What are investment trusts and their benefits?

Investment companies (often known as investment trusts) are a type of fund.

Listed on a stock exchange

One of the unique features of investment companies is that they are public limited companies (plcs). Their shares are listed on a stock exchange just like those of any other public company and you invest in investment companies by buying and selling their shares.

Investment companies can be listed on one of several stock exchanges but if you’re a UK investor, you’ll find most of them on the London Stock Exchange.

Closed-ended structure

Investment companies are known as closed-ended, as opposed to unit trusts which are open-ended. What’s meant by investment companies being closed-ended is that they have a fixed number of shares in issue at any one time. You invest in an investment company by buying the shares from another investor on the stock market. Similarly, when you want to sell your shares, you sell them to another investor.

In contrast, open-ended funds expand or contract depending on demand as investors move their money in and out of the fund. This means open-ended funds have to be ready to give investors their money back at any time. So they normally invest only in assets which can be sold very quickly.

Because investment companies are closed-ended, they don’t have to deal with these inflows and outflows of money. This allows them to invest in assets which can be hard to buy and sell like infrastructure, private companies or property, with the potential to deliver better long-term returns or higher levels of income. It also enables investment company managers to make long-term investment decisions as they don’t have to buy and sell investments based on investors moving money into or out of the fund.

Share prices

When you invest in an investment company you buy its shares on the stock market. There a few different ways that share prices can be shown.

The price you buy shares for is higher than the price you sell shares for. The buying price is called the ‘offer’ price. The selling price is called the ‘bid’ price.

The difference between these two prices is called the ‘bid-offer spread’.

Discounts and premiums

There are two ways that the value of a share in an investment company is often expressed:

• The share price – the price you actually buy and sell at.
• The net asset value per share (NAV) – the value of the investment company’s assets, divided by the number of shares.

The NAV of a share is the value of all the investment company’s assets, less liabilities such as any debt, divided by the number of shares. However, because investment company shares are bought and sold on the stock market, the share price is affected by supply and demand, so it might be higher or lower than the NAV. The difference is known as a discount or premium.

• Buying shares at a discount means you pay less than the NAV.
• Buying at a premium means you pay more than the NAV. 

When an investment company trades at a discount, it can be a good opportunity to buy. However, you shouldn’t assume that buying at a discount is automatically a good thing. The price of investment company shares depends on a whole range of things, including the sentiment towards the investment company, its investment strategy and the type of investments it holds. There may be a good reason why it is trading at a discount.

When the discount changes

If you invest in an investment company it should be for the long term, so changes in the discount shouldn’t make too much difference – but it’s worth understanding nevertheless.

• If you buy at a discount and the share price rises more than the NAV, narrowing the discount, you’ll get a better return than the NAV.
• If the discount widens, for example by the NAV rising faster than the share price, you won’t get as good a return as the NAV but you won’t necessarily make a loss.
• If the discount widens as the share price and the NAV are both falling, you will lose more than the fall in the NAV.
  
  

Boards of directors

Because investment companies are public limited companies (plcs), they have independent boards of directors, just like any other plc. The directors’ duty is to look after your interests as an investor, by ensuring the company is as successful as possible.

The directors meet several times a year and monitor the company’s performance. They answer to the shareholders, which means you have some say in how the company is run.

Shareholder democracy

When you buy a share in an investment company you become a shareholder. Shareholders in investment companies have the same rights as other shareholders in other companies.

Shareholders can:

• Vote on issues at the company’s annual general meeting (AGM).
• Table motions to be discussed.
• Call for extraordinary general meetings (EGMs).
• Vote in new directors if they are not happy with the current ones.

In other collective investments, you don’t have as much of a say in how the fund is run.

Gearing

Investment companies, being companies, can borrow money to make additional investments. This is called ‘gearing’. It lets the company take advantage of a long-term plan or a particularly attractive stock without having to sell existing investments.

The idea is that the additional investment makes enough money to pay off the loan (including interest) and make a profit on top of that. If it works, the more the company borrows, the more profit it makes. If the investment fails, the more the company borrows, the more it loses. So the more an investment company borrows the more risky it is.

Investment companies can usually borrow at lower rates of interest than you’d get as an individual. They also have flexible ways to borrow – for example they might get an ordinary bank loan, or issue preference shares.

Not all investment companies use gearing. Many of those that do use modest levels. It’s a decision taken by the fund manager and the board of directors. The gearing policy of the company may change from time to time. It’s regularly reviewed by the board and manager.

While all gearing adds risk, being able to gear is an advantage investment companies have over other kinds of fund, such as unit trusts, which are not permitted to do it.