Investment Trusts: Diversification, Flexibility, Long-Term Investing

Investment trusts are a form of investment fund that pools investors' money to invest in a variety of different companies. They are mostly found in the United Kingdom and Japan and are constituted as public limited companies. Investment trusts are closed-ended, meaning fund managers cannot redeem or create shares. The main benefit of investment trusts is that they provide investors with access to a wide range of investments, which may be too complicated or costly to manage as a directly held portfolio. They are also able to retain a portion of their revenue to maintain consistent dividend payouts during challenging market periods. Additionally, investment trusts can borrow money to invest in more assets, a strategy known as gearing, which has the potential to increase returns but may also magnify losses.

Investment trusts are a form of investment fund that pools investors' money to invest in a variety of companies

Investment trusts are listed companies that trade on the London Stock Exchange using funds from collective investment. They are constituted as public limited companies and are therefore closed-ended as the fund managers cannot redeem or create shares. The first investment trust was the Foreign & Colonial Investment Trust, started in 1868 "to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk by spreading the investment over a number of stocks".

Investment trusts can invest in a wide range of assets and shares, including listed equities, government/corporate bonds, real estate, private companies, and currencies. They can also hold back some dividends generated by the portfolio, which open-ended funds cannot do. This allows investment trusts to smooth payments by keeping back some income during the better years, which can then be paid out when the underlying portfolio disappoints during poorer periods.

The cost of investing in an investment trust will vary, but they usually have fees such as a management fee, performance fee, annual charge, and flat rate. There may also be tax implications, as you may pay tax on dividends and profits earned.

They are run as public limited companies and are closed-ended funds with a fixed number of shares

Investment trusts are run as public limited companies and are closed-ended funds with a fixed number of shares. This means that they are listed on the stock exchange, and their shares are traded on the market. When an investment trust is launched, it issues a fixed number of shares, and these are then traded on stock exchanges. This is different from open-ended funds, which continue to issue new units in response to demand.

Being closed-ended has several implications for investment trusts. Firstly, it means that fund managers are not required to buy and sell shares to meet demand. They can buy and sell when they believe it is the right time to do so, giving them more control. Secondly, because the number of shares is fixed, investment trusts are able to borrow money and take on more risk in pursuit of higher returns. This is known as gearing or leverage. This can enhance returns in a rising market but will detract from returns when the market falls.

Investment trusts are run by an independent board of directors, elected by shareholders, who monitor the performance of the company and look after shareholder interests. The board appoints a professional fund manager, who is responsible for the day-to-day running of the trust, including deciding where to invest the fund and when to buy and sell assets.

Because investment trusts are closed-ended, if you want to buy shares in a trust after its launch, you can only do so if an existing investor wants to sell their shares.

Investment trusts can borrow money to invest in more assets, which is known as gearing

Investment trusts are a form of investment fund that are constituted as public limited companies and are therefore closed-ended funds. They are mostly found in the United Kingdom and Japan. Investment trusts can borrow money to invest in more assets, which is known as gearing.

Gearing is when investment trusts take on debt to put more money to work in the financial markets. In other words, investment trusts borrow to invest. If the stock market goes up, gearing should magnify income and/or capital returns over time. However, gearing can also exaggerate losses and increase volatility because it exposes investors to greater market movements.

The maximum level of gearing is set by an investment trust's board, while the actual level is determined by the investment manager, often in consultation with the board. Trusts may maintain a level of structural gearing, but they can also adjust gearing depending on market conditions. Some use it to boost capital returns, while others use it to boost income.

In the case of shorter-term borrowing, a fund manager will assess market conditions and decide when it makes sense to borrow and when it doesn't. If a manager identifies many good opportunities in the market and believes they can generate a return above the cost of debt, they can increase the gearing. Conversely, they can lower it if the cost of borrowing is high or the market outlook is uncertain.

The cost of borrowing is an important consideration. In the past, when investment trusts could borrow at 1-2% and stock markets were rising, borrowing to invest made sense. In such cases, investment trust managers could typically generate a high enough return to cover interest costs. However, with rising interest rates, this decision has become more complex. For example, if an investment trust manager needs to generate a 5-6% return to meet borrowing costs, it may not be worth it.

Most trusts hold a mix of fixed and variable debt. For short-term borrowing, fund managers often use flexible borrowing facilities like overdrafts, which can be adjusted based on market conditions. For long-term borrowing, investment trusts may opt for fixed-rate loans called debentures. Trusts are cautious about long-term borrowing costs, as some have been caught out by locking in high borrowing rates, only to be unable to generate sufficiently high investment returns.

When analysing an investment trust's use of gearing, investors need to consider the type of debt the trust has taken on, as this affects the overall risk of the portfolio. If asset prices fall, debt can increase as a percentage of the trust's size, increasing risk. Therefore, investors should understand the level of gearing, the limits set on gearing, and the type of gearing employed.

They can be less risky than buying shares in a single company as they spread the risk across several companies

Investment trusts pool investors' money to buy shares in a variety of companies, which can make them less risky than investing in a single company. This is because they spread the risk across several companies, so if one underperforms, the performance of the others can help to counteract any losses.

The first investment trust was the Foreign & Colonial Investment Trust, started in 1868 "to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk by spreading the investment over a number of stocks".

Investment trusts are closed-ended, meaning there is a fixed number of shares available to buy. As a result, fund managers can buy and sell when they believe the time is right, rather than having to meet demand from investors joining or leaving. This gives fund managers more control and means they can take a long-term view.

However, it's important to remember that investment trusts are not risk-free. The value of your shares can still fluctuate depending on the stock market, and you may get back less than you paid in.

Investment trusts can be held in a tax-efficient wrapper such as an ISA or SIPP, making investment returns tax-free

Investment trusts can be held in a tax-efficient wrapper such as an Individual Savings Account (ISA) or a Self-Invested Personal Pension (SIPP). This means that investment returns are tax-free.

ISAs and SIPPs have annual allowances. For the 2024-25 tax year, you can pay up to £20,000 into an ISA and up to £60,000 into a SIPP. It's important to note that you usually pay income tax when you take money out of your pension beyond the 25% tax-free allowance.

If you don't place your investment trust within an ISA or SIPP, you must pay tax on dividends and profits. Dividends are a portion of a company's profits paid to shareholders. Each individual in the UK has an annual dividend allowance. For the 2024-25 tax year, this is £500, but you have to pay tax on any dividends you receive above this limit. The amount of tax depends on your income tax band.

You will also need to pay Capital Gains Tax (CGT) when you sell your shares for a profit. In the 2024-25 tax year, you can earn up to £3,000 in profit before having to pay CGT. The amount you pay is either 10% or 20%, depending on your tax bracket.

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