The tricky world of the trade in trusts

This where fortune favours the cautious, says Tony Lyons. But you can have fun on the rollercoaster, if you can afford to fall

One person's investment strategy can be pure speculation to another. It all depends on our attitude is to risk. Never forget, there maybe big gains to be made from equities, even in poor markets, the higher the risk, the greater the gain - and possible loss.

One person's investment strategy can be pure speculation to another. It all depends on our attitude is to risk. Never forget, there maybe big gains to be made from equities, even in poor markets, the higher the risk, the greater the gain - and possible loss.

In the short- to medium-term, investment trusts "are normally higher risk or more speculative than unit trusts or OEICs" says Justin Modray of Chase de Vere. "Their prices tend to be more volatile. Most of our clients are conservative, wanting lower risks with other types of investments."

Normally, speculation means maximising short- term gains. Roddy Kohn of Kohn Cougar, says: "Most independent financial advisers don't like speculation. But it does suit those who are happy to take high risks."

So if you want a more than usual exciting strategy, consider the investment trust sector. And run-of-the-mill trusts can be more rewarding than other pooled investments.

Most investment trusts use gearing. This means they borrow money to buy shares in the hope of making even greater returns. "Then there is the discount" adds Justin Modray. "Most trusts are traded in the market at a price lower than net asset value. If a particular fund comes into favour, with demand for its shares increasing, this discount can narrow, or even go to a premium, giving the investor a better return.

"Mind, if it falls out of favour, as has happened to many trusts, the discounts can widen even more."

The sector contains funds that can give you everything from a smooth, almost risk-free investment with zero dividend preference shares to a white-knuckle ride if you invest in split capital shares or warrants.

At the very high risk end of the market are warrants. Attracting no dividends, they are issued by trusts to raise additional capital. These give the holder the right convert into shares at a fixed price, the exercise price, at a specific date or period.

Warrants are traded the same way as ordinary shares, but rarely, and usually on a matched bargain basis. That means they often do not have a market marker, just a dealer who matches sellers with buyers.

They often have large spreads between buying and selling price, but cost a fraction of the share price and are much more highly geared. Because of this, the gains can be enormous. If an investment trust goes out of favour, its price will drop and the price of its warrants can plummet. If it suddenly returns to favour, the warrant price can rocket. Kim North of Pretty Financial says: "Warrants effectively give you gearing on top of gearing and are incredibly speculative."

Almost as high risk are split capital shares. These are issued by split investment trusts that have a fixed winding-up date and which usually have two or more classes of shareholders. The income holders receive all the dividends paid by the underlying portfolio. Zero dividend preference holders, if there are any, receive a fixed amount of the capital growth earned by the fund at maturity. Holders of the split capital shares take what's left. If the fund has done well, this can be a worthwhile sum. But the risk is that if the fund has done poorly, the returns will suffer, and the holders may not even get back their original capital.

Another area of speculation is following predators and take-over wheelers and dealers. Several funds have been under siege as institutional investors became more and more discontented with ever widening discounts. Various predators stalk the sector trying to get investment trusts to convert to unit trusts, which would give an instant profit because investors would receive net asset value, or try to set up a change in management.

Mercury European Privatisation came under attack when it was on a discount of around 14 per cent and capitalised at around £1bn. It retaliated by promising a major share buy-back campaign and a change in investment strategy. Roddy Kohn says: "It has spent £200m on share buy-backs and the change to aggressively seeking capital growth throughout Europe has seen the discount narrow to 8 per cent."

And investment in funds specialising in emerging markets, or single countries in the less economically developed world, venture capital or high tech can give investors lots of thrills and spills.

Anyone who bought into emerging markets through an investment trust a year ago will still be showing a loss after last summer's shakeout. Yet such has been the change in fortunes, that anyone who bought in during the last six months should be showing a sizeable profit. That's life, in the big City.

What the IFAs recommend

Most IFAs are loath to recommend speculative investments. Seek advice on warrants and split capital shares. For investment trusts with a bit of excitement:

Kim North of Pretty Financial (0171 377 5754) picks Templeton Emerging Markets "with an impressive record", Jupiter Primadonna, a small company specialist, and Schroder Ventures which "up 50 per cent in three months".

Roddy Kohn of Kohn Cougar (0117 946 6384) goes for "Scottish Value, a fund that speculates in other investment trusts", Fleming China as "a long-term punt", and venture capital specialists F&C Private Equity, Candover and Schroder Ventures. He advises a look at Henderson Technology.

Justin Modray Chase de Vere (01225 469 371) looks at City of London, a fund with an excellent long-term record, Fidelity European Values and Jupiter Primadonna. For excitement, he suggests emerging market funds such as Henderson TR Pacific, Fidelity Asian Values and Templeton Emerging Markets.