Special Report on Investment Trust: Roll up for the amazing shrinking discount: Investors pooling money with others have been rewarded with impressive results, writes Andrew Bibby

THE INVESTMENT trust industry is feeling quite chirpy. Gone are the days when the sector tagged along behind its apparently more dynamic cousin, the unit trust. Recent years have seen an encouraging influx of money (much of it from private individuals) into investment trusts, accompanied by a rush of new products. Even more encouraging, perhaps, small investors may at last have begun to get to grips with the basic concept.

Investment trusts, like unit trusts, are a form of collective investment. The same general principle applies: by pooling your money with other people, you are better able to extend the spread of your investment and therefore reduce the overall risk. You are also able to employ professional fund managers who - in theory, if not always in practice - should make more informed investment decisions.

Investment trusts are companies whose sole objective and activity consists of holding other investments. The idea dates back to 1868 (long before unit trusts were devised), when Foreign and Colonial - still a dominant player in the industry - was first launched. To become an investor in an investment trust you buy its shares.

There are currently about 260 investment trusts, which together have a stock market value of pounds 40bn. Investment trust share prices reflect very broadly the underlying value of the investments held by the company, but - unlike unit trusts, where the unit value moves up and down in line with the exact value of the assets - there is no direct correlation. Historically, investment trust shares have traded at a discount. For many years discounts were indeed substantial - 30 per cent and above, for example.

The last few years have seen discounts fall, so that the average discount is now around 5 per cent. In some cases, investment trust shares are trading at a premium: investors are paying more for shares than the value of the underlying assets would suggest.

The amazing shrinking discount has helped to give investment trusts impressive performance results in recent years, greater than would have applied solely from their investment performance. Conversely, if discounts were to widen again in the future investors would lose out when they came to sell their shares.

'There's always a risk that the discount may widen again, perhaps if people were to go off equities - if there was to be a mini-crash or a bear market,' says Hamish Buchan, investment trust analyst and director of NatWest Securities. 'But I don't believe the discount would go out beyond the high teens again.'

Fund managers of investment trusts have one advantage over their unit trust colleagues in that they are responsible for closed-end funds - in other words, there are a fixed number of shares issued and a fixed amount of money being invested. This means that they can plan their investment strategy without having to make allowance for the possibility of investor withdrawal. In theory, therefore, they should have greater flexibility to ride out big upheavals in the markets.

Another difference with unit trusts is that investment trusts, like ordinary companies, can borrow extra money and use it to increase their investments. This principle is known as gearing. Obviously, if a trust gears up and successfully invests in assets where the returns are greater than the borrowing costs it will increase its overall performance. However, borrowing brings an extra level of risk. Many in vestment trusts have powers to borrow, but in practice choose to adopt a conservative policy towards gearing. As the trade body the Association of Investment Trust Companies (AITC) puts it, 'gearing needs careful judgement and good management'.

Newcomers to this type of investment can also be confused by the share structures of investment trust companies. By creating different classes of share, investment trusts can try to widen their appeal to different types of investor. A simple split-capital trust, for example, is set up with two types of share - capital shares which benefit from capital growth and income shares which receive all the dividend interest from the investments.

John Korwin-Szymanowski, investment trust analyst with SG Warburg Securities, accepts that complex share structures can confuse private investors. 'People being given very high yields should realise that they could be getting that at the expense of their capital. Ask your financial adviser, and read the prospectus,' he recommends.

Investment trusts have been imaginative in developing ways of marketing themselves to private investors in recent years. Although shares can be bought through conventional routes such as stockbrokers and banks, the cheapest way is usually direct from the fund management companies. Most management companies have their own Savings Schemes and PEPs; these can normally be used for lump-sum investment as well as regular savings. The AITC produces a free Guide to Investment Trust Companies giving details of these schemes.

Historically, investment trust charges tended to be fairly low. However, fund management charges have recently been increasing sharply. A NatWest Securities survey found examples of trusts which have doubled, trebled or quadrupled their expenses since the mid-1980s. 'Massive rises in expenses cannot be other than disquieting', it pointed out, though it concluded that the narrowing of the discount has more than compensated shareholders.