Investment trusts: a beginner’s guide

There are over 420 investment trusts, including some of the UK's longest-established and most successful funds. What Investment explains how they work and how you can access them.

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Fund management

An investment trust (also referred to as a closed-ended fund) is simply a company, listed on the stock exchange, that makes investments in shares, bonds, property or other assets and aims to grow the value of them on behalf of its shareholders.

As with any listed company, there are two ways to buy shares in an investment trust:

  • Buying new shares, when a new investment trust is launched, or an established trust seeks to raise more money by issuing fresh shares. You’ll buy these direct from the investment trust
  • Buying shares on the secondary market – that is, buying shares from someone who wants to sell them. You’ll usually buy these through a broker or online share platform

Either way, you can hold investment trust shares inside a stocks and shares ISA or JISA and avoid paying capital gains tax on any increase in their value.

Benefits of investment trusts

The reason for using an investment trust is that you can pool your money with other investors’ and benefit from the added scale and diversification. Hopefully, you’ll also benefit from the skill of the fund manager in selecting investments.

For example, if you wanted to invest in property, you might struggle to buy a single building on your own. Buy shares in an investment trust, and you can invest as little as £100 in dozens of properties, and benefit from any increase in their value or rental yield.

The same principle applies to investment trusts that focus on shares. If you tried to maintain a portfolio of 50 stocks, dealing fees would eat into your returns, and you’d struggle to keep track of each individual company. An investment trust can keep the impact of those fees down to a minimum, while the fund manager does the hard work for you.

Of course, the fund manager gets paid for this, with his salary and other running costs coming out of the investment trust’s assets. But since investment trusts employ so few people, they tend to have low annual management charges (around 0.5 per cent on average, compared with 1 per cent for unit trusts).

How an investment trust works

Investment trusts, like all listed companies, have a board of directors. And like all boards, it will appoint professional managers. Unusually, though, these managers are typically not full-time employees of the investment trust. Rather, the board selects a fund manager from an asset management firm, who takes the money from the sale of shares and invests it in a portfolio. Investment trusts thus tend not to have any employees, just a board of directors.

Following legislation in 2011, investment trusts can invest in almost anything. There are now investment trusts focused on everything from UK dividends to high-risk emerging markets.

Investment trusts pay the standard tax on their investment income, but not on capital gains. This is to make sure that shareholders in investment trusts are not taxed twice: once on the underlying investments, and again on the investment trust shares themselves.

Net asset value (NAV) – the discount and premium question

The total sum of the investment trust’s holdings is known as the net asset value (NAV). If the investment trust owned £500 million worth of property and £500 million worth of shares, for example, its NAV would be £1 billion.

Because shares in an investment trust are traded on the stock market, the price of the shares can change. The price is based on what investors think the investment trust is worth, rather than the strict value of the assets it holds.

This is why an investment trust can be deemed undervalued (trading at a discount) or overvalued (trading at a premium). If it is trading at a discount, it means the share price is less than the NAV per share. When trading at a premium, the share price is greater than the NAV per share – in other words, the total value of all the shares in the trust exceeds the total value of its net assets.

If an investment trust is trading at a premium, this can indicate the market’s faith in its management and prospects for growth. A discount suggests the market expects the value of the assets held by the investment trust to fall. At present, most investment trusts are trading at a discount to their NAV.

Find out more about whether you should buy investment trusts at a discount.

Gearing

Unlike unit trusts or OEICs, investment trusts can borrow money to build a bigger portfolio. Remember that they do this from banks and other institutional lenders, not their shareholders.

By spending this borrowed money (called gearing or leverage), investment trusts can get better returns from their portfolios.

But the danger is that if the fund manager picks poorly, the investment trust’s returns will be even worse than they would have been without the borrowing.

Often, investment trust managers use gearing not to try and enhance returns, but simply to manage their portfolios more efficiently.

Related investment guides

Also see: Investment Trust Reviews – Research and analysis of the best investment funds currently available to UK retail investors

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