Secrets Of Success: Don't discount investment trusts yet

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The Independent Online

What is the point of investment trusts and can they really look forward to a bright future?

You could argue that this question has been up for grabs for nearly 75 years, ever since the now venerable M&G introduced the first unit trust in 1931.

This was a new form of investment vehicle (a so-called open-ended fund) that has proved to be a far more commercially successful proposition.

As John Spiers, chief executive of Bestinvest, points out in the second issue of Investment Trust Scrutineer, the specialist newsletter whose launch I mentioned two months ago (available from www.newlandsfr.co.uk, or www.global-investor.com), the figures speak for themselves.

The first investment trust was launched in 1868, giving it a start of more than 60 years over its later rival. Yet at the end of June this year the assets held in investment trusts amounted to £63bn, while those of unit trusts stand at £289bn.

Unit trusts and open-ended investment companies (Oeics), in other words, have grown to more than four times as large in roughly half the time. The reasons for this have been analysed to death over the years, and are not that hard to find - although it is certainly open to argument which of the various factors has been the most important one.

Investment trusts are on average cheaper to buy and own than unit trusts and Oeics, but they are widely seen as more difficult to understand, and - because of the discount phenomenon - more risky to own.

Time was when a number of professional investment institutions, such as life companies, used to buy investment trusts to give them exposure to a particular manager or asset class, but they can now gain that exposure in other ways.

While many institutions remain locked into their investment trust holdings for tax reasons, they are gradually disinvesting from the sector and are unlikely, in aggregate, to commit new funds to them.

So if investment trusts have a future, it has to be primarily as a vehicle for the private investor.

The trouble is that in today's investment market, in which the majority of fund sales are channelled through intermediaries, rather than bought directly, many advisers find it difficult in practice to come up with a coherent reason to put their clients into investment trusts.

This is partly because of the perceived complexity, but more importantly because of the fact that most trusts do not pay commission. Spiers is surely right when he says that the problem of commission is the main factor holding back investment trust sales.

His argument is that "until or unless the Financial Services Authority forces the unbundling of commissions on all investment products, investment trusts will continue to be at a serious disadvantage".

Although some investment trusts have come up with schemes to offer commission to those who recommend them, they are not very effective. Most unit trust companies spend higher proportions of their assets on marketing than investment trusts, which have traditionally been seen as somewhat backward in commercial savvy.

By buying through intermediaries, or from the fast growing fund supermarkets, investors in unit trusts and Oeics can benefit from discounts on upfront sales charges, which appears a great benefit (although they pay later in the form of commission taken out of the higher annual management charges). You cannot buy investment trusts through fund supermarkets for the same commission reason.

All this said, my view is that there are still respectable arguments for keeping investment trusts on your watch list. Many of the smartest professional investors I know continue to have large holdings in investment trusts, primarily for two reasons.

One is the lower annual charges. The other is the opportunity they provide to back particular funds, or particular investment managers, in a cost-effective way.

As the independent financial adviser Victor Mello points out, if you want to own a private equity fund, it is easier to do so via an investment trust, as there are few - if any - unit trust equivalents.

Another example of a unique vehicle is the TR Property trust run by Chris Turner. If you understand the way that investment trust discounts work, I would say there are times when you can turn an apparent disadvantage - the greater volatility generated by the discount - into an actual advantage.

Shares in trusts sometimes trade at a discount to the value of the underlying assets because the price depends on supply and demand of the stock, not the assets themselves.

Historically, by buying and selling trusts at favourable moments in the discount cycle, you can add one or two percentage points to your overall holding period return - more than making up for the general cost penalty of owning an actively-managed fund.

It is ironic therefore that part of the great debate in the investment trust world now is whether or not discounts are - or should - become a thing of the past.

Robin Angus, a director of Personal Assets, an investment trust that has not traded at a significant discount since 1995, saysdiscounts have become a purely voluntary matter for most investment trust boards.

His argument is that the ability to buy back shares when the price of a trust moves to a large discount, coupled with the ability to hold shares in treasury and release them to meet new demand (possible since a change in the law six years ago), makes it possible for trusts - if they so choose - to manage their discount effectively in a way that was not possible before. Good news for those who don't understand how investment trusts work - but not so good for those who do.

In the same issue of Investment Trust Scrutineer, Patrick Edwardson, a partner of Baillie Gifford, who recently took over the management of the Saints investment trust, argues that investment trusts need to concentrate more closely on which type of end user they are trying to reach. They must also smarten up their efforts to communicate and promote what they are doing.

That seems sensible, but one has to wonder whether that alone can produce a general revitalisation of the investment trust sector.

My view remains that there are about 20 to 25 investment trusts that, for a variety of different reasons, are potentially attractive additions to anyone's investment portfolio.

Most are types of fund that you cannot easily buy elsewhere. But you need to be very selective in how and what you buy, and where the discount is a factor, you must watch its progress extremely carefully.

jd@intelligent-investor.co.uk

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