In this sense, Mr Stoakley says investment trusts are the same as any investment in any asset class.
However Mr Stoakley says there are a number of risks specific to investment trusts;
Gearing (borrowing) provides the investment manager with the potential to boost returns when they expect prices to increase by increasing their fund’s exposure to an underlying investment.
If their judgement is correct, they will generate an additional return from gearing.
The converse is true if the investment falls in value.
As an investor, Mr Stoakley says it is important to understand that while gearing can increase potential returns in a rising market, it can also magnify the extent of losses in a declining market.
Also, he says a geared investment trust will fluctuate more than an equivalent non-geared fund and has the potential to deliver higher returns or greater losses.
When investing in an investment trust there is always the risk of a widening discount of the shares in relation to the NAV of the shares.
The share price of an investment trust is determined by supply and demand for the shares , this means that during times of market volatility if there are more sellers of the shares than buyers then the price of a share in an investment trust can fall further than the underlying NAV.
James Budden, director at Baillie Gifford, agrees the NAV can lead to greater volatility as prices are driven by liquidity and sentiment and not just the value of the underlying portfolio.
A past scandal involving trusts that advisers should be aware of is the Financial Service Authority’s huge investigation into split capital investment companies that ran between 2002 and 2007.
The investigation followed the heavy losses suffered by many private investors and clients of split capital investment trusts in the early part of the last decade.
The role of four individuals’ was highlighted and they agreed not to work within the financial services’ industry for fixed time periods.
The FSA had initially investigated 22 companies but reduced its efforts in 2004 when 18 of them offered an ex-gratia, no blame payment of nearly £200m to investors who had lost money on zero dividend preference shares (ZDPs).
Many at the time felt the outcome of the investigation was inadequate and offered clients and private investors too little protection or compensation.
The scandal came about because some money management institutions sold split-cap investment companies as relatively safe investments but they then began to believe their own press releases and took on additional risk themselves.
Some splits borrowed money to invest in the market, a standard practice known as ‘gearing’ that is still used by many investment trusts to this day, but the timing proved poor as the UK equity market peaked in late 1999.
The gearing magnified the losses suffered as share prices fell and the effects were compounded by how split-caps had bought shares in each other, a tactic which led to allegations they had colluded to try and support the market.
Upon wind-up, several splits were found to be worthless and tens of thousands of investors were left out of pocket.
However in a bid to address this issue in November 2003 changes to the investment trust listing rules and conduct of business of rules were introduced.
The changes meant the circularity of investment (investing in splits that arose so damagingly when split trusts invested in each other) could not happen again.
In terms of regulation split capital investment trusts, like all investment companies, are not currently regulated by the FCA, but by company law and the UK Listing rules.
