Investment trusts have traditionally been less popular than mutual funds, but this is changing. Recent figures from the Association of Investment Companies (AIC) show that investments in these trusts reached record levels in the last twelve months.
Both types of fund have their advantages and disadvantages, and it is important that you understand how each type of fund works, so that you can work out which structure is right for you.
Investment trusts and mutual funds have lots of similarities. Both are run by a professional manager who picks and chooses a portfolio of assets on the behalf of clients. In fact, many fund managers run two similar products – one an investment trust and the other a mutual fund, which are likely to have very similar portfolios and aims.
The difference between the two is in how they are structured, and in the rules that govern them. These differences can make a dramatic difference to performance.
An investment trust is a listed company, and shares in this company can be bought and sold on a stock market.
The price of these shares, like any others, is determined by demand and supply in the market. Because a fixed number of shares is issued, these funds are known as ‘close-end’ or ‘closed-ended’ funds. As companies they also have boards and shareholder meetings, something which mutual funds do not.
In contrast, mutual funds are open-ended funds, which work by splitting the assets they invest in into units (this is why they are sometimes referred to as ‘unit trusts’). When more people want to buy than sell, more units are issued.
The units in a mutual fund always reflect the value of the underlying investments of the fund (minus any charges). This is not the case for an investment trust. That’s because the share price will reflect market sentiment, rather than simply the value of the assets. So, if the stock market is performing poorly, it is likely that an investment trust will trade at below the value of its assets, while if it is rising high the shares may even cost more than the value of the underlying investments.
If you look at an investment trust you will find there are two valuations. One is the share price, which is the price you will pay to buy the investment or what you will receive if you sell it (disregarding spreads and trading costs). The other is the Net Asset Value (NAV), which is the value of the underlying investments. If the trust is trading at higher than its NAV it is said to be trading at a premium, and if lower it is trading at a discount.
Unlike mutual funds, investment trusts can take on gearing, or borrowing additional money for investments, which unit trusts are not allowed to do. That means they can take bigger risks, meaning potentially bigger rewards or potentially bigger losses.
Investment trusts are also allowed to keep back 15 per cent of their profits for what is known as ‘smoothing’ purposes. Mutual fund managers must distribute their profits annually, but trusts can use the income they keep back to help them pay dividends in years that have been less fruitful. That is why some investment trusts have increased their dividends year on year without a break for 50 consecutive years, namely City of London Investment Trust, Bankers Investment Trust and Alliance Trust.
Because of the different structure of these two different types of investments, selling an investment trust comes with different issues to selling a mutual fund. With a mutual fund, you sell units back to the fund manager. The funds are valued daily, but deals are forward priced so you do not know what price you are going to get. In extreme cases, as in the financial crisis, when lots of people wanted to sell up, mutual funds can impose exit penalties or refuse to buy back units.
Investment Trusts are listed on the stock exchange, so the price moves up and down with supply and demand. The price you receive for the shares may be less than you expect if lots of people want to sell at once, with market sentiment creating another level of volatility.
Both have advantages and disadvantages relating to volatility, simplicity and the cost of trading (which is often higher for shares than funds on platforms). Whichever is suitable for you, it is important to keep a regular eye on performance and ensure that your portfolio is diversified and aligned to your own investment goals.