InvestmentsAug 31 2016

A matter of trusts

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Both investment trusts and open-ended funds offer practical and affordable ways to gain exposure to a wide range of assets and investment strategies.

Investment trusts are limited companies that invest their capital in other businesses; their shares are traded like those of any other public company. They are the original stock market collective investment schemes, with some dating back to the 19th century.

Open-ended funds are investment vehicles designed to allow multiple investors to pool their capital to gain investment exposure to other assets. They come in many different forms including unit trusts, open-ended investment companies (Oeics) and exchange-traded funds (ETFs). The difference with these investment vehicles being that unit trusts are legally structured as ‘trusts’, Oeics are similar to unit trusts but structured as unlisted companies, while ETFs are investment companies that trade on stock exchanges and typically track a market index or some other type of benchmark. See Table 1 for a comparison of these investment vehicles.

In some cases, an investment manager may run both open-ended funds and investment trusts with similar aims and almost identical underlying investments.

Structural differences

Open-ended funds create new shares (or ‘units’) when investors subscribe to them. Conversely, they cancel shares when investors sell their holdings. There is no limit on the amount of shares they can issue. If an investor sells a large amount of shares in a fund, it may have to liquidate some of its underlying investments in order to pay the seller. There have been instances when successful funds have been closed to new investment as they have become too large for their investment strategy to be implemented effectively.

Investment trusts are closed-ended companies that sell a fixed number of shares at an initial public offering. The shares are subsequently traded on an exchange. This means that the underlying value of the fund does not change as shares are bought and sold between investors. The size of the fund is a function of the initial capital subscribed and any subsequent profits or losses it may have incurred.

Price differences

The pricing of shares in investment trusts is governed by supply and demand. As a result, the price of a trust may trade at a premium or a discount to the sum of the value of its underlying investments. When share prices are rising, investment trusts generally trade at a premium to this value. However, in normal market conditions they often trade at a discount as a result of various factors, including the fees of the investment manager.

Open-ended funds can be priced in different ways depending on their structure, but their pricing always reflects the mark-to-market value of their underlying assets. Unlike investment trusts, the value of both unit trusts and Oeics are determined at regular intervals (normally daily).

Fee differences

Both investment trusts and open-ended funds are similar in terms of cost, with annual management charges typically ranging from 0.5 per cent to 1.5 per cent. However, unit trust investors may also have to pay an initial charge (as a percentage of the amount invested) to cover the costs incurred when purchasing assets for the fund as well as any other administration fees.

Investment trustUnit trustOpen-ended investment companyExchange traded fund
Nature of fundClosed-endedOpen-endedOpen-endedOpen-ended
Legal structureCompanyTrustCompanyCompany
Investors’ holdingSharesUnitsSharesShares
Pricing frequencyReal timeAt valuation pointAt valuation pointReal time
Pricing calculationReflects value of underlying investments but driven by supply and demandPrecise value of underlying investments, charges within spreadPrecise value of underlying investments, charges shown separatelyBased on underlying investments (due to arbitrage activities of ETF manager)
Stock exchange listingListedNot listedListing optionalListed
Secondary marketAs for ordinary sharesDirect with managerDirect with managerAs for ordinary shares

Key advantages and risks of investments trusts

Gearing

Investment trusts are not always constrained by the investment restrictions that apply to most open-ended funds. Specifically, many are free to take on gearing (to borrow additional money to invest). When stock markets are performing well this can boost returns, since share prices tend to appreciate over the longer term. However, it also adds risk as, when share prices fall, the losses of geared funds are multiplied. In practice, investment trusts have had mixed success using gearing as a way to supplement their investment gains. Furthermore, it is sometimes expensive for such funds to borrow money and higher borrowing costs impact the returns their investors will ultimately receive.

Liquidity requirements

Investment trusts have lower liquidity requirements than open-ended funds because they do not have to release capital when their shares are sold. It could be argued that this provides them with a greater ability to make higher-risk and longer-term investments.

The bottom line

Open-ended funds may represent a safer, more liquid choice, but investment trusts may be able to provide superior returns in certain circumstances due to more flexible investment policies. In any case, investors should always compare the merits of different products before use, as both open-ended funds and investment trusts can provide useful and differing investment exposure.

Open-ended fundsClosed-ended funds
Price closely reflects the underlying net asset value of the investmentPrice is determined by supply and demand, and may trade at a premium or a discount to the mark-to-market value of the fund’s underlying investments.
There are no restrictions on the amount of shares (or units) funds may issue. The size of the fund will depend on the demand for its units from investors. However, if the fund is becoming too large its manager may choose to prevent it from receiving further investment in consideration of maintaining an ability to efficiently implement its investment strategy.The trading of shares does not affect the size of the fund.
Assets may have to be sold to raise cash to pay investors if they decide to liquidate their holdings.When investors sell, the total amount of money invested in the fund remains the same.

Jonathan Webster-Smith is a director at Brooks Macdonald

Key points

Both investment trusts and open-ended funds offer practical and affordable ways to gain exposure to a wide range of assets.

Open-ended funds are investment vehicles designed to allow multiple investors to pool their capital to gain investment exposure to other assets.

Investment trusts are not always constrained by the investment restrictions that apply to most open-ended funds.

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