The key concepts of an investment trust explained

Investing can often feel like a daunting and complex task to tackle. I get it, it’s a big scary world full of jargon and complex options, and no one really seems to make it “simple.” But if you’re new to investing, don’t worry, you’re not alone, and getting started doesn’t have to be overwhelming. To simplify things, let’s break down one of the investment vehicles you’ll find on FundCalibre: the investment trust.

Understanding the advantages and differences between an investment trust and an investment fund is a crucial step in building a strong foundation for making informed investment choices. This knowledge can also be a key factor in growing your wealth and achieving your long-term financial goals.

What is an investment trust?

Simply put, an investment trust is a specialised type of company created with the sole purpose of investing in other companies or diverse assets. When you buy shares in an investment trust, you’re essentially purchasing a small stake in a large, professionally managed, and diversified portfolio. This is similar to investing in an investment fund, where money from numerous investors is pooled together to create a collective portfolio. However, there are some significant differences between investment trusts and funds, which we’ll explore through a few easy-to-understand analogies to help clarify their unique characteristics.

Key characteristics of investment trust

Closed-Ended Structure

Investment trusts are structured as “closed-ended” entities, meaning they issue a fixed number of shares when they are initially set up. Once these shares are sold, no additional shares are created unless existing shareholders approve an increase.

Think of it like a concert with limited seating; only a set number of tickets are available. Once those tickets are sold, they’re gone, and entry is closed to additional buyers. In the same way, an investment trust operates with a limited share supply. This contrasts with an investment fund (such as a unit trust or OEIC), which can continuously create new shares to accommodate demand from new investors. This fixed share structure can lead to different market dynamics, affecting how shares are traded and valued over time.

Trading on Stock Exchanges

Investment trusts are listed on stock exchanges, meaning you can buy and sell their shares just like any other company stock. This provides you with added flexibility, as it allows you to choose when to buy or sell, depending on current market conditions. This can be particularly advantageous in responding to market changes or taking advantage of favourable pricing.

Premiums and Discounts

The net asset value (NAV) of an investment trust is determined by the value of its underlying assets, such as stocks or other investments within the portfolio. However, the share price of an investment trust doesn’t always align perfectly with its NAV, which can create premiums and discounts. This means that, depending on market demand and investor sentiment, shares of the trust may trade above the NAV (at a premium) or below it (at a discount). Understanding these fluctuations can help investors identify potential opportunities to buy shares at a discount or sell at a premium.

Let’s revisit our concert example to illustrate the concept of premiums and discounts. Imagine the face value of a concert ticket is £100. If it’s a highly popular event, like a sold-out Eras Tour, you might be able to resell the ticket for £110, reflecting a 10% premium due to high demand. On the other hand, if demand is lower, you might need to sell it for £90, which represents a discount. Similarly, an investment trust can trade at a price higher than its NAV (premium) or lower than its NAV (discount), depending on how much demand there is from investors and the overall sentiment toward the trust’s assets.

Gearing

Gearing refers to the practice where an investment trust manager borrows money to increase the trust’s investment potential. By borrowing funds to invest more, the manager aims to boost returns if the investments perform well. However, gearing is a double-edged sword, as it can also magnify losses if the investments don’t meet expectations.

Consider an example of a once-in-a-lifetime concert. You’re so excited about the event that you borrow £100 from a friend to buy an additional ticket, expecting ticket prices to increase. If the ticket prices double, you can sell both tickets for £400. After repaying your friend, you’re left with £300. Making a £200 profit, double what you would have made without borrowing. However, if the ticket prices fall to £50 each, you only make £100 from selling both tickets, meaning you lose your initial £100 investment.

Similarly, gearing in investment trusts has the power to significantly enhance returns during good performance periods but can also amplify losses if investments underperform.

Revenue Reserves

Investment trusts have a unique feature that allows them to smooth out the income they pay to shareholders by holding back up to 20% of the income generated in good years. This reserve can then be used to provide steady payments during leaner times when income may be lower.

Let’s adapt our concert analogy to illustrate this. Imagine that you’re not just attending concerts, you’re organising them. In a particularly successful year, every show sells out, generating substantial profits. Instead of spending all the earnings immediately, you decide to set aside 20% in case future concerts don’t perform as well, perhaps due to bad weather or competing events. This financial buffer allows you to keep your concert standards high, regardless of how well ticket sales fluctuate each year. In the same way, investment trusts can hold back a portion of their income in strong years, ensuring they can maintain consistent dividend payments even during less profitable periods.

If you’re looking to understand more investment terms, visit our Investment Glossary for clear definitions.

Benefits of investing in investment trusts

Independent board

Investment trusts are governed by an independent board of directors, whose primary role is to represent and protect shareholders’ interests. This board meets several times a year to closely monitor the trust’s performance and ensure that management decisions align with the best interests of the shareholders. Acting as your eyes and ears, the board members have the authority to question the management team and provide oversight, making sure their actions support and enhance shareholder value. By holding management accountable, the board plays a crucial role in maintaining transparency and ensuring that your investment is handled responsibly.

Potential for growth

One of the appealing features of investment trusts is their growth potential, thanks to their ability to borrow money for additional investments through a process called gearing. By leveraging borrowed funds, investment trusts have the opportunity to amplify returns, which can lead to higher gains when investments perform well. However, it’s essential to remember that this growth potential also comes with increased risk, as mentioned earlier. Gearing can boost returns in favourable markets but may also magnify losses during downturns, making it crucial for investors to weigh both the growth opportunities and the associated risks.

Diversification

Investment trusts often provide significant diversification by investing in a wide range of assets, which helps to spread risk and balance potential returns. For instance, a single investment trust might include assets ranging from care homes to aircraft leasing companies, allowing you to gain exposure to multiple sectors within one investment. This approach helps spread your money across various asset types, reducing the impact of any single asset’s performance on your overall portfolio. By diversifying, investment trusts enable you to avoid putting all your eggs in one basket, adding a layer of resilience to your investments.

Discounts

The pricing dynamics of investment trusts allow investors to potentially purchase shares at a discount, which can provide both flexibility and added value. Unlike some other investment options, investment trusts can trade at a price below their net asset value (NAV), meaning investors may acquire assets at a lower cost than their actual worth. These discounts allow investors to capitalise on market sentiment—buying when prices are favourable and benefiting from potential upside as the market adjusts. By strategically purchasing at a discount, investors can maximise their investment’s value and take advantage of fluctuations in demand.

For a deeper dive into investing, explore our Demystifying Investments course.

Exploring Investment Trusts: Your Next Steps

Investing doesn’t have to be intimidating. By gaining an understanding of investment trusts and how they compare with other investment vehicles, you’re already on the path to making smarter financial decisions. Remember, key factors like diversification, professional management, and the potential for growth make investment trusts a valuable option, especially if you’re just starting your investment journey.

Whether you’re looking to dip your toes into the world of investing or planning for long-term financial security, take the time to explore investment trusts. When you’re ready for more guidance, explore resources like FundCalibre to gain expert insights and support in choosing the investment trust that best aligns with your goals. Happy investing!