Investment trusts and unit trusts, such as open-ended investment companies and pension funds, are all collective investments. They are based on a fund of stocks and shares, run by a manager, which individual investors can buy into. The great advantage of any collective investment is that it allows you to spread your risk across possibly hundreds of shares for a relatively small amount of money.
Although less well known than unit trusts, investment trusts came along first. The Foreign & Colonial Investment Trust was launched in 1868 as the world's first collective investment vehicle, while the first unit trusts started in 1932.
While both vehicles are collective investments, they have very different rules. Investment trusts are incorporated as public companies. They issue shares and are "closed-end" funds. That is, they do not increase the number of shares in issue. Unit trusts on the other hand expand according to demand for their units.
How have unit trusts managed to steal the limelight from investment trusts? Daniel Godfrey, director general of the Association of Investment Trust Companies (AITC), says this is due to the dynamics of the two types of investment vehicle. Unit trusts make a profit for their fund managers, so they want more investors because this makes them grow, producing more profit.
Investment trusts exist to make a profit for shareholders by successfully investing their assets. So there is no need to attract new shareholders.
With the aim of introducing 75 per cent of UK adults to investment trusts over the next five years, the AITC has launched its advertising campaign with a pounds 17-million budget this year.
The traditional customer base for investment trusts has been institutional investors, says Mr Godfrey. But mergers between life insurance companies have created new companies large enough to do their own investing and therefore less reliant on investment trusts, he says.
However, as the old-style welfare state system continues to recede, people increasingly need investment vehicles to provide for their retirement years. "There is plenty of evidence to suggest that investment trusts do this very well," Mr Godfrey says.
Because shares in investment trusts are traded securities, they can go up and down in value according to market conditions. They are not firmly tied to the value of the assets held by the trust, as is the case for unit trust units.
So they can trade at a discount or a premium to the net asset value of the investment trust. This makes the shares more volatile than unit trusts as investments, but also increases the potential gains. This dwindling demand for investment trusts has led to most of their shares trading at a substantial discount.
It is this discount, or premium in some cases, which makes investment trusts appear complicated to many smaller investors. "Unit trusts are simple to understand: whatever the value of the assets is, divide it by the number of units, and that is their price," says Alastair Conway of independent financial advisers Clark Conway.
But closed-end funds may enable fund managers to invest more effectively. James Dalby of independent financial advisers Bates Investment Services says: "It is easier for a fund manager to invest when he knows what his pot of money is, some unit trusts have been flooded with money, and it can be hard to invest that money in the market."
But you can use discounts to your advantage, by picking one that is well- managed but temporarily out of favour for some reason. You may then be able to benefit from a subsequent closing of that discount, as well as an increase in the value of the underlying assets.
However, this will not necessarily happen. Mr Conway says: "There is nothing to say that a discount gap won't widen over the life of the trust."
When choosing an investment trust, you should take the discount or premium to net asset value into account, but pay more attention to the performance of the underlying investments, he says. The trust could be trading at a premium simply because effective recent marketing has temporarily stimulated interest in the trust.
Investment trusts can borrow money to invest, but unit trusts cannot. This means they can magnify gains by borrowing at a certain rate of interest, and investing that money in shares which produce a higher return. Of course, this ability to become geared brings with it a greater risk too.
Unlike unit trusts, investment trust have no restrictions on how they invest. They can hold property as an investment, for example, and also buy shares in unlisted companies. Again, riskier, but can mean higher returns.
"Investment trusts tend to work very well when you start dividing the shares up in a split capital investment trust," says Mr Conway.
Split capital investment trusts invest in the same way as any other investment trust, but they issue several different types of share. This allows investors to choose precisely the type of return and level of risk they want. The most common types are capital shares, which assume the capital growth of a trust not allocated to other shares, and income shares which take on the dividends of all the shares.
Other types include zero dividend preference shares. They pay no dividend but are instead entitled to a fixed return when the trust is wound up. They are low risk because they have first call on the trust's money at the end. Capital shares, on the other hand, are the most risky because they're last in the pecking order.
Shares in investment trusts can be bought through a stockbroker, or directly from the management group. Most investment trusts accept regular savings and their shares can be held in an Individual Savings Account, which keeps them largely capital gains an income tax free.
Mr Dalby recommends the Fleming Claverhouse investment trust, which has produced a return of 142.53 per ent over the past five years, well above the average for trusts in the UK general sector of 86.40 per cent, according to financial data provider Moneyfacts.
In the UK income growth sector, he recommends Merchants Investment Trust, where the five-year return has been 85.40 per cent, also above sector average.
AITC: 0171 431 5222, www.itsonline.co.uk
Bates Investment Services: 0113 2955955
Clark Conway: 0181 241 1000Reuse content