Investment trusts have been in existence for nearly as long as the London underground – almost 150 years. And they have been growing in popularity lately due to the flexibility they offer in terms of access to various sectors and geographies in order to diversify a portfolio, as analysed in Money Management’s December supplement.
But what are investment trusts? Here are five things to keep in mind about investment trusts to help explain to your clients.
How do they work?
As closed-ended funds, they work like any other company where investors buy shares, and the money raised is re-invested by the trust. If the underlying investments do well, the share price of the investment trust rises. Unlike other types of funds, investment trusts are entitled to keep up to 15 per cent of the income they earn each year for their reserves. This gives them a buffer from which income payments to investors can be made in years when the fund’s earnings disappoint.
What sectors are there?
There is a range of sectors that investors can diversify their funds into. The Association of Investment Companies (AIC) lists 55 sectors grouped by region, asset class and alternative strategies. The largest spaces tend to be those within specific regions, such as Asia, Europe, Global and UK. There are also specialist sectors such as biotech, healthcare, commodities and natural resources, or property; and alternative sectors such as hedge funds, VCTs and private equity.
How do investment trusts perform?
In general over a long-term investment of at least 10 years, investment trusts tend to outperform their open-ended counterparts. According to the data from the AIC, supported by Morningstar figures, a total of 451 investment trust funds are invested across the 55 sectors. Data looking at investments over three years shows the best performing sector is Biotechnology and Healthcare. A number of advisers have also identified a growing trend in this sector and there is more of a shift from traditional sectors to alternative and specialist sectors. The worst performing sector according to the same data is Commodities and Natural Resources.
What are the advantages of using investment trusts?
Aside from the ability to pay dividends from the income they receive, investment companies can also pay dividends out of the profits they make when they buy and sell investments. This income can be particularly valuable for investors in retirement. Furthermore, the AIC believes investment trusts can be a useful part of a Sipp portfolio due to the advantages of the structure – good long-term performance due to gearing, than closed-ended structure, from an income perspective they have a good deal of flexibility and, with shareholder approval, can pay income out of capital.
What are the major risks?
The investment trust sector may be lucrative and offer a diversified portfolio to investors, but it does come with its own set of challenges. Although these are often similar to those an equity-based unit trust may face. A number of advisers and fund managers say that the biggest challenge with the investment trust sector is its reliance on equity investments and consequent exposure to the risks of a volatile market. They are also exposed to the markets reacting to different events. While higher returns are attractive, but they come with a higher risk too.
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