Although investment trusts have suffered at the hands of market sentiment recently, their ability to gear and invest in a wider range of products than unit trusts means they make a good option
Investment trusts are certainly having it tough. As if usurpation by their younger upstart, unit trusts, was not enough, the ongoing splits scandal has severely damaged public perception.
Investment trusts are now viewed with a mixture of wariness and derision ' a dinosaur in a world of exciting new products like securitised derivatives and exchange traded funds.
Investment trusts are the UK's oldest collective investment scheme. The first trust, set up by Foreign and Colonial in 1868, is still in operation today.
However, they are now increasingly under pressure as demand for them has fallen. This has lead to falling prices, making it harder for investors to sell them. Furthermore, many institutions that once retained investment trust managers are building in house capabilities. A number are trading at significant discounts to net asset value, indicating the collapse of confidence in the sector.
However, as is often the case, such negative sentiment presents opportunities. One of the paradoxes of investing is that when everyone is chasing an investment, it represents bad value.
Where demand is low, value tends to be better. This is not to say that an investment's performance will do better, merely that value weightings can affect the price you pay for those investments.
In short, investment trusts represent good value. With such a large number trading at a discount to net asset value, they are effectively bargains. They are also highly visible bargains ' with figures for net asset discounts easily available to prospective investors.
And although it should be considered that such negative sentiment is not totally without justification, the downside of investment trusts really has been overplayed.
It is also unreasonable to make like-for- like comparisons between the unit trust and the investment trust sectors as the two are very different structurally. Unit trusts, where funds are open ended, require scale to survive. If funds leave unit trusts quickly, the fund manger may be compelled to sell at a less favourable price, leading to a fall in fund performance.
Equally, small unit trusts may find themselves with little leeway for asset allocation and fears of investors leaving the fund.
By the same token, the financial strength of unit trust managers is rooted in the size of fund manager, and therefore the amount of revenue they generate on funds under management. Such as structure favours larger funds and fund houses, creating an essentially oligopolistic market.
Investment trusts operate quite differently. Their close-ended nature means that fund managers are able to operate in niche markets with few investment opportunities and investors.
For example, Taverners Trust specialises in investing in breweries, pubs and restaurants. Such niche operations offer a diversity of investment styles and objectives not available currently in the unit trust marketplaces.
Such niche investments can be suitable as part of a wider portfolio or for investors with specific preferences or specialist knowledge.
Such niche operators have sat side by side with the much bigger trusts, such as Foreign and Colonial Trust PLC.
With investment trusts, asset size is built up over time, so the older funds tend to be a lot bigger. However, the size reflects the growth of the fund's assets, not consumer sentiment.
This unusual structure means that investment trusts are able to offer greater investment diversity than unit trusts, and small companies with niche expertise can do exceptionally well.
Such diversity has meant that some of the best investment opportunities have come out of the investment trust sector. Anomalies such as the Gresham Trust VCT has offered 3000% growth over five years. Although this is quite atypical (it made most of its money on one company), it is indicative of the broader investment canvas investment trusts can offer.
Venture capital trusts, warrants and specialist markets offer investors access to a number of exotic, albeit high-risk investments. Equally the split sector, with its well documented demise, offers a number of alternatives for experienced or professional investors.
Such diversity means that investment trusts can frequently be used as an integral part of portfolio construction. The number of different options allows more accurate negative correlation of portfolio assets, enabling the creation of a better-balanced portfolio.
This is crucial, especially when you consider the growing interdependence of global economies. Currently most equity based investments will have significant exposure to global markets through benchmarking to major world indices.
The heaviest weighted companies on these indices are truly multinational and global. This means that most investors in different sectors will have exposure to the same factors, especially if they invest in the major sectors of UK, Europe and the US.
Niche investments are not necessarily subject to this exposure, which in turn means they can be used to negatively correlate against such exposure.
However, arguably the greatest advantage that investment trusts can offer against unit trusts is their ability to gear. This ability to borrow is particularly significant in recovery markets, where, historically we have seen very quick price rises. These rises can have a very significant bearing on the performance of a fund. For example, a number of unit trust focus funds launched in the period just after 11 September, when share prices had collapsed.
Within a couple of months, prices had returned to previous levels, generating significant returns for those funds, which are now amongst the top performing UK funds.
Gearing means that investment trusts can capitalise more on any market upside. Although this money is borrowed, and will have to be repaid, timely gearing can generate significant returns for a fund. This makes investment trusts ideal as a recovery play.
Furthermore, recoveries have traditionally been lead by smaller companies, whose flexibility and nimbleness mean they can change capacity much quicker than larger companies.
Investment trusts tend to be particularly strong in the smaller companies sector. This is due to the fact that the funds are closed ended. Since smaller companies generally have less opportunities for investment, there are fewer high quality investments for money to chase. Therefore, they are best suited to small fund sizes.
This means that some of the top smaller companies funds, such as Peter Webb's Eaglet or Aberforth Smaller Companies, are particularly well placed to capitalise on market recovery. With global markets already showing signs of rebound, they could present a very interesting recovery play.
The opportunities for investors looking for recovery is not limited to conventional investment trusts. For professional or highly experienced investors who are looking for a gutsy recovery, the split sector could present possibilities.
The split sector remains high risk because of massive uncertainty in the valuation of trusts, which brings the risk they could go bust. Nonetheless, the splits scandal centred around cross holdings of splits caps, which have now been revealed and are subject to the rigours of an FSA investigation.
Splits which did not have the cross holdings are not nearly as risky, and should not suffer the same problems. However, they have suffered from the negative market sentiment associated with the magic circle splits. This means that a number are trading at a huge discount to net asset value, when they are not nearly as risky as other splits. These trusts represent extremely good value for investors, with the major risk attached to ongoing negative market sentiment, and the ongoing undervaluation of the trust.
For those prepared to make a long-term investment, and are fully aware of the associated risks, splits could be an excellent investment, especially when the market starts to accurately value splits again. However, such as strategy should only be used for those fully aware of the risk.
Although investment trusts have suffered at the hands of market sentiment and detractors, they still offer a very significant role in the collective investment market. With a wide range of investment options, interesting structures and strong potential as recovery plays, investment trusts should be carefully considered at the moment.
There are those who have rung the death knell for investment trusts. They may well be forced to reconsider. Far from dead and buried, investment trusts could well be the investment that shines when markets finally recover.
The UK's oldest investment vehicle, investment trusts are under increasing pressure as demand for them has dropped.
It is unreasonable to make like-for-like comparisons between unit and investment trusts as the two have different structures.
The splits sector remains high risk because of massive uncertainty about trust valuations.
EIS and Seed EIS sectors
'Truly making a difference'
Avoidance, evasion and non-compliance
From 6 April 2019