Understanding the features of investment trusts

Compared to open-ended funds, investment trusts can seem a little more complex, with their ability to use gearing.

Concepts such as net asset value (NAV) and discounts sometimes alienate advisers but there are now plenty of resources available, explaining some of the jargon around investment trusts and helping them understand where they might fit into a wider investment portfolio.

“Investment companies have a number of features unique to the closed-ended structure. These include gearing, NAV and discounts/premium, to name a few,” points out Annabel Brodie-Smith, communications director at the Association of Investment Companies (AIC).

The AIC has been making inroads by going out to advisers with their roadshows, headed up by Nick Britton, head of training at the association.

Education, education, education

It does appear as if the industry is tackling directly the lack of knowledge among many advisers.

James Burns, partner at Smith & Williamson, says it has been an education process on the part of the fund houses and the AIC.

At its simplest, gearing means borrowing money to buy assets and works by magnifying the performance of both income and capital returns.Annabel Brodie-Smith

Tony Yousefian, FundCalibre’s investment trust expert, points out they have created their own guides to discounts, premiums, revenue reserves and gearing. These guides are available on the website and all aimed at the retail investor. They have also created some video content. 

The prevalence of jargon can be off-putting but there are often simple explanations for the more technical sounding aspects of closed-ended funds.

Ms Brodie-Smith starts by explaining gearing – a feature unique to investment trusts and one which advisers will need to understand before investing.

“At its simplest, gearing means borrowing money to buy assets and works by magnifying the performance of both income and capital returns,” she says. 

As gearing has contributed to the strong performance of investment companies over the long-term as markets have risen, she acknowledges it is important to understand how it works. 

“The idea is that the additional investments make enough money to meet the costs of the borrowing and make a profit on top. If the performance of a company with gearing is strong, the gearing boosts the company’s performance.” 

Ms Brodie-Smith cautions: “However, the reverse is true and if the performance of a company with gearing is weak, gearing will be a drag on the performance. Not all investment companies use gearing, with just over half not using gearing and those that do use gearing use relatively low levels.” 

Figure 1: How gearing affects performance

Source: AIC

She suggests should advisers and investors want a clearer understanding of how geared an investment company is, the AIC publishes the current level of gearing of member companies on its website and the gearing range – “the maximum and minimum levels the company would expect to be geared in normal market conditions”.

Discounts and premiums

The net asset value, or NAV as it is referred to, is simply the value of an investment trust’s assets minus any liabilities such as debt.

Once this is understood, the idea of discounts and premiums in relation to investment trusts is a much easier concept to apply.

We would acknowledge though that, like any industry, there is a certain amount of technical jargon to get your head around.James Carthew

James Carthew, head of research at QuotedData, explains: “In simple terms, the NAV is the same as a unit trust price and the discount is the difference between that value and the market’s perception of that value. 

“A positive number means the trust is trading at a premium to its net asset value and a negative number means it is trading below it.”

But he adds: “We would acknowledge though that, like any industry, there is a certain amount of technical jargon to get your head around.”

The reason an investment trust might move to a discount is due to negative sentiment towards it, or to a premium if the trust is popular.

Ms Brodie-Smith uses an example: “An investment company with £100m of net assets and 100m shares would have a net asset value per share (NAV/share) of 100p. 

“If the share price was 90p, it would be trading at a discount of 10 per cent. If the share price was 110p, it would be trading at a premium of 10 per cent.”

Investment trusts can move from a discount to a premium fairly quickly, or they might stay above or below their net asset value for some time.

It is also common for a whole sector to trade at a discount if it is out of favour.

Putting it into practice

Mr Yousefian explains what this means when an investor goes to buy a closed-ended fund.

“This means you are sometimes paying a bit more for a share in a trust or you could be getting a 'bargain'.

“However, while the January sales may only last for a few weeks, some trusts can trade for very long periods at a discount or a premium and the price may not trade at its net asset value.”

There is such a thing as a zero discount policy which, as the name suggests, means the investment trust takes steps to avoid trading at a discount to its net asset value.

Those trusts which adopt a zero discount policy “will issue or buy back as many shares as necessary to keep the share price trading close to asset value”, says Mr Carthew. 

“This makes them a lot more like an open-ended fund and it is not something that an investment company can really do unless it holds investments that can quickly be turned into cash. These policies are used to give investors confidence of being able to trade in and out of a trust at close to NAV.”

He points out the Martin Currie Global Portfolio (MNP) was one of the first trusts to adopt a zero-discount policy, which has been in place since launch in July 2013. 

I think, like many things, advisers don’t get comfortable with it unless they’ve actually had a go.James Burns

“During the past 12 months, MNP has traded at an average discount of 0.5 per cent (median discount 0.6 per cent). 

“Seven months ago, multi-asset trust Seneca Income & Growth Trust (SIGT) introduced a new discount control mechanism which has been successful in keeping it trading close to a zero discount as intended. Since the introduction of the new mechanism, SIGT has traded at an average discount of 0.10 per cent (median discount 0.15 per cent).” 

Buy and learn

But Mr Burns feels many advisers are still not dipping their toes into the investment trust pond.

“I think quite often some of them use the discounts and the gearing as an excuse to say they’ve thought about it but it’s too risky for their clients,” he suggests.

"Like many things, advisers don’t get comfortable with it unless they’ve actually had a go. 

“In a way, there’s an educational element but people just have to get on with it and if they know there’s a very good manager in the investment company space they like they should just [buy] it and learn that way, I think.”

eleanor.duncan@ft.com