Understanding and using investment trusts in a client portfolio

The investment universe has expanded rapidly over the past several years, with new instruments coming to market each week. Investment Trusts remain a useful and somewhat underutilised tool for financial advisers.

After reading this article, you will have an enhanced understanding of the Investment Trust, the intricacies of the vehicle and how they are perceived by the wider market. You will have learned about the pricing mechanisms for Trusts, along with how investment managers navigate liquidity and borrowing within their propositions.

30 minutes of CPD include:

• Article: 20 mins
• Related learning video: 5 mins
• Related learning articles: 17 mins
• Quiz: 5 mins

The investment universe is expanding and, for financial advisers, that means there are now more instruments available than ever to meet each client’s specifications.

This notion of optionality is not limited to thematics alone, but to the vehicles also. OEICs, ETFs and direct shares are now commonplace retail devices, each offering divergent characteristics and, more crucially, price structures.

But as the American entrepreneur Seth Godin once said, “In a world where we have too many choices and too little time, the obvious thing to do is just ignore stuff”.

This may explain the relative apathy towards the Investment Trust, which despite increased accessibility and thematic diversity, struggles for notoriety among the wider array of active and passive funds available.

Related learning: Building a portfolio with investment trusts

The Investment Trust’s structure has different quirks to that of its peers, which may explain some of the hesitance towards their usage. However, this should not be seen as a barrier to entry as, in the right conditions, a Trust can add a great deal to an investment portfolio.

As a brief overview of the vehicle, an Investment Trust is a publicly listed company (or PLC) which is traded on the London Stock Exchange. Like funds, Trusts invest in other companies to generate shareholder returns.

Trusts are known as ‘closed-ended’, owing to the fixed number of shares available to purchase. This provides a degree of stability to the portfolio, and a specific quantum of money for the manager to work with (unless the Trust can use leverage, which we will cover later).

Trusts can also retain up to 15% of their net income annually, which provides a more stable dividend pay-out ratio.

As with ETFs, platform availability can vary but the vast majority offer a selection of Trusts.

This essentially covers the basics of the vehicle, but throughout the remainder of this paper, we will endeavour to unravel some of the more nuanced aspects of Investment Trusts and how they are navigated.

Related learning: A guide to investment trusts

How does liquidity apply to Investment Trusts?

Following the global financial crisis in 2008, an investment’s liquidity became of paramount importance.

At a fund level, liquidity issues are typically more prominent within OEICs, with the most notable example of recent years being those in the property sector – as we know, buying and selling both residential and commercial property can be a very slow process.

Within the Investment Trust space, liquidity is managed differently owing to the closed-ended nature of the structure. Whereas OEICs need to retain a degree of liquidity to facilitate client purchases and redemptions, Trusts do not have this issue and do not become forced sellers or buyers of assets.

That being said, intra-portfolio liquidity is still a consideration for Investment Trust managers.

Gareth Powell, co-manager of the Polar Capital Global Healthcare Trust, explains the Trust’s process in this regard:

“The underlying stocks in the fund are dominated by stocks that are generally quite liquid as defined by number of days to exit the position – we refer to this as the Growth portfolio. In the Innovation portfolio, which is less than 20% of the Trust’s assets, sub $5bn companies are the relevant universe, and thus liquidity here is managed through position sizing.”

The structure of the Investment Trust affords the investment management team wider scope to pursue themes and holdings that may flourish over the longer-term. From an investor perspective, this may provide a degree of comfort when looking at specific thematic allocations.

On this, Gareth adds: “One last point to make is that investors are exposed to the liquidity of the Trust itself, highlighting one of the key advantages of Trusts in terms of being able to invest in small and mid-cap stocks.”

Premiums and Discounts – Mind the gap!

Like all investments, Trusts are subject to the influence of the wider market.

The pricing mechanisms of Investment Trusts operate under different principles to those of other vehicles, with Trusts trading on either a premium or discount to their Net Asset Value (NAV). This injects an element of risk into purchasing Investment Trusts, as this dynamic can fluctuate.

At which end of the spectrum a Trust is trading can be dependent on a variety of factors, with the premium/discount dynamic not necessarily indicative of the investment opportunity, as Chris Salih, investment writer and research analyst at FundCalibre, explains.

“A Trust trading on a discount could be an opportunity, if an investor thinks this discount will close. But the Trust could always trade on a discount which means the upside could be more limited,” he said. “Likewise, a Trust could be trading on a small premium, but its long-term average may be an even higher premium, so that could still be an opportunity even though you are paying more for the share than the underlying NAV.”

So, discounts may not necessarily directly reflect an investment’s potential. However, they are worth being mindful of, particularly in a falling market.

A discount occurs when a Trust’s share price begins to lag its NAV. In a rising market, the effects of this dynamic would be offset by a continued rise in share price, however as markets fall, losses can be amplified by a widening of discount.

While market persuasion lies firmly out of the investment manager’s hands, there are some tools available to help Trusts manage these risks, such as share buybacks, something that the Polar Capital Global Healthcare Trust has previously undertaken:

“The discount on the trust has narrowed over the recent months but varies particularly when markets are volatile. The discount is in our view still larger than warranted considering the underlying investments”, says Gareth Powell. “We have the ability to buy back stock, and have done in the past, when we think it adds value to shareholders.”

The BlackRock World Mining Trust, co-managed by Evy Hambro and Olivia Markham, set out the policies on the matter in their annual reports, as described by the BlackRock Natural Resources Team of which Olivia is a part:

“The Board recognises the importance to investors that the market price of the Company’s shares should not trade at a significant discount to the underlying NAV. Accordingly, the Board monitors the Company’s discount to NAV and will look to buy back shares in normal market conditions, if it is deemed to be in shareholders’ interests.”

It continues: “Equally, the Board does not believe shares should trade at an excessive premium to NAV and so, where deemed to be in shareholders’ long-term interests, will exercise its powers to issue shares. Issuing shares not only avoids an excessive premium developing but also benefits shareholders because all such share issuance is carried out at a premium to Net Asset Value, the fixed costs of the Company are spread over a larger asset base and the increased size of the Company should improve the liquidity in the Company’s shares.”

Gearing and Leverage

In pursuit of higher returns, Investment Trusts can use debt to deploy additional capital into assets.

Gearing is the practice of borrowing money to fund investments. This additional dry powder can afford further opportunities to the investment manager. However, as with any loan, there will be interest payments, regardless of whether the Trust benefits from the loan.

This is relatively commonplace in the market, though it remains a key consideration for analysts when assessing the Investment Trust universe, as confirmed by Chris Salih who spoke on behalf of the Elite Ratings system: “We select our Trusts based on the likelihood of them outperforming in the future. We obviously have to take other things into account too, such as premiums, discounts and gearing.”

One Trust that uses such practices is the BlackRock World Mining Trust, as the company’s Natural Resources Team highlights: “Gearing is used within the trust. The Investment Manager believes that tactical use of gearing can add value from time to time. This gearing is typically in the form of an overdraft or short-term loan facility, which can be repaid at any time or matched by cash. The level and benefit of gearing is discussed and agreed with the Board regularly. The Company may borrow up to 25% of the Group’s net assets.”

Another regularly used tool is leverage, which relates to the amount of debt carried by a firm relative to its equity. Trusts can create leverage by borrowing at short-term rates and investing the proceeds into the portfolio.

Gareth Powell describes how the Polar Capital Global Healthcare Trust has used this method: “When the Trust’s life was extended in 2017, structural gearing was introduced via Zero Dividend Preference shares, which were issued in a ratio of 1 ZDP for every 8 PCGH shares.”

Zero dividend preference shares offer capital growth with a predetermined redemption value, paid from the assets of the trust at wind-up.

“We vary the leverage depending on our view of the macro-outlook and its impact on equities and the healthcare sector,” Gareth concluded.

Reliable income and revenue reserves

Another attraction of investment trusts is that they have a facility called a revenue reserve in which the manager is able to store up to 15% of any income earned each year. This means in good years they can build up the pot and then use it if they need to at times when dividends are scarce.

This was particularly pertinent in 2020 when many firms either cancelled or cut their dividend payments due to Covid lockdowns. The knock-on effect was that most open-ended funds in the equity income sectors had to cut the level of income they too paid out. But investment trusts were able to fall back on the revenue reserve to maintain their payouts.

Philip Remnant, Chairman of City of London, said at the time: “Over the past ten years, we have set aside over £30 million in the revenue reserve to underpin future dividends in circumstances such as we face now. Those reserves stood at £58.3 million at 30 June 2019. If in July 2020 we need to draw on those reserves to maintain our unique record of annual dividend growth, then it is our intention to do so.” And do so they did

In fact, a number of investment trusts have used this facility to great effect over the years and it has helped them to maintain a stable and growing dividend for investors.

Related learning: Five trusts fulfilling their dividend promises

The Association of Investment Companies (AIC) has a list of ‘dividend heroes’ – investment trusts which have consistently increased their annual dividends for at least 20 years in a row. This list of 17 includes five Elite Rated trusts: City of London (55 years), BMO Global Smaller Companies (51 years), Murray Income (48 years), Scottish Mortgage (39 years) and Schroder Income Growth (26 years).

Related learning: Which trust has joined the next generation of dividend heroes?

A reminder of the learning objectives

• Understand liquidity within the context of Investment Trusts
• Identify which factors can affect a Trust’s pricing
• Learn how Trusts use gearing and leverage and revenue reserves