PROFESSIONAL
GUIDE TO
INVESTMENT TRUSTS
DEBUNKING
THE MYTHS
2
MYTH 1Investment trusts are complicated and hard to understand
4
MYTH 2Investment trusts borrow money, which makes them risky
6
MYTH 3Discounts and premiums create a headache
7
MYTH 4Investment trusts can be volatile and unstable
8
MYTH 5Investment trusts are opaque and lack accountability
9
MYTH 6Investment trusts are hard to access
11
DUE DILIGENCE IS KEYThe investment environment is changing. From 1 January 2013,
the Retail Distribution Review (RDR) requires all advisers who
want to be labelled as ‘independent’ to offer truly unbiased
advice that considers all products which may be suitable for
their clients.
To date, investment trusts have not necessarily received the
same attention as unit trusts or open-ended investment
companies (OEICs). The structure of investment trusts – with
the associated detail surrounding discounts, premiums and
gearing – can sound complex, and this might prove offputting
to some investors. However, we believe their robust structure is
a key benefit.
It is worth taking a fresh look at investment trusts, not only to
dispel the myths, but also to understand their qualities and
consider how they can be included in your clients’ portfolios.
Investment trusts:
Investment trusts are companies created to invest in a diversified portfolio of investments, with the aim of generating returns for their shareholders. Shares in investment trusts are bought and sold just like shares in other companies and are quoted on the London Stock Exchange (LSE).
A POOLED STRUCTURE
Like collective investment schemes, investment trusts are pooled vehicles that are spread across a range of holdings. This helps to distribute risk and reduce volatility: if one underlying holding does badly it shouldn’t drag down the overall portfolio. This is one of the benefits of a diversified fund and is a feature common to investment trusts, unit trusts and OEICs. The principal difference of investment trusts lies simply in their structure.
Unlike unit trusts and OEICs, investment trusts are ‘closed-ended’, with a fixed number of shares issued at the time the trust is set up. This means the investment manager is managing a fixed amount of money, and this allows the manager to take a long-term view – something that can prove particularly beneficial if the investment mandate is focused on illiquid assets such as emerging markets or smaller companies.
Closed-ended vs. open-ended funds
A fixed number of shares are issued at the time the investment trust is set up, and this is what makes investment trusts ‘closed-ended’. In contrast, units in open-ended funds are created or eliminated according to investor demand. Closed-ended funds are owned by their shareholders and are listed on the stock exchange.
Myth 1: Investment
trusts are complicated
and hard to understand
WHAT IS ANINVESTMENT TRUST? Investment trusts are companies that invest in a diversified portfolio of shares, bonds or other asset classes with the aim of generating returns for their shareholders.
SUPPLY, DEMAND AND THE THORNY ISSUE OF DISCOUNTS
The price of shares in an investment trust depends not only on the value of the underlying portfolio, but also on wider issues of supply and demand. Investors’ appetite for the shares, combined with broader market sentiment surrounding the particular investment mandate, sector or geographical region – not to mention the popularity of its manager – will all affect the share price. If the shares in an investment trust are valued at a lower level than the net asset value (NAV) of the underlying holdings, the trust is valued at a discount. Similarly, if the shares are valued at a higher level than the NAV, the trust is valued at a premium.
FLEXIBLE AND VERSATILE
Investment trusts can provide a valuable asset allocation tool for advisers, who can select from a wide variety of investment trusts across a range of asset classes, geographies, market capitalisations, and industry sectors. Some trusts prioritise income or capital growth; others focus on a combination of the two. Investment trusts can be used as part of a wider portfolio and alongside open-ended funds in order to achieve the desired mix of asset classes. There are many large and highly diversified trusts available that could make ideal core holdings. Meanwhile, specialist investment trusts can prove particularly useful as satellite holdings. The robust, closed-ended structure of an investment trust is particularly supportive for illiquid assets or specialist sectors such as energy or mining. Meanwhile, private investors are able to gain access to specialist investment opportunities and top-performing fund managers who might otherwise be inaccessible.
WHAT IS A NAV? NAV is the market value of the investment trust’s total assets, minus total liabilities, divided by the number of shares in issue.
Investment trusts have the same ability as any other company to borrow money in order to fund future purchases. This activity may, for example, allow them to take advantage of a particularly attractive share or opportunity without having to sell existing investments. This borrowing activity is known as ‘gearing’. Investment companies have a variety of options when it comes to gearing, including borrowing money from a bank, issuing long-term debentures (an unsecured bond) or preference stock (a special type of share that regularly pays the holder, in a similar way to a bond).
Investment trusts can usually borrow very flexibly, in a variety of ways and at relatively favourable rates of interest.
Gearing affects the performance of the investment trust: in effect, gearing increases investors’ exposure to the stock market. This is positive for
performance in a rising market, but can become less attractive when markets are in decline, as any losses will be magnified.
GEARING EXPLAINED
Gearing is perceived by some investors to be negative. However, gearing can be both constructive and beneficial for performance. It provides valuable additional flexibility: the manager is able to seize fresh investment opportunities and, equally importantly, pursue their chosen long-term strategy.
Of course, gearing does mean that the manager is potentially taking on more risk; after all, the resulting performance has to be good enough to justify the cost of the loan. Some of the risk depends on what the trust invests in, and where it invests, but it is highly dependent on the skill of the manager. If the investment trust borrows and the investments perform well, the overall performance will more than validate the decision to borrow. Conversely, if the performance of the underlying investments disappoints, losses will be exacerbated by the cost of the gearing.
Myth 2: Investment
trusts borrow money,
which makes them risky
WHAT IS GEARING?Investment trusts have the ability to borrow money which can be used to buy shares. This is often referred to as ‘gearing’, and can enhance returns in a rising market, but detract from returns when a market falls.
CHECKS AND BALANCES
Gearing is carefully controlled: the maximum level has to be agreed by the Trust’s Board of Directors in advance. Gearing policy is reviewed regularly by the investment manager and by the board, and can be modified if necessary. Even so, not every investment trust is geared, and those that decide to take advantage of the opportunity to gear tend to take a relatively conservative approach to their gearing policy and the terms on which they borrow. As with any investment, it is important that you conduct adequate research and due diligence to ensure you understand the level of gearing and therefore what type of investment trust you are buying into.
One aspect of investment trusts that can cause anxiety is the issue of discounts and premiums. They sound complicated, but are really very straightforward. Put simply, the value of an investment trust can be assessed in two ways. The first is the NAV of the underlying portfolio; the second is the price paid by investors to buy shares in the investment trust on the open market, which reflects the broader investment community’s opinion of what the share is worth. This difference between the two is known as the discount (if the share price is lower than NAV) or the premium (if the share price is greater than NAV).
A DISCOUNT IS NOT NECESSARILY A BAD SIGN
Historically, investment trusts have been more likely to trade at a discount than a premium1, and it is always worth looking at the reason for the discount. If it is
unusually wide, it might represent a warning that the trust, its manager or its board are unfavourably perceived. Equally, a discount might signal an attractive opportunity – perhaps the trust is undervalued by the wider investment community because its mandate has temporarily fallen from favour.
UNDERSTAND THE REASONS FOR A PREMIUM
On the other hand, investors might avoid buying shares in an investment trust that is valued at a premium, perhaps believing they are paying too much for an asset that is overvalued relative to its NAV. Once again, it is worth focusing on why the investment trust is trading at a premium. Perhaps it is because there is limited capacity available to invest in funds managed by that particular manager. Perhaps the investment manager is particularly well respected, and investors believe the manager’s talent will reap rewards over the long term. Maybe the investment trust is focused on a particularly fashionable region or industry sector. Nevertheless, it is always worth taking a second look at an investment trust that is trading at a premium, to determine whether it truly merits its premium.
Strong performance will not necessarily push shares in an investment trust to trade at a premium. An investment trust can trade at a discount to NAV despite very strong performance.
Myth 3: Discounts
and premiums
create a headache
Premiums and discounts
NAV provides an indication of the investment trust’s fundamental value, but the investment trust’s share price is different from its NAV. The premium or discount to the NAV shows how the share price compares easily.
SHARE BUYBACKS If an investment trust is trading at a particularly large discount, its Board of Directors can instigate a share buyback at less than NAV, subject to shareholder approval and certain rules and regulations. A buyback reduces the number of shares in issue, which will boost the net asset value of the remaining shares.
Myth 4: Investment
trusts can be volatile
and unstable
The share price of an investment trust is subject to the pressures of supply, demand and market sentiment, and therefore it is likely to fluctuate according to these influences. Gearing can magnify market movements and the performance of the underlying investments. This can be hard to swallow in a falling market, but is easier to digest in a rising market. Meanwhile, the issues of discounts, premiums and gearing can lead some investors to believe that investment trusts are more complex (and potentially more volatile) than, say, an OEIC.
A ROBUST STRUCTURE
Unlike open-ended funds, purchases and sales of shares in the investment trust itself have no impact on its underlying portfolio. Their closed-ended structure offers an element of stability: in volatile markets, many investors might decide to sell their holdings, presenting a problem for the manager of an open-ended fund, who might find their chosen investment strategy compromised by the need to sell holdings – perhaps at unreasonably cheap prices – in order to accommodate redemptions. In comparison, the sale in the market of existing shares of an investment trust does not change the underlying amount of money within the portfolio, and therefore the manager’s long-term strategy remains unaffected. The closed-ended structure also increases the manager’s scope to invest in relatively illiquid assets such as in emerging markets or smaller companies.
A STEADY INCOME STREAM
Unit trusts have to pay out 100% of their income to unit holders, whereas investment trusts only have to pay out 85% of their income. Investment trusts can maintain their dividend payouts by shoring up their revenue reserves during good years, which allows them to supplement their dividend payouts during difficult periods when underlying companies might be cutting their dividends. This can make them particularly attractive to investors seeking income. According to the Association of Investment Companies (AIC), at the end of 2011, one-third of conventional investment trusts yielded more than 3.2%, exceeding the annual average of the FTSE 100 Index.2
2 AIC, 21 November 2011.
www.theaic.co.uk/media-centre/press-releases/one-third-33-of-investment-companies-yielding-more-than-ftse-100-average-yield
In common with any listed company, an investment trust is overseen by an independent Board of Directors with a Chairman. The board is fully accountable to its shareholders and has to run the company in the shareholders’ best interests. This means that performance and costs are always under scrutiny. The investment manager has to report regularly to the board, who can decide to change the manager if necessary. Moreover, investment trusts have to comply with strict regulations and stringent reporting conditions, and the board has to publish an annual report and audited accounts.
TRANSPARENCY FOR ALL
Investment trusts also have to report to the LSE, which makes information on them freely available to any interested parties, including the press, and increases overall transparency.
SHAREHOLDER RIGHTS
Unlike units in a unit trust, buying shares in an investment trust confers upon the purchaser the rights of a shareholder. Shareholders have the right to vote at annual general meetings, and can even vote for a new Board of Directors if they believe the current Board is not effective. In many ways, investors in an investment trust have a greater voice and more influence than those investing in an open-ended fund.
Myth 5: Investment
trusts are opaque and
lack accountability
“
In many ways,
investors in an
investment trust have
a greater voice and
more influence than
those investing in an
open-ended fund.
Myth 6: Investment
trusts are hard to
access
Shares in investment trusts are quoted on the LSE and can be a cheaper proposition than some other pooled investment options. Investors do not pay any initial charges, except stockbrokers’ dealing charges; although they have to pay stamp duty of 0.5% on purchases of shares already listed on the LSE, they do not have to pay stamp duty at the time an investment trust is launched. At present, overall costs, or ‘ongoing charges’ are often relatively low compared with OEICs and unit trusts; an investment trust’s structure as a company means that the Board of Directors has to promote shareholders’ interests and therefore costs can be kept to a minimum.
Investors large or small can buy shares in investment trusts, either using a lump sum or via a savings scheme with regular monthly payments.
INCREASED INTEREST WILL RESULT IN BROADER ACCESS
To date, the leading investment platforms have tended not to offer investment trusts; however, this is expected to change as a result of the RDR, providing valuable access for a new generation of investors and advisers.
Ahead of implementation of the RDR, a study undertaken by Citywire and the AIC3 showed that 42% of financial advisers intend to increase their exposure to
investment trusts over the next three years. At present, over 60% of advisers perceive investment trusts to be specialist holdings, with only 15% regarding them as a core holding. Further research by NMG4 suggests that 18% of
advisers still feel they don’t understand investment trusts well enough. Under the new regime, investment trusts are expected to become available via investment platforms. This change is already under way, although the leading investment platforms are at different stages in their expansion. Nevertheless, an increase in interest from advisers is likely to spur platforms to make investment trusts available, and may even encourage fund-management houses to expand their range of investment trusts.
3 AIC, 14 March 2012.
www.theaic.co.uk/media-centre/press-releases/42-of-advisers-to-increase-investment-company-exposure-over-next-three-years
4 Source: NMG Consulting as at June 2012.
Enlarging an investment trust
Investment trusts can only issue new shares when there is clear demand from investors and the shares usually need to be trading at a premium to NAV. If there is a significant level of demand, the Board might decide to issue new shares in the form of ‘conversion’ or ‘C’ shares. These are held in a separate pool to the original assets of the investment trust, and the two are managed side by side for a given period, after which the two portfolios are combined and the ‘C’ shares are converted into ordinary shares.
“
42% of financial
advisers intend to
increase their exposure
to investment trusts
over the next three
years.
3FACTORS TO CONSIDER WHEN SELECTING
INVESTMENT TRUSTS
When deciding to invest in an investment trust, due diligence is vital. There are several factors to consider when selecting the right trust for your clients’ portfolio:
`
` What are your clients’ investment goals? What do they want to achieve? Are they looking for long-term capital growth or a regular income stream – or perhaps a mixture of the two?
`
` What are your clients’ attitudes to investment risk? Are they happy to take on a slightly higher level of risk in order to increase the scope for higher returns, or do they prefer to play it safe?
`
` Do your research and understand the investment trust’s level of gearing and why it is trading at a premium or discount? Have you discussed this with your clients?
`
` What are your clients’ time horizons? Investment trusts are relatively long-term investments, so you should consider how long your clients are able to leave their money invested.
`
` Can your clients invest a lump sum, or would they prefer to invest via a monthly savings scheme?
`
` Above all, you need to be fully aware of what you are buying and whether it meets your clients’ needs.
Due diligence is key
“
There are several
factors to consider
when selecting the
right trust for your
clients’ portfolio.
THERE ARE MANY REASONS TO RECOMMEND INVESTMENT TRUSTS
AS PART OF YOUR CLIENTS’ PORTFOLIOS:
A USEFUL CORE HOLDING A WAY TO GAIN EXPOSURE TO SPECIALIST ASSET
CLASSES INCOME GENERATION WIDE CHOICE
There are many established, well-diversified global investment trusts with long track records that can be used as core holdings within a portfolio. The closed-ended structure of investment trusts makes them particularly suitable for specialist mandates, which often focus on relatively illiquid investments that require a long-term approach. Investment trusts’ ability to build up their reserves during periods of strong market performance allows them to boost dividend payments if market conditions deteriorate, providing additional peace of mind for income-seeking investors. The investment trust sector is very large, comprising over 400 companies with total assets in excess of £92bn5 and spanning a wide range of investment mandates, asset classes, geographical regions and industry sectors.
The first investment trust was set up in 1868 to provide an
opportunity for a diversified investment portfolio for the
‘investor of moderate means’. However, although investment
trusts are steeped in history, they are anything but
old-fashioned. Fast forward to 2013, and BlackRock’s highly
rated
6range of innovative investment trusts already offers
exposure to a wide variety of geographical regions, market
capitalisations and industry sectors. The RDR is widely
expected to generate renewed interest in investment trusts;
this vibrant sector continues to offer new and innovative
products, providing access not only to large, highly diversified
portfolios, but also to specialist investments.
Visit the Adviser Centre at
blackrock.co.uk
to view the full range of
resources that are available to you on this subject. Alternatively,
contact your Relationship Manager for further information.
Conclusion
6 BlackRock’s range of Investment Trusts has been recognised in recent years with several industry awards including: Investment Trusts Magazine – Best Group 2010; What Investment Trust – Best Group 2011; Money Observer – Premier Group 2011.
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