gain access – as offering the best potential in the future. That’s because some of the most innovative companies in the world today are private businesses, often because they are technology-based and have lower costs meaning there is little need to raise capital via the stock market. One well-known example is SpaceX, the rockets and spacecraft business founded by Elon Musk.

Scottish Mortgage has been a notable victim of market volatility owing to its focus on the technology sector. Although there are prospects of rapid growth, sentiment has cooled in light of higher inflation and interest rates, which translates to higher funding costs and a reduction in the ‘real’ value of future cash flows. Significant stakes in immature businesses whose success or otherwise can be binary in nature, adds to the risk, as does some gearing.

The distinctive, high-risk approach is bound to have poor as well as good times. It will appeal most to those who share the managers’ long-term perspective – as well as their assertion that a small band of companies will dominate market returns – and are happy to ride out significant short-term volatility in a smaller part of their portfolio.

City of London

A favourite among income seekers, City of London’s objective is to provide a reliable and rising income, alongside capital growth, from a broad portfolio of UK companies, mainly large ‘blue chip’ businesses. The trust has the longest track record of providing annual dividend increases in its investment trust sector, presently standing at 56 years. Its charges are also very low at 0.325%.

The Trust is managed by Job Curtis of Janus Henderson who has been at the helm for 30 years. He takes a long-term view and favours conservatively run and well-financed businesses companies that can deliver sustainable cash flow to support both dividends and capital expenditure to fund growth. This approach has delivered small but steady outperformance over the years, alongside the enviable dividend track record, although past performance is not a guide to the future.

The high yield of around 5% currently, variable not guaranteed, remains an attraction. Maintaining dividend income is a priority, making the Trust a possible core option for investors wanting UK equity income exposure.

RIT Capital Partners

RIT offers a portfolio featuring a broad range of assets and takes a flexible, differentiated and unconstrained approach. The overall aim of the Trust is to beat inflation while limiting the ups and downs usually associated with investing in the stock market – a goal that resonates with many investors.

Shares make up the core of the Trust, represented by managed funds and some individual stocks, and this is supplemented by bonds, absolute return funds, investments in private companies and the ability to add downside ‘protection’ through derivatives.

One of the main differentiating factors is the exposure to private equity investments, which are made directly, alongside established partners or through specialist third-party funds. RIT has access to a broad range of private equity investments through a well-established network. These sorts of investments (currently representing around a quarter of the portfolio, with two-thirds in funds and one third in direct holdings) are ordinarily out of reach for private investors but can provide a source of long term returns as well as important diversification.

RIT Capital has a good long-term track record, providing some insulation from falling markets whilst participating in the upside, though past performance is not a reliable guide to the future and the share price has been far more volatile than net asset value, which is inevitable risk of using investment trusts compared to funds. It could be worth considering for investors seeking a balanced approach through a diverse portfolio who are happy with the additional technical risks of investment trusts, as well as the relatively high total charges that are inflated by fees on underlying funds that can include performance-related charges.

Monks

Like Scottish Mortgage, Monks is managed by Baillie Gifford with the objective of harnessing the long-term growth of global companies. However, it is focussed on listed companies, and it has a broader spread of types of businesses and industries. It includes many more established businesses alongside the more disruptive, technology-led businesses backed by Scottish Mortgage.

The result is a more diverse and well-rounded portfolio than its higher-octane cousin, which means the Trust could be worth considering as more of a ‘core’ holding for global equities that is still aligned with exciting themes linked to secular changes in the global economy and society. It is still higher risk, however, owing to its defined style and bias to high-growth sectors.

The managers spread the portfolio across companies that fall into one of four broad growth categories: ‘growth stalwarts’ that can deliver robust returns and profitability regardless of the economic conditions; ‘rapid growth’ companies in the earlier stages of their development; ‘cyclical growth’ businesses that rely to some extent on economic cycles but can ultimately grow through them; and ‘latent growth’, which comprises out-of-favour businesses that are experiencing a catalyst that could rapidly accelerate earnings from an unspectacular level.

Worldwide Healthcare

The key structural driver behind the healthcare sector is growth in patient numbers, spending and drug approvals. The world will have 1 billion more elderly people by 2050, which means more government and private spending. A growing middle class in the developed world is also likely to add substantially to the numbers of patients and worldwide spend. At the same time, the industry is producing cures, treatments and technologies at a faster pace than ever before, notably in areas such as oncology, obesity and Alzheimer’s – so it is well placed to meet the growing demand.

These ingredients make the sector popular with investors looking for growth, and in our view the complexities mean there is scope for specialist active managers to add significant value. Worldwide Healthcare Trust has been managed by New York-based OrbiMed Capital for nearly 25 years. They are the largest dedicated healthcare investment firm in the world with around 80 investment professionals. The depth of resource upon which they can draw in terms of medical and investment expertise, longevity in the sector and network of industry contacts is impressive.

The portfolio comprises a combination of pharmaceutical majors such as Bristol-Myers Squibb, Merck and AstraZeneca, broad healthcare companies such as United Health, device manufacturers and smaller, innovative biotech firms. This Trust could be worth considering as a ‘satellite’ position in a broad portfolio for adventurous investors looking to harness the growth potential of this specialist, fast-changing and higher-risk area.

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