Why investment trusts are a solid basis for building wealth

Investment trusts are one of three main types of funds, with the other two being exchange-traded funds (ETFs) and what are variously called open-ended investment companies (OEICs) or unit trusts (depending on their exact structure). Each of these has advantages and disadvantages. To see why, let’s look at how they work and where investment trusts win out.

Investment trusts are closed-ended, which means that they have a fixed amount of shares. They are listed on the stock market, so when you invest, you buy the shares from another investor who wants to sell (via your broker). If you want to cash out, you sell to another investor who wants to buy. These trades do not affect the money within the trust.

OEICs are open-ended and are not listed on a stock exchange. If you want to invest, you send your money to the fund manager (via your broker) and more shares are created for you. If you redeem, the manager cancels your shares and sends you the cash. Each of these trades changes the amount of money held in the fund.

ETFs are listed on the stock market, but are open-ended. This may not be obvious to you, since you will trade one in the same way as an investment trust. However, institutional investors, known as authorised participants, also trade directly with the manager to create and redeem shares. When they do this, money flows in or out of the fund.

Investment trusts have a permanent capital structure

One strength of an investment trust is that buying and selling shares has no effect on its portfolio, because the manager does not need to invest fresh cash or sell assets to fund redemptions. Having this permanent capital is important for investing in assets that can’t be sold quickly – infrastructure, private equity, real estate or small caps – or certain long-term investment strategies. On the other hand, the price that investors pay or receive for shares in a trust is the prevailing market price. This can be at a discount or a premium to the trust’s underlying net asset value (NAV) – the value of its assets minus its liabilities. There is no automatic mechanism for keeping them in line.

Conversely, an OEIC always trades at NAV, while the price of an ETF should also be very close to NAV because the authorised participants will quickly trade away any discount or premium. This makes them good for tracking an index or investing in liquid assets. You should be able to cash out your holding at full market value at any time.

Investment trusts help create long-term value

So ETFs and OEICs are simpler – but investment trusts offer more ways to boost returns. For example, if you buy a trust’s shares at a discount to NAV, this will amplify your gains if the discount shrinks on top of the underlying investment return. An unusually wide discount should reduce over time if performance is good, although this is not guaranteed. A trust can use share buybacks or tender offers to try to raise the price and close the discount faster, but this won’t always work. Sometimes discounts can last longer than expected because of weak demand among investors for a certain sector or style, or even investment trusts as a whole. Still, when a trust buys back shares at below their fundamental value, that should create value for its remaining investors over the long term.

And the long term is what trusts are about. A trust is a listed company whose role is to make investments. The investors are shareholders, with a board to look after their interests, and an external manager to run the portfolio. They have options that open-ended funds don’t have. They can borrow to buy extra assets up to a limit set by the board (often 20%). This gearing has the potential to increase returns, although it can also amplify losses. They can hold back some income to keep dividends steady. If returns are poor, they can replace the manager. And if weak performance or a wide discount persists, shareholders may vote to sell some assets and take back some capital, or wind up altogether. In short, it is a very different relationship with investors compared to OEICs – and, in MoneyWeek’s view, a solid basis for building wealth.

This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.