Welcome to the new Independent website. We hope you enjoy it and we value your feedback. Please contact us here.


Personal finance: The benefit of pooling your resources in a trust

Understanding the stock market
"When is a trust not a trust?" sounds like one of those riddles which pop out of crackers at Christmas. However, it is not supposed to be a frivolous question. The answer is: "When it is an investment trust."

An investment trust is, in fact, a limited company whose shares are quoted on the stock market. They came into being in the last century as a means of raising capital for pioneering investment overseas. Over the years their investment outlook has changed and today they concentrate on forming portfolios of shares quoted on the world's stock markets.

By comparison, unit trusts are relative newcomers. The first one was launched in 1931 to offer investors an "instant portfolio" of shares. The concept is simple. Investors' funds are pooled and divided into a number of units in proportion to their investments. The investments are held in the name of an independent trustee (hence their name).

Units in an unit trust are bought and sold by the unit trust company's managers, at a price which is extremely close to the value of the shares represented by the units. On the other hand, the price of a share in an investment trust is determined by its supply and demand on the stock market. Consequently, its price may bear little relationship to the net asset value (NAV) that it represents. Investment trust shares on average are currently selling around 15 per cent below their NAV.

There are many explanations as to why investment trusts sell at a discount. These range from the view that there is an over-supply, to the opinion that it reflects the cost of selling the portfolio. Given all the variables that determine the price of a trust's shares - supply and demand; management expertise and the view of the market in which the trust invests - it is not surprising that NAVs and prices do not coincide.

It will come as no surprise to learn that for many years a fierce battle has been raging between the proponents of unit trusts and investment trusts. The Association of Unit Trust and Investment Funds' view is that as the prices of investment trusts are determined by market forces, they are riskier than unit trusts.

On the other hand, the Association of Investment Trust Companies (AITC) emphasises that as investment trusts generally sell at a discount to the NAVs, investors obtain more shares for their money. They also point out that the charges are less than an unit trust's. Furthermore, whereas an unit-trust manager has to sell the underlying shares when unitholders want to cash in their units, an investment trust does not and, therefore, can take a longer-term investment strategy compared to an unit-trust manager.

Over the last 20 to 30 years, investment trust discounts have been in the 4 to 25 per cent range. As opposed to being a "problem" in a fundamental sense, it can, in fact, be a worthwhile advantage to investors. A smart and active investor can make money by buying at a relatively wide discount, selling when the discount has reached its narrowest for the current cycle and reinvesting in the same trust when he judges that its discount has gone as far out as it is going to go. In fact, the discount can be rather like an everlasting escalator - if you are prepared to back your judgement and to monitor your shares carefully.

If you are a long-term investor looking to build-up capital, it is well worth considering an investment trust for either a lump sum investment or regular savings plan. The golden rules are:

Do not chose a trust for its discount - make sure that you like the trust's policy, its performance and its management.

Do not sell shares just because the discount has narrowed - the change may reflect improved quality in the trust and you may do far better to hang on for an even better performance.

Look at the assets. The discount tells you how much the market undervalues the company's assets. If there is a big discount to a portfolio of good quality listed shares, you could be on to a winner - though rest assured, you are unlikely to be alone in your discovery. On the other hand, if the discount is because of the poor quality of the portfolio, the shares could seriously damage your wealth.

Finally, do not demonise the discount. Except for the minority of active investors who are looking to trade on discount movement, the trust's share price, total return and asset growth are more important.

For an introduction pack to investment trusts and performance information, telephone AITC on 0171-431 5222.