Investment Trust Vs Fund: What's The Difference?

Investment trusts and funds are both 'collective investments', allowing investors to pool their money and benefit from exposure to a wide range of assets. However, they differ in their structure, with funds typically being open-ended, meaning investors buy and sell units directly from the fund manager, and investment trusts being closed-ended, with a fixed number of shares bought and sold between investors on a recognised stock exchange. This difference can have a dramatic impact on performance, with investment trusts offering fund managers more flexibility and the ability to borrow money or 'gear' to enhance returns.

Investment trusts are closed-end funds with a fixed number of shares

The closed-end structure of investment trusts has several implications. Firstly, it allows fund managers to focus on long-term investment strategies without the pressure of short-term redemption demands. Secondly, it means that investment trust shares can trade at a premium or discount to their net asset value (NAV), depending on investor demand. Finally, it reduces the need for liquidity, as fund managers don't need to keep large amounts of cash on hand for redemptions.

The fixed number of shares in investment trusts also has implications for investors. For example, in extreme market conditions, investors often want to move into cash. With open-ended funds, managers sell assets to achieve this, and returns for investors may be affected if they need to sell at a loss. However, with investment trusts, the manager can match sellers to buyers and avoid being forced to sell investments in a falling market.

Funds are open-ended, creating new units as demand increases

Investment trusts and funds are both collective or pooled investment vehicles, meaning they pool money from a large number of investors to create a larger amount to be invested. However, they differ in their company structures, with funds being open-ended and investment trusts being closed-ended.

Funds, also known as open-ended investment companies (OEICs) or unit trusts in the UK, are open-ended by definition. This means that when new investors want to invest, new units in the fund are created, and the fund grows. Conversely, when investors want to withdraw their money, the fund shrinks as these units are cancelled. There is no limit to the number of units that can be issued at any given time.

Investment trusts, on the other hand, are closed-ended funds. They issue a fixed number of non-redeemable shares for investment. Investors buy and sell these shares from each other on a recognised stock exchange, similar to how standard company shares are traded. In principle, for an investor to buy shares, another investor must be willing to sell. This is the main difference between the two types of investment vehicles.

The open-ended structure of funds means that they constantly experience inflows and outflows of investors' funds. This can create challenges when investors withdraw their money en masse during periods of market volatility. In contrast, investment trusts are not required to cater to these inflows and outflows, and therefore they do not need to dispose of any assets or hold a cash reserve to meet the needs of those selling shares.

The open-ended nature of funds also means that fund managers must sell assets to move into cash when investors want to withdraw their money, including in extreme market conditions. This can affect returns for investors if the fund manager needs to sell at a loss. Investment trusts, on the other hand, match sellers to buyers, so their managers can avoid being forced to sell investments in a falling market.

Investment trusts can borrow money to enhance returns

Investment trusts and funds are both collective or pooled investment vehicles, allowing investors to pool their money to create a larger amount to be invested. However, they differ in their structures, with funds being open-ended and investment trusts being closed-ended. This distinction has several implications, including the fact that investment trusts can borrow money to enhance returns, while funds typically cannot.

Investment trusts, as closed-end funds, issue a fixed number of shares at inception, which are then traded on a recognised stock exchange. This structure allows investment trusts to borrow money, or "gear", to enhance returns in a rising market. This provides the fund manager with additional flexibility to take advantage of opportunities that may otherwise be out of reach. However, it is important to note that borrowing money can amplify losses if the investments perform poorly.

In contrast, open-ended funds, such as mutual funds or unit trusts, are not permitted to borrow money. They create new units as more people invest and cancel units when investors want their money back. This structure does not allow them to take on additional debt to enhance returns.

The ability to borrow money gives investment trusts the opportunity to pursue higher returns and take on bigger risks. However, it is essential for investors to understand the potential benefits and drawbacks of this strategy before investing.

Funds cannot borrow money to invest

Funds, also known as open-ended investment companies or OEICs, are not permitted to borrow money to invest. This is in contrast to investment trusts, which can borrow money to invest through a process known as "gearing". This restriction on funds means that they cannot take on additional risk by borrowing money, which may lead to larger gains or losses.

Investment trusts are able to borrow money to invest because they are structured as public limited companies. This means they are governed by company law, which allows them to borrow money. Funds, on the other hand, are structured as open-ended investment companies or unit trusts, which are not permitted to borrow money under their governing rules.

The ability to borrow money can be advantageous for investment trusts as it allows them to take advantage of a long-term view or react swiftly to invest in a particular asset. Additionally, it provides the opportunity to take on more risk, which could lead to larger gains or losses. However, borrowing money can also amplify losses if the investments perform poorly.

It is important to note that while funds cannot borrow money to invest, they may still be able to access other sources of capital, such as through issuing new shares or units to investors. This is a key difference between funds and investment trusts, as funds are open-ended, meaning they can create new shares or units to meet investor demand. Investment trusts, on the other hand, are closed-ended and have a fixed number of shares, so they must rely on borrowing money or selling existing shares to raise capital.

Investment trusts can retain up to 15% of income for future years

Investment trusts are allowed to retain a portion of their profits for "smoothing" purposes. They can keep back up to 15% of the income earned by the underlying assets in any given year to build a safety net for leaner years. This practice is known as dividend smoothing and helps investment trusts maintain consistent pay-outs and grow their income distribution to shareholders year after year. Trusts can use the income they keep back to help them pay dividends in years that have been less fruitful. This ability to retain a portion of their profits sets investment trusts apart from mutual funds or unit trusts, which are required to distribute all their income annually.

The ability to retain up to 15% of income provides investment trusts with greater flexibility and stability in their dividend payouts. It allows them to maintain a consistent dividend payout even during challenging market conditions or periods of lower income. By smoothing out their income, investment trusts can provide a more reliable stream of income for investors, especially in years when they receive less money. This feature is particularly attractive to income-seeking investors who value stable and growing dividend payments.

The practice of dividend smoothing can also contribute to the long-term growth of the investment trust. By retaining a portion of their profits, investment trusts can reinvest the funds into their portfolio or take advantage of new investment opportunities. This ability to compound their earnings over time can enhance the overall returns for investors. Additionally, the retained income can be used to cover any shortfalls or unexpected expenses, providing a buffer for the investment trust's financial stability.

However, it is important to note that not all investment trusts may choose to retain the maximum allowed amount of 15%. The decision to retain income depends on the trust's financial performance, investment strategy, and the needs of its shareholders. Some investment trusts may prioritise distributing higher dividends over retaining income, especially if they have committed to a track record of consecutive dividend increases.

Overall, the ability of investment trusts to retain up to 15% of their income for future years provides them with greater financial flexibility and stability. It allows them to smooth out their dividend payouts, maintain consistent distributions, and build a safety net for leaner years. This feature distinguishes investment trusts from other types of funds and can be a significant consideration for investors seeking stable and growing income from their investments.

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