Simon Read considers what information investors should consider before opting for an investment trust, and whether there are supporting trends for long-term outperformance.

The year’s biggest investment launch so far has been Fidelity’s China Special Situations, run by famed fund manager Anthony Bolton. The firm hoped to attract around £630 million to the new fund, but launched it as an investment trust. What followed was a period of head-scratching while investors wondered why.

Bolton said that the attraction of making it an investment trust was that it would give him a set amount to invest – in other words, he would know from the off how much money he has. He said that stability was essential given the volatility of some of the potential stocks he would be investing in.

‘A closed-ended investment trust structure was selected after careful consideration of China’s market characteristics,’ he said at the time. ‘A stable pool of assets considerably helps management of liquidity and volatility, and ensures maximum flexibility for a diversified portfolio remit which may include small- and mid-cap companies and unquoted pre-IPO stocks.’

The alternatives – chiefly unit trusts or OEICs (open-ended investment companies) – are open-ended, which means the amount of money available to the fund manager can fluctuate depending on the popularity of the fund. Therefore, a new fund could, for example, start with just a few million pounds and grow as it builds up a track record. Or the amount of cash available could reduce if investors cash in their units.

Stable funding
With an investment trust, however, people effectively buy shares in the trust, which means they can’t take their money out, only sell the shares to other investors.

While that may suit a fund manager like Anthony Bolton who is moving into China, is an investment trust a good idea for investors?

‘There are certain features that are particular to investment trusts,’ remarks Peter Hewitt, manager of F&C Managed Portfolio Trust.

‘They tend to have lower expenses than open-ended funds, which can work in investors’ favour over time, but there are also the double-edged swords of discounts and gearing, which can work for or against you. That said, these, to me, are not the most important factors when choosing an investment trust.’

Gearing is when fund managers borrow money to take advantage of investment opportunities. When it works, it improves returns, but when it fails it magnifies losses.

The discount is the difference between the price of a share in an investment trust and the value of the actual assets.
So if the assets held in an investment trust were worth £100 million and the total share value of the investment trust company totalled only £90 million, the shares would be trading at a 10 per cent discount. But choosing to invest on the basis of the discount or gearing is a mistake, says Hewitt.

‘There is usually a reason for a wide discount – it may be performance, or a capital structure with a high level of gearing between share classes, or the investment style may be out of favour,’ he says.

For example, Peter McGahan, managing director of Worldwide Financial Planning, invested in real estate investment trusts last year. ‘They were trading at a 57 per cent discount in February 2009 so it was a no-brainer to buy them,’ he says. ‘Today they trade at a premium to the net asset value.’

Such stories show that buying investment trusts at a discount can prove to be a good policy.

Weigh up the information
While the discount is important, it shouldn’t be the main factor in a purchase, particularly if you’re looking for outperformance. ‘The driving force for us is finding the best of breed,’ Hewitt adds.

‘We’re not short-term investors, and once we have decided on the areas where we want to invest – whether that is
UK equity income, Asia, Europe or property – we want to find the managers who are going to be towards the top of
the sector.’

Seeking out the best managers is also the policy of Simon Moore, a senior research analyst at Bestinvest: ‘I look at trusts outperforming their benchmark and then ask how long a manager has been managing the trust – the longer, the better.

‘It’s also important to check performance over several discrete periods, such as 12 months, rather than simply relying on cumulative figures over the last one, three, five years, etc. It will help you to spot periods of outperformance or underperformance.

‘It’s also useful to find out whether a manager runs other funds, such as OEICs, in the same sector and, if so, to check the performance of those funds. That will give an indication of whether or not he has a consistent outperformance.’

Timing – as with any investment – will be crucial, Moore points out, but he says that investors have to make up their own mind on whether they think a particular sector or geographical focus is set to boom.

‘When it comes to investment trusts, investors need to find out the level of borrowing – the gearing – and the discount,’ Moore says.

‘Gearing can be particularly crucial as, if the borrowing limit is near to the banking covenants on the loans, this could allow the bank to call in the loan and force a liquidation or another reconstruction.’

Finding out such information is essential before investing, says Hewitt: ‘As professional investors we have access to more information than the individual investor – for example, we regularly meet managers and we have lots of data coming in all the time, which is clearly an advantage. But for the private investor, there is still a lot of information out there that you can arm yourself with.’

For example, the AIC’s website, www.theaic.co.uk, has a lot of useful data, updated monthly, and you can request annual and interim reports for trusts that interest you. You can also look at fund factsheets online, which will keep you informed about the trust’s portfolio. Bringing together all this information can help you to make more informed decisions than performance data alone allows.

Charges are another factor to bear in mind. ‘The effect of charges is to reduce the return to shareholders,’ says Simon Moore. ‘Investors need to ask whether the level of fee corresponds to the level of return. In other words, are you getting what you pay for?’

You could be forgiven then for assuming that by knowing the charges, discount, gearing, longevity of the fund manager and objective of the fund you could find the right investment trust to produce long-term outperformance.

Peter McGahan thinks not: ‘I am not a believer in long-term performance. I am happy to drop anything at a pinch.
Assets perform very cyclically, so I choose based on how the market is actually behaving.’

The pitfalls
Patrick Connolly of AWD Chase De Vere goes further and advises his clients to avoid investment trusts altogether. Why? ‘First, the buying and selling prices of the trust are dictated by demand and supply rather than just the underlying value of the investments,’ he explains. ‘This means that the price can swing from a premium to a discount, or more likely from a discount to a bigger discount, solely on sentiment.

‘Second, investment trust managers are able to borrow money they don’t have – gearing – to invest. It is then possible that these investments will fall in value while they still have to pay interest on them and then pay back the money they borrowed. Both of these factors increase the risks of investment trusts compared with OEICs and unit trusts.’

He’s right. These factors do increase the risks. But they also offer the potential for greater returns. Of course, the answer is much simpler. Ensure that you know exactly what you’re buying and ensure that you’re comfortable with the risk.

Simon Read is personal finance editor at The Independent