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Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

We explain why closed-ended funds can be very attractive investments

Investment trusts are the oldest form of managed fund with some dating back more than a hundred years. They are structured as publicly listed companies with their shares quoted on the London Stock Exchange.

There are about 400 investment trusts available in the UK and they have a combined market value of around £160bn. The largest are worth more than £3bn each and include the likes of Scottish Mortgage (SMT) and Foreign & Colonial (FRCL).

When an investment trust floats on the market it issues a set number of shares, which raises a permanent pool of capital to invest, hence the reason they are known as closed-ended funds.

Once it has listed, investors can buy or sell the shares whenever they want on the stock exchange in the same way that they would for any normal trading company.

Governance and pricing

Shareholder interests are safeguarded by an independent board of directors that is charged with making decisions on their behalf and whom they can periodically vote to re-elect.

There is also a separate depositary that is responsible for the safeguarding of the company’s assets, in addition to the protection afforded by the custodian.

The board has several important duties including hiring and overseeing the investment manager, with the shareholders able to vote on key issues such as whether to approve the remuneration report, which covers investment management costs as well as the directors’ fees.

What moves the share price?

The price of an investment trust fluctuates with the performance of the underlying portfolio and orders to buy and sell its shares.

This means the shares can trade at either a premium or discount to their underlying net asset value (NAV).

Investors who get the timing right can use a discount to their advantage.

If they buy when it is relatively wide and the underlying portfolio does well, the share price should catch up with the newly appreciated net asset value.

The problem is that if they get it wrong the discount could widen against them, although many boards try to reduce the risk by implementing a discount control policy.

This involves the use of share buy backs to reduce the discount when it gets to unacceptable levels.

Some of the best performing funds consistently trade at a small premium, but investors shouldn’t be put off as the long-term returns are mainly driven by the skill of the manager and the underlying assets rather than changes in the discount or premium.

Closeup thinking woman with question signs and light idea bulb above head looking up on gray wall background

Structural advantages

The closed-ended nature of an investment trust can give it a significant advantage over an open-ended fund because the purchase or sale of the company’s shares does not result in any cash flows into or out of the underlying portfolio.

This allows the managers to take a longer view and may enable them to invest in less liquid holdings that have the potential to generate higher returns.

These kinds of liquidity considerations are particularly relevant for sectors such as direct property, infrastructure and private equity.

During the short lived post-Brexit market sell-off, many open-ended funds that invest in commercial property were unable to sell the buildings fast enough to meet client demand and had to suspend redemptions leaving investors locked in while their funds fell in value. There were no such problems with the equivalent investment trusts.

Another potential attraction is that investment trusts can borrow money to invest. This is known as gearing and in a rising market it can help to boost the returns, although it can work against shareholders when markets fall by adding to the short-term volatility.

The level of gearing varies from trust to trust, but the overall average has been quite consistent in the last couple of years and is currently 7%.

When it comes to paying dividends, investment trusts have a major structural advantage over their open-ended counterparts, as they can retain up to 15% of their annual income.

This is added to their revenue reserves, which they can use to smooth dividend payments from one year to the next to potentially generate a steadily increasing stream of income for their investors.

Open-ended funds that are domiciled in the UK have to pay out all of the income that accrues in their annual reporting period over the course of the year.

They do not have the flexibility to set any of it aside, with the result that investors could receive more variable levels of annual income.

Many investment trusts have been able to consistently raise their dividends each year for decades. According to research by the Association of Investment Companies (AIC), there are 20 trusts that have been able to do this for 20 years or more.

Three trusts have increased their dividends every year for the last five decades: City of London (CTY), Bankers Investment Trust (BNKR) and Alliance Trust (ATST).

 

What are the charges and how do they perform?

Investment trusts are required to disclose an ongoing charges figure, which is the cost of running the business as a percentage of the net assets under management.

INV TRUSTS

The average for all conventional investment trusts excluding venture capital trusts (VCTs) is 1.36%. In some cases there may also be a performance fee and when this is added in the average cost rises to 1.52%.

It is important to bear in mind that some investment trusts are more expensive than others, with the most costly examples being the relatively small funds that invest in less liquid assets.

The larger investment trusts tend to be cheaper with the average ongoing charges for the global sector being 0.82%, or 0.86% once the performance fees are included.

Whenever you buy or sell an investment trust you will pay commission to your broker in the same way that you would for normal company shares. Most brokers also levy a separate annual charge based on the total value of your holdings.

Data to the end of December 2016 shows that in most sectors, the average investment trust has outperformed the average open-ended fund over the last five and 10 years based on shareholder total returns. In many cases the excess cumulative returns over the decade were more than 40%.

It is a very different picture over the last 12 months with open-ended funds outperforming in 10 of the 16 sectors, with the biggest differences in areas such as Europe and Japan.

The returns over such a short period of time can be heavily affected by the widening or narrowing of the discounts and the impact of the gearing, although it is difficult to be more precise.

Growth and income appeal

Investment trusts have less of a cost advantage over their open-ended counterparts than they used to, but they still have much to offer.

Being closed-ended allows them to invest in less liquid assets that could generate higher long-term returns, while the ability to retain up to 15% of their income gives them a better chance of generating a gradually increasing stream of annual dividends.

This should ensure they continue to appeal to both growth and income investors.

How an investment trust manager picks stocks

Murray International Trust (MYI)

Bruce Stoat, manager of Aberdeen’s Murray International Trust, has a simple philosophy for selecting the companies in its portfolio: ‘If you can understand the business, you can value it’.

He adds that he’s trying to establish a relationship of trust, so that of the 4,000 companies visited each year his team particularly like ones that achieve what they said they would do.

Stout condenses his universe of 950 global equities into a 50 stock portfolio. Of the firms held in the trust, 75% have been present for over 10 years.

With an annual fee of 0.75%, not overly high for an actively managed product, Murray also rewards investors with a dividend yield of 3.95%.

Top holdings include Mexican airport operator Grupo Aeroportuario and Phillip Morris International. None can exceed 5% of the portfolio which is strictly followed. This rule can mean the trust has to reduce its holding in a company it likes, should it become too big in the portfolio.

Using research from stockbroker Numis which identified several investment trust opportunities for 2017 we highlight a handful of trusts to fit different investment themes. All the quotes come from Numis.

 

Global equity exposure

Monks Investment Trust (MNKS) ‘We believe that a portfolio of Baillie Gifford’s best-ideas is an attractive vehicle for investors seeking exposure to long-term growth stocks.’

MNKS - Comparison Line Chart (Actual Values)

UK small caps

Henderson Smaller Companies (HSL)
‘We regard Henderson Smaller Companies as an attractive core holding for investors seeking exposure to the asset class. Neil Hermon’s approach is focused on companies with good growth prospects, sound financial characteristics and strong management.’

HSL - Comparison Line Chart (Actual Values)

US small and mid-caps

JP Morgan US Smaller Companies (JMI)
‘The focus is on companies from $350m-$10bn market cap via a stock-picking approach, focused on quality businesses with durable franchises, strong management teams and stable earnings that are trading on attractive valuations.’

JMI - Comparison Line Chart (Actual Values)

Emerging markets

Templeton Emerging Markets (TEM)
‘Following a number of years of underperformance, Templeton Emerging Markets has significantly outperformed since Carlos Hardenberg took over as lead manager… it is still early days to assess performance under the new manager, but he has made a very promising start.’

TEM - Comparison Line Chart (Actual Values)

Healthcare

Worldwide Healthcare (WWH)
‘The portfolio is managed by Sam Isaly and Sven Borho of OrbiMed, a specialist healthcare fund manager based in the US with $15bn of assets under management. The fund has an excellent long-term track record with net asset value growth of 16.8% per annum over the past decade through a stock-picking approach.’

WWH - Comparison Line Chart (Actual Values)


DISCLOSURE: Daniel Coatsworth, who helped to edit this article, owns shares in Scottish Mortgage

 

 

 

 

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