Investment trusts

What Is Investment Trusts?

Investment trusts are a type of pooled investment vehicle that allows multiple investors to combine their capital to invest in a diversified portfolio of assets. Constituted as public limited companies, investment trusts issue a fixed number of shares that are traded on a stock exchange, making them "closed-ended" funds. This structure means that, unlike other collective investment schemes, the fund itself does not redeem or create shares after its initial public offering. Investors buy and sell shares of the investment trust directly from other investors on the secondary market. The investment trust's assets are professionally managed, providing investors with immediate diversification and access to various asset classes that might otherwise be difficult for individual investors to acquire.

History and Origin

The concept of investment trusts originated in the United Kingdom during the 19th century, driven by a desire to provide smaller investors with access to the benefits of a broad range of securities. The first modern investment trust, the Foreign & Colonial Investment Trust, was launched in London in 1868. Its stated objective was "to give the investor of moderate means the same advantage as the large capitalists in diminishing the risk by spreading the investment over a number of stocks."⁵ This innovation allowed individuals to participate in a professionally managed portfolio, which was particularly appealing given the volatile nature of individual company investments at the time. Over time, while the legal structure evolved from a "trust" to a public limited company, the term "investment trust" persisted, especially in the UK. In the United States, a similar structure known as a "closed-end fund" emerged, which functions similarly to UK investment trusts.

Key Takeaways

• Investment trusts are closed-ended pooled investment vehicles that issue a fixed number of shares.
• Their shares trade on stock exchanges, and their market price can differ from their underlying net asset value (NAV).
• Investment trusts can use financial leverage to enhance returns, though this also increases risk.
• They provide investors with professional portfolio management and instant diversification.
• Shareholders typically receive distributions from the fund's income, such as dividends and capital gains.

Formula and Calculation

A key aspect of investment trusts is the relationship between their share price and their Net Asset Value (NAV). The NAV represents the total value of the investment trust's underlying assets minus its liabilities, divided by the number of shares outstanding. The market price, however, is determined by supply and demand on the stock exchange.

The premium or discount to NAV for an investment trust is calculated as follows:

$\text{Premium/Discount (\%)} = \left( \frac{\text{Market Price per Share} - \text{NAV per Share}}{\text{NAV per Share}} \right) \times 100$

A positive percentage indicates the investment trust is trading at a premium, meaning its shares are more expensive than the underlying assets per share. A negative percentage indicates a discount, where shares trade below the value of the underlying assets.

Interpreting the Investment Trust

Understanding the unique characteristics of investment trusts, particularly the concept of premiums and discounts, is crucial for investors. When an investment trust trades at a premium, investors are willing to pay more than the intrinsic value of its assets, often signaling strong market confidence in the fund manager's abilities or the fund's specific strategy. Conversely, trading at a discount suggests the market values the investment trust's shares at less than its underlying assets. This can occur due to various reasons, including investor sentiment, concerns about the fund's liquidity or future performance, or simply a lack of demand for the specific assets held within the trust.⁴ Investors considering an investment trust should assess not only the quality of the underlying portfolio but also the historical and current premium or discount, as this can significantly impact overall returns. The ability of investment trusts to use gearing (borrowing money to invest further) can also influence market perception and the fund's risk management profile.

Hypothetical Example

Consider an investment trust, "Global Growth Opportunities plc," with 10 million shares outstanding. The trust's total assets are valued at $500 million, and it has liabilities of $50 million.

First, calculate the Net Asset Value (NAV) per share:
Total Assets: $500,000,000
Total Liabilities: $50,000,000
Net Assets (NAV): $500,000,000 - $50,000,000 = $450,000,000
Number of Shares Outstanding: 10,000,000
NAV per Share: $450,000,000 / 10,000,000 = $45.00

Now, let's assume the market price of Global Growth Opportunities plc shares on the stock exchange is $42.50.

Calculate the discount:
$\text{Discount (\%)} = \left( \frac{\$42.50 - \$45.00}{\$45.00} \right) \times 100$
$\text{Discount (\%)} = \left( \frac{-\$2.50}{\$45.00} \right) \times 100$
$\text{Discount (\%)} \approx -5.56\%$

In this example, Global Growth Opportunities plc is trading at a discount of approximately 5.56% to its NAV. This means investors can buy shares in the trust for about $0.945 on the dollar compared to the value of its underlying assets.

Practical Applications

Investment trusts serve a variety of practical applications for investors seeking diversified exposure and professional management. They are commonly used to invest in less liquid or niche asset classes such as private equity, infrastructure, property, or alternative investments that might be challenging for individual investors to access directly. Because their shares are traded on a stock exchange, investment trusts offer a degree of liquidity that direct investment in these asset classes might not. They are also subject to regulation by bodies like the Securities and Exchange Commission (SEC) in the U.S. (for what are known as closed-end funds), providing a framework of investor protection.³ Financial data providers such as Morningstar provide detailed analysis, including performance metrics, portfolio holdings, and the critical premium/discount to NAV data, allowing investors to make informed decisions.²

Limitations and Criticisms

While investment trusts offer compelling advantages, they also come with certain limitations and criticisms. A primary concern is the potential for their market price to deviate significantly from their net asset value (NAV), leading to shares trading at a persistent discount or premium. A wide discount can be frustrating for existing shareholders who wish to sell, as they may receive less than the true value of the underlying assets. Conversely, buying at a substantial premium means paying more than the intrinsic value, which could erode returns if the premium later narrows or turns into a discount.¹

Another potential drawback is the use of financial leverage. While gearing can magnify returns in rising markets, it can also amplify losses during downturns, increasing the overall risk management challenge. Furthermore, like all managed funds, investment trusts charge fees for portfolio management and administrative expenses, which can impact net returns to investors over time. Investors incur standard brokerage commission fees when buying or selling shares on the secondary market.

Investment Trusts vs. Mutual Funds

Investment trusts and mutual funds are both types of collective investment schemes designed for diversification and professional management, but their structural differences lead to distinct characteristics. The primary distinction lies in their share structure and trading mechanism.

The fixed share capital of investment trusts means their managers are not forced to sell assets to meet redemptions during market downturns, potentially allowing for a more long-term investment strategy, particularly in less liquid assets. Conversely, mutual funds constantly issue and redeem shares, with their price directly tied to their NAV, eliminating the premium/discount phenomenon.

FAQs

Q: Are investment trusts risky?
A: All investments carry risk. Investment trusts have specific risks, including the potential for their shares to trade at a discount to their net asset value, which can mean selling for less than the underlying assets are worth. Additionally, some investment trusts employ leverage, which can magnify both gains and losses. Investors should evaluate the fund's specific portfolio, management, and historical premium/discount performance.

Q: How do I buy shares in an investment trust?
A: Shares in investment trusts are bought and sold on a stock exchange, similar to individual company shares. You would typically purchase them through a brokerage account with a brokerage commission.

Q: What is the difference between an investment trust and a Unit Investment Trust (UIT)?
A: While both are "trusts," they are distinct. Investment trusts (or closed-end funds) are actively managed companies with a fixed number of shares that trade on an exchange. A Unit Investment Trust (UIT) is a passively managed, unmanaged portfolio of securities that are held until a specified termination date. UITs generally have a fixed portfolio that does not change, unlike the active portfolio management of an investment trust.