Investment trusts versus funds: how do they differ and what are their pros and cons?
The UK’s investment trust industry can chart its history back more than 150 years, when Queen Victoria sat on the throne.
But it has been eclipsed by unit trusts, which are a relatively new kid on the block, having been introduced in the UK in 1931.
There’s currently around £270 billion held in UK investment trusts, compared to around £1.5 trillion in unit trusts, or speaking more accurately, open-ended funds.
Investment trusts and open-ended funds are championed by two different industry groups, which can sometimes lead to a polarised view of these two investment vehicles.
But the reality is that investors can happily have a portfolio that includes both, because there are pros and cons to either option, and different investment strategies might lend themselves better to one or the other structure.
KEY CHARACTERISTICS OF OPEN-ENDED FUNDS
One of the key differences between investment trusts and open-ended funds is that the former are closed-ended, and the latter are open-ended.
Open-ended means these funds create or cancel new shares depending on investor demand. They only issue one price per day, and to deal you would usually have to place your investment instruction the day before, so you don’t know precisely what price you’re going to get.
For long term buy and hold investors, this forward pricing structure shouldn’t make a great deal of difference, because one day’s performance will ultimately be neither here nor there.
The fund manager must ensure the price you get is based on the value of the underlying portfolio of securities held in the open-ended fund, give or take any transaction costs involved.
WHERE INVESTMENT TRUSTS DIFFER
Some investors may prefer investment trusts because there is a live price throughout the day, so you can trade at any point, and you will know exactly the price at which you’re buying or selling.
That’s because investment trusts are closed-ended, which means the fund manager is investing a fixed pool of money. Shares in the investment trust then trade on the market like ordinary stocks, and investors buy and sell them between each other.
The price can therefore deviate from the value of the underlying portfolio of securities (which along with cash and debt is called the net asset value), depending on demand for the investment trust itself.
DISCOUNTS AND PREMIUMS
Investment trusts often trade at a discount or a premium to the underlying portfolio, and sometimes there can be a significant divergence, especially in distressed markets.
Now you may think if you are buying an investment trust at a discount, you’re getting a bargain, and in a sense you are.
But to realise the value of that discount, you would need to be able to sell the trust nearer to the net asset value of the underlying portfolio at some point, and if a trust continually trades at a hefty discount, you may find that is easier said than done.
You need to look at the track record of an investment trust to see what its discount has been historically, to gauge whether you’re picking up a good deal.
The same goes for trusts trading at a premium, which shouldn’t necessarily put you off a purchase. For long term buy and hold investors, the movement in the discount or premium should be small in comparison to the returns generated by the underlying portfolio.
KEY RISKS OF INVESTMENT TRUSTS
The existence of discounts and premiums does make investment trusts more complex than open-ended funds. It also makes them more volatile, because as well as variation in the price of the underlying portfolio, there is movement in the discount or premium.
Investment trusts are riskier than open-ended funds for another reason too: they can borrow money to invest. This amplifies returns in the bull markets, but exacerbates losses in downturns, so investors need to be prepared for a bumpier ride with investment trusts.
BETTER FOR PROPERTY AND INCOME INVESTMENTS
Investment trusts are generally preferable when investing in illiquid assets, like commercial property. That’s because open-ended funds might have to suspend trading if lots of investors want their money back at once – it’s quite hard to sell an office block or a shopping centre at the drop of a hat.
Investment trusts might also be useful for income-seekers, because they can effectively keep some dividends back in good years to top up the dividend payments in bad years. This facility can produce a smoother income stream.
There are currently no passive investment trusts, so for investors who want a simple tracker fund, then open-ended funds are the way forward.
WHAT ABOUT CHARGES?
It’s probably fair to say that investment trusts tend to have lower annual charges than their open-ended cousins. For instance, in the global sector, the average annual charge for an active open-ended fund is around 0.9%, but for investment trusts, it’s around 0.6%, according to data from Morningstar.
However, this isn’t universally true, and investors should also be aware that approximately a third of investment trusts carry a performance fee, compared to around 5% of unit trusts.
Partly this is down to the fact that a greater proportion of investment trusts offer exposure to more specialist markets, such as unlisted companies.
Investors should compare the specific charges of the funds or trusts they are considering, because there are cheap and expensive examples in both camps.
The same goes for the quality of the fund manager because that will be one of the key drivers of your returns, whether you’re investing in investment trusts or open-ended funds.