Discounting their blessings

Investment trusts have emerged from under a cloud and are finding favour again

The investment trust movement has lived for many years under the cloud cast by the "discount", the difference between the lower market price of the vast majority of investment trust shares and the value of the shares they invested in (known as the net asset value or NAV). The size of the discount varies between trusts and all go up and down with supply and demand, adding to the fluctuating value of the assets and making trusts a potentially volatile investment.

The investment trust movement has lived for many years under the cloud cast by the "discount", the difference between the lower market price of the vast majority of investment trust shares and the value of the shares they invested in (known as the net asset value or NAV). The size of the discount varies between trusts and all go up and down with supply and demand, adding to the fluctuating value of the assets and making trusts a potentially volatile investment.

They can be a real bargain if the discount is wide and starts to narrow when the asset value is rising, but widening discounts can exaggerrate the declines if they coincide with falling asset values.

There are many reasons for discounts but investment trusts were barred from buying their own shares, like other companies, to take them off the market. Abolition of Advance Corporation Tax made that cost-effective, using spare cash in the fund. Last week investment trusts were given the freedom also to use capital to buy in their own shares.

Investment trusts are the oldest form of pooled investment allowing small investors to buy a share in a much larger fund which in turn invests in a wide range of shares to minimise the risk of backing a loser. The oldest management company Foreign & Colonial goes back 130 years and there are more than 100 different managers with 300 trusts between them.

You can find big ones, small ones, general ones, specialist ones investing in selected parts of the London stock market such as small companies or venture capital schemes or in overseas markets, with some targeting income and others capital growth. The vast majority are actively managed which means the professional managers try to produce a better than average performance for the sectors or markets they invest in, but there are even a few investment trusts that track a chosen index.

You can find split-level trusts which offer two separate kinds of shares, one of which takes all the dividends and the other keeps all the capital growth. Even more specialised are split level trusts which consist of zero coupon shares which pay no interest but deliver a fixed capital gain when the trust is wound up. More conventional investors hold capital and income shares which receive the annual income and the balance of any capital growth.

Investment trusts offer several advantages over their brash younger relations, the unit trusts invented in 1933 and the OEIC, which was created two years ago, and the SICAV, the continental version. (see box)

Investment trust managers can sell assets when they feel stock markets are overvalued and invest the proceeds in cash until they think assets are cheap again, and they can borrow money to buy more assets when they think they are cheap. Dealing costs are lower than for unit trusts. Trust managers normally charge only between 0.3 per cent and 0.5 per cent of their fund each year to cover expenses, and there is only a small difference, the "spread" between buying and selling prices of investment trust shares at any one time.

But in the early Seventies the whole stock market was depressed and discounts soared to more than 30 per cent. They almost disappeared during the early Nineties and reappeared in the last five years as investors chased real asset values in FTSE 100 companies.

Twelve months ago average discounts were again nudging 20 per cent. This is partly because trusts tend to invest in specialist sectors or overseas markets such as Japan, which have been less attractive investments to investment funds and pension funds. Some institutional investors are disillusioned with the sector.

A trust suffering from a large and widening discount can find itself in a self-sustaining spiral until the assets look cheap enough for a predator (usually another fund manager or a purpose-built consortium known as a vulture fund) to bid for the whole trust, keep the assets it wants, dump the rest and still end up in profit.

Alternatively, in the hope of getting the backing of the investors, they announce plans to turn the trust into a unit trust which raises the value of the trust back up to its asset value.

The last year has seen a number of bids and battles which trust managers fight bitterly because their jobs are on the line. Some like the Mercury European Trust succeed in fighting off the predator by announcing their own plan to realise shareholder value.

A year ago discounts were so large that investment trusts seemed doomed. But a year on the sector is showing some signs of revival, and discounts have now narrowed again to around 13 per cent, helped in part by the recovery in the Japan and Far Eastern markets and a rally in the small-cap market after many years of underperforming the FTSE 100 share index.

The investment trust movement's trade body the AITC also claims some credit for appointing a new director general and launching a £18m campaign designed to raise consumer awareness and rebrand investment trusts as a cheap way for individual investors to get hold of assets for the long term.

But trusts have also out-performed both unit trusts and the FTSE Allshare index over the past 12 months. The AITC says £1,000 invested in the average investment trust would have grown to £1,473, compared with £1,290 in the average unit trust and £1,234 in the Allshare index.

Most investment trust managers offer monthly investment plans and investment trusts can also be held in a tax-free Individual Savings Account (ISA).

Foreign & Colonial are offering readers a free Investment Trust Consumer Guide. Call 0800 136420 or visit website www.fandc.co.uk

Beginner's guide

Investment trusts are shares in their own right, bought and sold on the stock market. They employ managers to buy and sell shares using their shareholders' capital. They can also borrow money to "gear up" and increase the number of shares they buy. They are closed-end funds which means the managers have no obligation to take in more capital and you must sell your investment trusts in the market if you want your money back.

Unit trusts also employ managers to buy and sell shares on behalf of unit-holders. Investors can only buy and sell through the managers and the trusts are open-ended which means the managers must buy assets if money flows in and sell them if holders want their money back. As a result the asset value is always the same as the value of the shares in the trust.

OEICs or open-ended investment companies are hybrids, with a single price structure which eliminates the buy/sell spread. Many managers are converting their unit trusts to OEICs.

SICAVs are a continental form of investment trust that are bought and sold on stock markets like investment trusts