The cheaper route into high-rise investments

The City's less well known funds lack the fame but they offer good value, says David Prosser
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The Independent Online

Forget the famous unit trust managers such as New Star, or top-performing Oeics (open-ended investment companies) such as Fidelity Special Situations. Pound for pound, low-profile investment trusts offer much better value - and the sector, traditionally perceived as a sleepy backwater of the City, finally seems to be getting its act together.

Investors who seven years ago staked £1,000 in the typical actively-managed UK unit trust, for example, would today have a holding worth £1,436. The same contribution to the typical investment trust, on the other hand, would now be valued at £1,956. Similarly, a £1,000 investment seven years ago in the average emerging markets unit trust is now worth £2,522, but the investment trust equivalent has delivered £3,822.

Individual investment trusts have beaten seemingly identical unit trusts. Anthony Bolton's hugely respected Special Situations fund has turned £1,000 into £3,094 over the past seven years. But Bolton also runs Fidelity Special Values, an investment trust with a similar mandate - its return is £3,937 over the same period. In fact, if you're buying stock market funds for a particular financial planning need, the best funds in the sector you're focusing on will almost certainly be investment trusts. But despite this outperformance, few investors know much about the funds.

One issue is that in legal terms, investment trusts are listed companies rather than financial products, which means managers can't advertise them. A second problem has been that like all companies, investment trusts are run by boards of directors - these have typically been dominated by employees of the investment company given the job of running the fund. As a result, many boards have been poor guardians of shareholder value.

However, Daniel Godfrey, chairman of the Association of Investment Trust Companies, insists this is no longer the case. "It has been an eventful 2005 for investment trusts and while the ongoing trend of activity in the sector has been prompted by external pressures in some cases, it has also been driven by boards who have increasingly demonstrated their independence."

Investment trust boards should have two priorities. First, they must ensure the fund's manager delivers decent performance to shareholders. And second, they must try to limit the discount at which shares in the trust trade relative to the value of its assets (see story below). If discounts widen, shareholders suffer no matter how well the trust performs, because they don't get the benefit of increases in the value of its assets.

When a trust's board is stuffed full of directors who also work for the fund management company running its assets, shareholders are missing an independent advocate who will ensure they get a good deal - ultimately, the manager is unlikely to get the sack, however poorly it performs.

However, over the past 10 years, many trusts have been targeted by arbitrageurs, specialist companies that have bought large holdings in many underperforming funds and then used their weight to force boards to take action. As a result, even those trusts that haven't been attacked are now better run. Investment trust directors are becoming much better at tackling failing management.

Last month, for example, the board of Foreign & Colonial Emerging Markets Investment Trust, a long-standing under-performer, agreed the trust could be taken over by its rival, JPMF Emerging Markets, which has a much better track record.

Other boards have taken different measures to improve shareholder value, with a slew of announcements in the past month alone. Last week, for instance, Foreign & Colonial announced its largest investment trust would operate a share buyback programme designed to keep its discount below 10 per cent.

In October, Invesco English & International said it would offer quarterly share buybacks, while Gartmore Global has introduced similar measurers. More radically, Martin Currie Japan's board announced in September that the trust would be wound up, with investors offered cash or a holding in a new fund.

As a result of these types of action, the average discount in the investment trust sector has fallen to 7.4 per cent, the lowest level for 10 years. Alan Ray, an investment trust analyst at Panmure, says deals like the F&C/JPMF merger are crucial if investors are to be persuaded to invest in the sector.

"The outsider's view that boards aren't as independent as they would have you believe has persisted for decades," says Ray. "Good corporate governance is an often intangible benefit of investment trusts, but one that investors often cite as important, so demonstrations that it is working are useful for the sector's image."

Put another way, if investors can be confident the trusts will be properly run, they are more likely to back the funds. Other things being equal, investment trusts are a better option than unit trusts for exposure to the same assets because of superior performance and lower charges.

In any case, investment trusts are often better at exploiting opportunities. The sector is widely considered a good way to speculate on emerging markets, for example, and several managers have also been quick off the mark with new asset classes. ING has just raised £505m for a real estate investment fund.

For more active investors, there is also the possibility of speculating on trusts that might be merged or reconstructed. If a board successfully reduces a trust's discount, investors make money without any need for a increases in the value of the underlying assets. In reconstructions, investors can often make a quick turn. For example, F&C Emerging Markets investors have been offered cash for their shares at a value that is the equivalent of a discount of 4 per cent to the underlying assets. The trust previously traded on a discount of 9.1 per cent, so this represents an overnight profit.

Spotting these opportunities before they develop isn't easy. But the investment trust sector also has the benefit of being much smaller - there are around 230 mainstream funds to choose from, compared to almost 2,000 unit trusts.

Finally, don't be misled by concerns about the split-capital investment trust scandal. Splits are very specialist funds but conventional investment trusts were unaffected by the crisis.

The basics

Investment trusts, like unit trusts and Oeics, pool the cash of many investors, and a professional fund manager runs the money according to an agreed brief - to invest in UK smaller companies, say, or emerging markets. Some investment trust managers are well-known unit trust managers too - Fidelity's Anthony Bolton, for example (pictured right).

While investment trusts have been around much longer than their unit trust rivals, the funds have become less popular, even though they are cheaper. Investors pay no initial fee and annual management charges below 1 per cent.

One reason for this good value is that investment trusts do not pay commissions to independent financial advisers. But this has been a problem for the sector - unit trusts do pay commissions and have become the funds of choice for intermediaries.

Some investors are also put off by the structure of the funds. Investment trusts are companies, with a fixed number of shares in issue. To get exposure to the assets in the trust, you buy its shares, but the value of your investment then depends on demand and supply of the shares.

Supply and demand should move in line with how the investment trust performs, but shares rarely exactly reflect the value of underlying assets. Most investment trust shares trade at a discount to the value of the funds' assets, which may widen or narrow. This extra complexity does not exist in a unit trust.

Some experts believe investment trusts are more risky than unit trusts because managers are allowed to borrow money to invest. This gearing boosts returns when the trust's investments perform well, but increases losses when markets fall.

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