Three ways to use an investment trust

Investment trusts are a type of fund. They are a way of pooling your money in one place – but at the same time, investing across lots of different assets, so spreading your risk.

They have a number of unique characteristics, including being able to borrow money to make investments and storing extra income for ‘rainy days’.

Find out more: Five things to know about investment trusts

Here, we take a look at three ways you can use an investment trust in your portfolio.

1. For income generation

Investment trusts 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 is particularly pertinent in 2020 when many firms have either cancelled or cut their dividend payments due to lockdown. Funds that would usually pay out these dividends – such as those in the equity income sectors – will struggle to pay income to their investors at these times. But investment trusts can fall back on the revenue reserve to maintain their payouts.

Philip Remnant, Chairman of City of London, said earlier this year: “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.”

Find out which other investment trusts committed to using their reserves in 2020.

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.

For example, City of London and BMO Global Smaller Companies are both ‘dividend heroes‘ having grown their dividends for more than 50 consecutive years.

In this video Job Curtis, manager of City of London, tells us how he has used the revenue reserve to achieve this track record.

Scottish Mortgage Investment Trust is not far behind, with a 38 year track record, while Murray International, Schroder Oriental Income, Fidelity Special Values and Lowland are all ‘next generation dividend heroes’ with more than 10 years of dividend increases apiece.

2. As a performance booster

Whether you are saving for your retirement, your children, or simply your future, investment trusts can be performance boosters over the long term. This is because they have a number of tools they can use to potentially enhance returns.

The first is gearing. Investment trusts can borrow money to invest if the manager thinks there are extra opportunities they would like to take advantage of. Of course, if the manager gets it wrong, this can also be a drag on performance.

The second is the lack of ‘cash drag’. Because investment trusts are closed-ended (there are only a certain number of shares in circulation), there is no need for managers to hold on to cash in order to meet potential redemptions. Instead, investors simply buy or sell the shares to another investor. This means that 100% of the money pooled in a trust can be put to use, rather than some having to sit in a bank account.

Finally, because the manager doesn’t have to sell an underlying asset to meet redemptions or buy an asset to invest new money received, it not only means that they don’t have to worry if the underlying asset is illiquid (harder to buy and sell quickly), they also only buy and sell based on the investment case, not to meet fund flows. They can invest with conviction.

3. To gain access to alternative assets

Some investments are simply not available in an open-ended fund structure, as the asset class is too niche.

For example, Hipgnosis Songs is special investment trust that owns to rights to more than 13,000 songs from artists including Adele and Cher. Professional investors such as the managers of VT Seneca Diversified Income fund, tend to use these trusts as an alternative source of income in their own portfolios – so why not retail investors too?

Infrastructure is another popular area for this type of fund. Indeed, VT Gravis UK Infrastructure Income, invests almost entirely in infrastructure investment trusts.

Investment trusts also make good homes for less liquid assets for the reasons mentions above. Property is a prime example, as well as unquoted companies.

TR Property Investment Trust invests in both the shares of property-related companies and physical buildings and Scottish Mortgage Investment Trust has recently increased the maximum amount it can invest in unquoted companies from 25% 30%, because, as co-manager James Anderson said: “The bulk of our emergent opportunities lie in unquoted companies.”

Of course, as with all investments, there is the risk that investment trusts could lose money. So it’s important to understand what the trust is trying to achieve, what it invests in and how much gearing it could use before you invest.