How to choose an investment trust

Investment trusts have seldom been the first port of call for Britain’s retail investors, who prefer the familiarity of conventional open-ended funds and direct stakes in listed companies. As returns-hungry investors seek new opportunities, however, what was once “the City’s best-kept secret” is moving into the mainstream. 

In a comparison of conventional open-ended funds versus investment trusts to the end of September 2021, trusts outperformed funds in more than 70 per cent of the last five and 10-year periods, according to Morningstar. Total returns from 14 out of 20 investment sectors were higher from closed-ended funds than from open-ended ones over both those medium to long-term periods.

What makes investment trusts different from other funds — and how can investors go about choosing one?

Investment trusts are closed-ended — that is, they usually raise money just once by issuing shares at launch. By contrast, open-ended funds such as unit trusts grow or contract depending on inflows and outflows of investor money.

Investment trusts are not nearly as well-known or as heavily marketed as their open-ended fund cousins and there are far fewer of them — about 400, compared with several thousand unit trusts on the market.

Moira O’Neill, head of personal finance at investment broker Interactive Investor, says investors looking to move into these vehicles should focus first on their investment goals.

“If you want to make regular monthly investments as you build up a retirement fund, choose one of the big, steady, internationally diversified trusts in the global sector as a core holding,” she says.

If you want to draw a regular income, however, she says you need to look for a big global or UK trust which has a good yield. Many of these have the ability to smooth out dividend payouts to investors over the years.

“In fact, some have brilliant track records of paying out increasing levels of income to investors every year,” she says. “These ‘dividend heroes’ include City of London Investment Trust and F&C Investment Trust.”

Once you have decided which type of trust you want, you can turn to the question of a fund’s performance record.

Annabel Brodie-Smith, director at the Association of Investment Companies, the trade body for investment trusts, says the average investment company is up 267 per cent over the past 10 years.

“It’s useful to look at different time periods such as one, five and 10 years, but also individual years so you can understand how a manager has performed in different market conditions,” she says. “You should also check when the current manager started managing the investment company so you can see what performance relates to their tenure.”

Since an investment trust is a company, market sentiment can dictate its share price. This may move above or below the value of the assets, known as the net asset value (NAV). When the share price is higher than the value of those assets it trades at a premium; if below it is trading at a discount.

Discounts often attract investors looking for a bargain. But Laura Suter, head of personal finance at AJ Bell, warns that investors should not buy an investment trust solely for the discount. “Instead, they should buy trusts that they think will be a good investment. If it’s on a discount that can be an extra reason to buy now, or to top-up an existing holding.”

If the trust invests in a niche area, charges may be higher than one that invests in broad UK equity markets, for example

By looking at historical data, investors should be able to see if a trust perennially trades at a discount or if this is a recent blip. Those that trade at long-term discounts might do so because their strategy has been out of favour for some time or the market is unconvinced about the investment rationale. That can mean investors are forced to wait longer before they rebound.

While price is key, there are other factors to consider when picking a trust. “Charges is a clear one,” says Suter. “You don’t want to pay too much for people to run your investments. If the trust invests in a niche area, charges may be higher than one that invests in broad UK equity markets, for example, which means two trusts’ charges aren’t necessarily comparable. If this is the case you can compare the trust to its peer group and see how it stacks up.”

Another factor is gearing. One of the big advantages of investment trusts is that they are allowed to gear or borrow to invest. This adds risk but it can boost performance in the long run.

It is worth looking at how much gearing an investment company currently has, as well as its gearing range. The range shows how much or little gearing an investment company would expect to have in normal market conditions, so is a useful indicator of how the company’s gearing could change in the future.

Darius McDermott, managing director of research group FundCalibre, says gearing is often used when a manager sees a rise in a certain stock or sector. “If that stock or sector rises in value it can boost returns for the trust, but should they fall it can easily make the losses greater — it means the trust carries extra risk. The additional cost of gearing should be considered when investing.”

Income seekers will also want to look at a trust’s dividend record. Investment trusts are well suited to giving investors a steady income, as they can withhold up to 15 per cent of the income they receive each year to be used to boost dividends in future years when payouts may be lower.

“This means that the fund manager can smooth out income between years, using the income withheld from previous years to supplement leaner years when dividends are harder to come by. This is ideal for investors who are relying on that money to fund their lifestyle,” says Suter.

She makes the point that while dividends are not guaranteed, a long track record of rising dividends shows it is a priority for the fund manager and the board.

Another magic ingredient is the independent oversight looking after investors’ best interests. An investment trust typically has an independent board of directors whose role includes ensuring it is managed well.

“Many investors like the directors to have stakes in the trust, often called skin in the game,” says O’Neill. “This means their interests are closely aligned with yours. Just look at the report and accounts to find out.”