Investment trusts: don't write them off just yet

They are out of fashion, but investment trusts can offer value if you're prepared to do your homework, says Iain Morse
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The Independent Online

Should we ignore investment trusts? After all, they can seem old-fashioned, complex and opaque. And, because their shares are traded on the stock market like any other company, they are at the mercy of whatever is worrying or exciting investors at large. "But that ought not put anyone off," argues Charles Cade, head of investment trust research at Winterflood Securities. "There is real value to be found in this sector if you search for it."

Investment trusts have evolved a great deal over the last 20 years. They used to be dominated by large, long-lived generalist trusts like Witan, F&C and Scottish Mortgage, investing generally in all sorts of industries all around the globe. But they have lost many institutional investors, notably insurance companies and pension funds, as nowadays these bodies prefer to run their money in-house or entrust it to more specialist managers. Some generalist trusts have been successful in attracting compensatory numbers of retail investors, but many have not.

Overall the sector has shrunk with some trusts winding up, and some converting into unit trusts. Meanwhile, a new generation of specialist investment trusts have opened, investing in narrower areas: emerging markets, Europe, private equity, technology and the like. Other niche trusts, investing in such areas as UK Smaller Companies or the Far East, continue to receive support from both institutional and private investors.

"You should determine the ratio of institutional to private shareholders before you invest," says Mr Cade, "and judge how persistent they are likely to be." The message is simple. Institutions prefer trusts investing in those narrower, less liquid asset classes. This is partly because the share value of a trust, unlike the unit value of a unit trust, does not directly reflect the value of the assets which it owns.

Instead the two are detached. Traded like any other share, the price of an investment trust is set by market sellers and buyers. As a result, most trade at a discount to net asset value (NAV), a notional measure of value based on the trust selling all its assets then distributing the proceeds to shareholders. It is usually calculated by adding up the stock market value of the trust's investments.

This means that if some investors decide to sell a trust's own shares its managers are not forced into selling, as a unit trust would be. Forced disposals can drive down values in seldom-traded shares, pushing values down for the investors who remain. Hence the attraction of investment trusts to an investor seeking exposure to more specialist share sectors.

All this may sound excessively technical until you consider the discount to NAV on a fund. If wide, and some are over 20 per cent, these can be taken as a buy signal as investors are effectively buying into the trust's assets on the cheap.

"But you should be careful," warns Mr Cade, "as there may be good reasons for that wide a discount." Some types of fund trade at wide, long-term discounts, others may have geared up by borrowing money at now unfavourable rates of interest. And a discount can widen into a chasm if a big institution sells a major holding.

But what if a discount narrows? This implies that the share price must have risen relative to the value of the trust's assets. And if both are rising you can benefit twice over, gaining more than by being invested in a comparable unit trust. Of course, the same applies in reverse: if share prices and asset values are falling you can lose more than with a comparable unit trust.

The investment trust sector offers other sources of profit to investors prepared to do some homework. New issues sometimes offer warrants to successful subscribers. These confer the right to buy shares in the trust at some date in the future, but at a price fixed now. In a rising market, these can offer investors easy rewards, but in a falling market there is no obligation to exercise them. And trusts now regularly replace under-performing managers, or opt to wind up or convert their status to that of an open-ended fund like a unit trust or Oeic. Such events usually occur because the market sees underlying value trapped in an under-performing trust and wants it released.

So much for theory. If you are still discount-hunting, try the UK Smaller Companies sector, which trades on an average discount of over 18 per cent, or Global Growth, on just over 14 per cent. European trusts are also available at a handsome average discount of 14 per cent, as is Technology, while Life Sciences trade at -12 per cent.

When it comes to picking a trust in any of these sectors things get a little more complex. "Many of the UK Smaller Company funds are small, illiquid, hampered by expensive debt," warns Mr Cade, "and still have an overhang of institutional investors." Global Growth funds look a surer bet, offering huge diversification. The average discount on this sector has widened since July 2002, when it stood at less than 9 per cent.

"Institutional selling, notably by insurance companies trying to satisfy new solvency requirements, is the likely reason for the higher discount," says Mr Cade. Possible buys include Scottish Mortgage, F&C and Henderson Electric & General.

Anyone trying to diversify will want some exposure to Europe. Fidelity's European Values trust trades at a discount of 7 per cent, Merrill Lynch's European trust at minus 12 per cent and JPMF Continental European at minus 17 per cent. All have at least reasonable performance records and should see their discounts narrow if investors decide to follow the sector.

'They can be great value compared to the unit trusts'

Dr John Murphy, a psychiatrist based in Kingston-upon-Thames, Surrey used to be a fan of investing in unit trusts and their European Union counterpart, Oeics, but he has become a convert to the oldest type of collective investment.

"I've been putting my cash in investment trusts since I realised some years ago that they can be great value by comparison to unit trusts and Oiecs," says Dr Murphy. "The initial charges are much lower, and annual management charges tend to be too. Buying through a stockbroker on an execution-only basis, this can be cut to less than £20 per purchase."

Dr Murphy is a strong believer in the benefits of portfolio diversification, with core holdings in large generalist trusts like F&C. But he also likes more peripheral areas such as emerging markets in Eastern Europe, South America or Asia.

"Diversification is a key issue for private investors and one we neglect at out peril," he says. "What happens if you have all your money invested in a sector like technology or a single country and the market turns against you?"

By their nature, investment trusts also allow private investors to add value by doing their own research. "Wider than average discounts can be a buy signal, but you should research whether any trust borrowing is on favourable terms and the ratio of private to institutional investors," he says.


* The Association of Investment Trusts (AITC) has a free database at Call 020 7282 5555 for a free copy of their monthly guide. Details include all member trusts, including performance over one to 10 years, trust gearing and peer group performance. It compiles comparative data on discounts or premiums to net asset value and their longer-term averages.

* There are some useful web sites that run continuous analyses of investment trusts. The best,, gives investment trust news and separate comparisons of conventional and split-capital trusts. It carries profiles of individual trusts and fund management groups, as well as lists of the most popular trusts. The best websites for data on individual trusts are, gives up-to-date share prices and company information.

* Investors have to buy investment trusts through a stockbroker, a new issue or a trust manager offering regular premium savings plans which you can go into direct, by-passing the broker. If you know which trust you want to buy, use a discount broker and pay a fixed commission.

* Investment trusts do not normally offer intermediaries any commission, so few commission-based financial advisers recommend them.

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