Updated 03 September 2020
What are investment trusts and why might you want to consider them? Here’s a beginner’s guide from Neil Mumford, Chartered Financial Planner at Milestone Wealth Management Limited.
Once known as the Cinderella of investments, investment trusts have gradually emerged into the mainstream in recent years. However, a large number of investors still tend to ignore them, and even today they are rarely recommended by advisers. Why should this be? More to the point, is it right?
There are certainly a few extra factors to consider about investment trusts, such as the share price being able to trade at discounts or premiums, and the fact that some trusts use gearing. But I believe that many advisers use these as excuses for not recommending them to clients, rather than valid reasons for not doing so.
They say you should eat what you cook. With this in mind, I spent five years investing my own money into investment trusts, so that I truly understood the mechanics of how they work before I started recommending them in client portfolios – which I began to do about 6 years ago. Now seems like a good time to share what I learned from personal experience.
A quick introduction
Investment trusts come in various shapes and sizes. Some invest in specialist areas such as infrastructure or private equity, which are outside my personal area of expertise, as well as being high risk. I’ll focus here instead on mainstream investment trusts, as they mainly invest into the assets we all understand such as equity and fixed interest markets.
To fully benefit, you need to view investment trusts as buy-and-hold assets – just as many unit trusts are. They are suited to clients in the growth stage of their financial planning, but if you require income then in my opinion they should undoubtedly form some part of your portfolio. When it comes to the income dimension, unit trusts simply cannot compete.
There are of course certain risks that you need to understand and accept before investing. In short, go in with your eyes open.
We have seen some excellent returns over the last 10 years, some of which has been due to the narrowing of any discount a trust may have traded at – but even if you take that away, the returns are still extremely attractive. What is clear is that when markets fall, a trust will generally fall more in value than unit trusts do. However, when they rise, the rise in price can be just as dramatic.
If a trust is ‘flavour of the month’, you have to decide if it is worth buying it at a premium. You should bear in mind the value of its underlying assets, and judge accordingly – in my view anything more than a 5 per cent premium should make you think very carefully before buying. Also, just because a trust is trading at a discount, does not necessarily mean it is a ‘screaming buy’. Understand the trust’s objectives, look at the manager’s pedigree and try and find out why the share price is discounted.
The value in volatility
A great benefit of an investment trust is that, because it is listed as a company on the stock exchange, it has only a certain number of shares in circulation (although by resolution it can issue a certain number each year, if demand requires). This means that if the trust suffers from poor performance or investors need to withdraw capital, it does not have to sell any holdings or redeem those shares. By contrast, a unit trust has to redeem the units, which could involve selling assets which could in turn lead to even poorer performance. When Neil Woodford left Invesco Perpetual, many billions of pounds were redeemed, although thankfully in that instance the performance was not adversely affected.
Another thing to bear in mind is that investment trusts are traded by the second, whereas unit trusts are priced and can be bought only once a day. Also investors will try to exploit anomalies in the share price discounts and premiums, so an investment trust share price will exhibit far more volatility. Because of this volatility, when we recommend investments trusts for clients they will typically make up no more than 25 per cent of a portfolio, with the remainder being in unit trusts.
To maximise the benefits of investment trusts, you need to take a long term view. So when we buy a trust it usually stays in a client portfolio for a considerable length of time. We should all accept that every manager will go through a period of underperformance, and remember how many investors have switched out due to impatience, only to regret that decision later on.
While we’re on the subject, a word about ‘underperformance’. I do not believe it should be a comparison against the sector, but against your expectations. For instance, Alistair Munday who manages the Temple Bar Investment Trust sits in the bottom quartile of the sector, yet has returned 50% over the last 3 years. Some ‘underperformance’!
Don’t panic, Mr Mainwaring!
Because investment trusts are buy-and-hold investments, it’s important to take a longer term view. In hindsight one of the worst times to invest would have been the summer of 2007. As an example I will again use the Temple Bar trust. An investment into this trust of £10,000 in May 2007 would have dropped to £6,000 by December 2008. Part of this was due to the trust falling to a discount of more than 14 per cent. However, by the end of April 2014 that investment was worth £14,000 and you would have also received over £4,000 in dividend payments. Overall this is an average total return of 10 per cent per annum. There are many other trusts with similar stories.
The quest for income
With the introduction of pension freedom, and the expectation that interest rates will remain low for the rest of the decade, the search for income becomes ever more pressing. If you have capital to invest, you are generally looking for two things above all: an income that is greater than cash deposits, and an income that will increase each year. Just remember that if you plan to use the investment solely for income, you must accept that the initial capital will fluctuate in value and fall, but in the long term should also increase in value.
There are over 35 investment trusts currently on the market that have increased their dividend payments each year for more than 10 years. It is therefore possible to build a diversified portfolio with a blend of some of these trusts, together with unit trusts to complement them.
This field of investment is a complex one and also relatively high risk, so you should not take any action without first consulting an independent financial adviser.
Neil Mumford is a Chartered Financial Planner and principal director of Milestone Wealth Management. He has been advising clients for more than 25 years and holds some of the industry’s leading investment retirement qualifications. He specialises in retirement and estate planning, with an emphasis on income strategies post-retirement.