Investment trusts are useful vehicles for all investors

They could be an important component in your broader portfolio

INVESTMENT trusts have outperformed the market in seven of the past ten years. But despite being an attractive investment vehicle, they have traditionally been the preserve of the more sophisticated, self-directing private investor. Investment trusts are listed companies with shares that trade on the stock market. They are closed-ended, issuing a fixed amount of shares that can be bought or sold on an exchange. And they currently account for roughly 12.5 per cent of the UK fund market.

In a post-retail distribution review (RDR) landscape, investment trusts may find themselves on a more level playing field with unit trusts or open-ended investment companies (the review implemented a ban on investment advisers taking commission from product providers). “Now that commission payments for financial advice have been ruled out, financial advisers’ business models will better enable advice to be given on investment trusts alongside other vehicles,” suggests Glenn Williamson of Fidelity. But Henderson Asset Management’s manager of funds Paul Craig doesn’t think this will be a game-changer. “Managers are having to address their fees, so investment trusts will no longer be seen as the cheaper alternative,” he says.

Nevertheless, their performance over the past decade makes them a vehicle worth considering. The average investment company is up 227 per cent, compared to 137 per cent for the average unit trust or open-ended investment company, according to data from the Association of Investment Companies (AIC). It analysed all investment trusts to pinpoint the top 20 performers – seven of which were from the UK smaller companies sectors, and five from the Asia-Pacific, excluding Japan sector.

It isn’t hard to see what is fuelling this performance. First, investment trusts are able to gear to boost returns (gearing enables investment trusts to borrow money to make further investments). “In rising bull markets” – the FTSE 100 has risen by 8.26 per cent since the beginning of 2013, for example – “investment trusts tend to perform very well,” says Adrian Lowcock of Hargreaves Lansdown. And Jemma Jackson of the AIC thinks it is worth remembering where markets were a decade ago. “The Iraq War started in March 2003 and markets were at a low point. So factors like gearing have helped investment companies bounce back strongly from stock market lows, enhancing their performance,” she says.

But gearing has deterred some investors, and it is important to remember that it can lead to further losses. “There have been times when certain trusts have exposed themselves to too much borrowing, only to find the market goes against them and the debt to Net Asset Value (NAV) ratio has resulted in them breaching their banking covenants,” says Jason Hollands of BestInvest. But the average gearing level for the sector currently sits at a relatively modest 7 per cent.

As you might expect, the top performing funds of the past decade have tended to be more specialist. On a five year view, Hollands points to the “Asian smaller companies trusts, which have topped the performance tables”. Among those trusts with a less specialist focus, he points to Finsbury Growth & Income and Lindsell Train Investment Trust (both managed by Nick Train of Lindsell Train) as notable high achievers.

Second, the average investment trust has historically had lower costs than the average open-ended fund. Most investment trusts charge a standard 0.6 per cent annual fee in contrast to the 1.5 per cent annual fee charged by unit trusts. The gap in the total cost of ownership will likely narrow, however, with RDR enforcing transparency in how how investment vehicles are sold. And be aware that closed-end funds will charge brokerage fees (usually between £10 and £15 per transaction).

A third key reason why these trusts have seen good returns is that they give investors access to markets that may not be available or suited to other investment vehicles. “They are the most suitable structure for certain illiquid asset classes – like physical infrastructure, property, hedge funds, private equity and venture capital – which are either unavailable in open-ended funds, or if held in an open-ended fund will be diluted by the need to hold large amounts of cash to meet any redemptions (like property),” says Hollands.

So is it all good news? Not entirely. Many of the higher-quality trusts are trading at big premiums – akin to paying a high charge on a unit trust. And just as gearing has spooked some investors, complexity over premiums and discounts can act as a deterrent – with good reason. The price of an investment trust is not derived from its inherent NAV: share prices reflect supply and demand. A quarter of investment trusts and venture capital trusts (95 out of 395) are currently trading on a premium, the highest number since before the financial crisis.

So how can investment trusts feature in a wider portfolio? First, Craig says investors should define their investment strategy. “The fund selection is only part of the jigsaw. Investors will first need to establish their asset allocation. Only then should portfolio construction be a consideration.” If you are seeking exposure to US equities, for example, consider investment trusts alongside open-ended investment, as well as exchange-traded funds. “Investment companies cover a diverse range of sectors, which can be a useful way to add diversity to a balanced portfolio,” says Jackson. And they also feature more generalist sectors – global and UK, for example – which could form part of any portfolio.