Discounts and premiums change over time and reflect the popularity of the investment trust, the market’s appetite for risk, sentiment about the asset class in which the trust invests, and many other factors.
They can create opportunities as well as risks, but their importance shouldn’t be overstated. An investment trust’s ability to generate strong underlying performance is what matters over the longer term.
The second major difference between investment trusts and Oeics is that investment trusts may borrow money to invest, known as gearing. Though gearing across all investment trusts is modest (an average of 6 per cent), some have much higher gearing.
A ‘gearing range’ is provided on the AIC’s website to show the minimum and maximum levels of gearing a board expects to be used. This is written as 0-25, for instance, indicating maximum gearing of 25 per cent under normal market conditions.
Reasons to use investment trusts
While investment trusts won’t be right for every client, there are three useful roles they can play in portfolios.
The first is to generate the strongest possible long-term performance, for example when accumulating a pension. Studies of investment trusts run by the same managers as open-ended funds show that the investment trusts tend to outperform.
For example, Winterflood Securities found that 76 per cent of investment trusts outperformed their open-ended ‘sister’ funds on an NAV basis in the five years to 30 November 2017, while 80 per cent outperformed on a share price basis.
Potential reasons for this outperformance include the ability to gear and the efficiency of the investment trust’s closed-ended structure. Because there are no fund flows, cash does not need to be held to meet redemptions, and assets do not have to be bought or sold in response to inflows or outflows.
It is worth noting, however, that investment trusts will not always outperform, and will tend to suffer relative to open-ended funds in down markets, when discounts may widen and gearing act as a drag on returns.
The second role investment trusts can play in portfolios relates to income. Because investment trusts are allowed to reserve up to 15 per cent of the income they receive from their investments within any year, they can ‘smooth’ dividend payments over multi-year periods.
This has led to 21 investment trusts building up records of at least 20 consecutive years of dividend increases, the so-called ‘dividend heroes’. City of London Investment Trust and Bankers Investment Trust have notched up 51 years each, investing in UK and global equities respectively.
Investment trusts are also legally able to distribute income out of their capital profits, if shareholders agree. While this ability is not widely used, it gives a small minority of investment companies additional flexibility to pay higher levels of income, or produce income streams from assets with little or no natural yield, such as private equity.
