IFA Guide to Investment Trust
Like unit trusts and open ended investment companies (OEICs), investment trusts are collectives of underlying securities. The important difference in structure is that they are 'closed ended', which essentially means that at launch they raise money to invest in the underlying securities, and shares are issued. As this usually only happens once, the capital of the company remains fixed.
Investment trust techniques
Unit trusts and OEICs are 'open ended', which means the trust can grow in size as more money is invested. The effect of being closed ended is that the price of the shares does not necessarily, in fact rarely, reflect the value of the underlying assets. Like any other stock market security the trading price is subject to the vagaries of supply and demand.
Investment trusts are an alternative vehicle for investing as opposed to an alternative asset. Historically this vehicle has been ignored by the retail market because, like exchange traded funds (ETFs), they are listed on the Stock Exchange so their structure has not facilitated the payment of commission.
We believe that the Retail Distribution Review (RDR), which is banning commission, will open the doors for this investment to the wider investment community. Indeed the RDR policy paper specifically mentions investment trusts as a packaged investment vehicle that advisers will have to consider if they are to retain their independence.
What are the key characteristics?
Discount and premium
If there is little demand for the trust, the price is likely to trade at a discount (a price that is less than the net asset value of the underlying investments). If a particular company is in demand, the trading price is likely to be at a premium to the underlying assets. In this respect, if timing is right there can be an artificial boost to performance if a company moves from a discount to a premium.
The board of directors
Although these are collective investments, they are also companies and as such have a board of directors. It is their job to monitor performance and uphold the interests of the shareholders.
The asset managers
Often, the manager of the underlying investments is an employee of the parent company that launches the vehicle. The board of directors of the investment company is within its rights to, and indeed has a duty to, replace the manager and appoint a third party if it believes it is in the interest of the shareholders and will result in improved performance. With unit trusts and OEICs, although the manager can be replaced, it will almost always be with an employee of the issuing fund house.
Gearing
As a company, they can borrow to invest. This is useful if an investment opportunity presents itself as it can be taken advantage of without having to sell an investment first. This kind of activity can give a boost to performance in rising markets. However, in falling markets, it can exacerbate falls, so this kind of detail needs to be checked by prospective investors. Each company should publish its policy on gearing so advisers should check this carefully. The more gearing used, the more risky the investment.
Different share classes
The single share class companies are usually classed as ordinary shares, and notwithstanding gearing and the discount/premium influence will broadly follow the price and value of the underlying assets. Some investment companies do issue different share classes designed to meet the needs of different classes of investor. These companies are called 'split capital'.
These different share classes (shown below) are structured with a priority of rights and entitlements. There are many variations of split capital trusts, but in essence they are structured to go for growth or income.
Zero dividend preference shares
Income shares
Capital shares.
Wind-update
It is likely that one or more classes will have a limited life with a fixed wind-up date. At a pre-determined date shareholders that have voting rights are asked to agree to the winding up of the company. This is the order that shareholders can receive their entitlements according to their investment choice, as long as sufficient assets are available.
Of course, even the splits are quoted securities so there is not a necessity for shareholders to hold until term. They can simply sell on the stock exchange at a price that will reflect the likelihood of the share class reaching its pre-determined target.
Hurdle rate
A hurdle rate defines the amount of annual growth of the underlying assets that needs to be achieved to repay the share class at the pre-determined level. This is usually quoted by the investment company.
Client need
Investment trusts are the oldest form of collective investments. Their price, and therefore their value, are a reflection of the demand for the assets and do not necessarily reflect precisely the value of the underlying assets.
As with any other investment vehicle, suitability for the client needs to be assessed.
Commission aside, the main issue is whether the client's attitude to risk allows the inclusion of a vehicle that can be priced at less, or more, than it is worth. As we approach RDR implementation, these vehicles will inevitably be compared alongside mainstream unit trusts and OEICs and in many instances become the preferred solution.
To find out more about investment trusts download a free copy of our Alternative Investments Guide.
