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The pros and cons of investment trusts

This article is part of
Guide to Investment Trusts

Investment trusts are legal entities with all the shareholder protection that encompasses, says Simon Moore, senior research analyst at Bestinvest.

Further on the plus side, he notes that “it is unlikely that a poor performing IT will be around for long before some sort of corporate action will have changed its remit, wound it up or moved its management elsewhere.

“Whereas an open-ended fund is ‘owned’ by the management group so is unlikely to be closed down even if performance is suffering.”

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The closed-ended structure means that investment trusts are well suited to investing in illiquid sectors such as property and infrastructure.

Annabel Brodie-Smith, communications director at the AIC, notes that during the credit crunch when property slumped, a number of property open-ended funds had to ‘soft close’.

“The share prices of property investment trusts suffered but investors could always sell if they wanted to – or buy – even at distressed levels,” she recalls.

Investment trusts also have important structural advantages when it comes to paying dividends as they can retain 15 per cent of the income they receive each year and use this to boost dividends in leaner years.

“This has helped the investment trust sector gain an unrivalled dividend track record, with many companies having raised their dividends each year for decades,” Ms Brodie-Smith adds.

Analysis over the long term in most asset classes shows investment trusts do outperform open-ended funds on average, with the exceptions of the Japan and UK smaller companies sectors.

Says Ms Brodie-Smith: “The freedom to gear to enhance returns, combined with the closed-ended structure, which allows managers to take a long-term view without the worry of having to sell stock to meet redemptions, are advantages that have helped the investment company sector outperform.”

But she admits investors will tend to get a bumpier ride along the way due to the effects of gearing, as well as the fact that investment trusts trade at discounts and premiums to the underlying asset value. Many investors and advisers hence see these factors as off-putting.

But Stephen Peters, investment trust analyst at Charles Stanley, stresses that potential investors need to understand that leverage is not a bad thing per se.

“It’s not right to distrust all investment trusts as they use leverage. The advantage of gearing is that equities should outperform other asset classes and many equities also produce dividends that are growing faster than inflation.”

So an investment trust manager should be able to invest in a portfolio of equities that is yielding 4 per cent and with a cost of borrowing of say 2 per cent, would be making money by using that leverage.

“The risk is that the value of your assets declines while the cost of your debt remains the same. You have to be prepared to accept the volatility that comes with them.”