What are investment trusts and how to invest in them?

What are investment trusts?

Investment trusts are collective investment vehicles that pool money from multiple investors to purchase a diversified portfolio of assets. Unlike their more common cousins (unit trusts and open-ended investment companies), investment trusts are structured as public limited companies listed on stock exchanges.

When you invest in an investment trust, you're buying shares in a company whose business is investing in other assets. These assets might include stocks, bonds, property or alternative investments like infrastructure projects or renewable energy assets.

The trust employs professional fund managers who make decisions about which investments to buy and sell, aiming to generate returns for shareholders through capital growth and income.

The closed-ended structure means investment trusts issue a fixed number of shares at launch. While shares can be bought and sold on the stock exchange, the trust itself doesn't create new shares every time an investor wants to buy in, nor does it cancel shares when investors want to exit. This creates a market-driven pricing mechanism where shares can trade at a premium or discount to the underlying net asset value of the portfolio.

How investment trusts differ from other funds

The closed-ended nature of investment trusts creates distinctive characteristics that set them apart from open-ended funds.

Open-ended funds like unit trusts continuously issue and cancel units based on investor demand. When money flows in, they create new units and must invest that cash immediately, and when investors redeem their holdings, the fund must sell assets to return their money. This can force fund managers to make suboptimal decisions, selling promising investments during market downturns or holding excess cash during periods of strong inflows.

Investment trusts are not constrained in the same way. Their fixed share structure means fund managers never need to sell investments to meet redemptions or rush to deploy incoming cash.

They can take a truly long-term view, holding positions through market volatility and waiting patiently for their investment thesis to play out. This structural advantage becomes particularly valuable during market stress when open-ended funds may be forced sellers at precisely the wrong time.

Investment trusts can also employ gearing, which involves borrowing money to invest beyond their shareholders' capital. When deployed during rising markets, gearing amplifies returns. However, potential losses are correspondingly magnified when markets fall, adding an extra layer of risk.

Why invest in investment trusts?

Investment trusts offer several advantages that have made them popular with both institutional and individual investors for over 150 years. Given just how many financial products now exist, the structure's longevity itself speaks to its enduring appeal.

The ability to take a genuinely long-term perspective is perhaps the most significant advantage. Fund managers can invest in illiquid assets, turnaround situations or emerging opportunities that might take years to reach their full potential. They don’t need to worry about maintaining liquidity reserves to meet redemptions, allowing them to remain fully invested in their chosen strategy.

This can lead to superior performance over time, particularly in less efficient markets where patience earns a premium.

Many investment trusts have established exceptional dividend records, with some having increased their dividends annually for decades. They can achieve this consistency by retaining up to 15% of income received each year in reserves, smoothing out the inevitable fluctuations in underlying income.

During the lean years, they can draw on these reserves to maintain or even increase dividends, providing reliable income streams for investors regardless of short-term market conditions.

The ability to trade at discounts to net asset value creates opportunities for astute investors. When sentiment turns negative or a trust falls out of favour, shares might trade 10%, 15% or even 20% below the value of underlying holdings. Patient investors who buy at these discounts can benefit from both the portfolio's performance and the potential narrowing of the discount over time, creating a dual source of returns.

Understanding premiums and discounts

The relationship between an investment trust's share price and its net asset value (NAV) is the most important concept to grasp, as it creates opportunities and risks that don't exist with open-ended funds.

Net asset value per share represents the total value of all investments held by the trust, minus any debts, divided by the number of shares in issue. If you could liquidate the trust today, selling every holding at current market prices and paying off all liabilities, each shareholder would theoretically receive this amount.

However, the market price of shares rarely matches this figure exactly.

When shares trade above net asset value, they're said to trade at a premium. Investors are paying more than the underlying holdings are worth, typically because they expect strong future performance, value the manager's expertise or want exposure to a scarce asset class. Premiums often emerge for trusts focused on hard to access markets (such as emerging or private markets) or those with stellar long-term track records.

Conversely, discounts occur when shares trade below net asset value. This might reflect poor recent performance, concerns about the trust's strategy, changes in investor sentiment toward the asset class or simply a lack of market awareness. Discounts can widen and narrow based on market conditions, creating volatility beyond that of the underlying portfolio.

Buying a quality trust at a wide discount can provide downside protection and improved return potential, while purchasing at a premium requires confidence that future performance will justify paying above asset value. It’s worth noting though that a wide discount may well be justified and could deepen.

Types of investment trusts available

The investment trust universe is diverse, with a range of strategies and asset classes offering investors access to every corner of the global market:

1. Equity income trusts — focus on generating reliable income streams from dividend paying stocks, often blue chip companies. These trusts appeal to investors seeking regular income alongside potential capital growth, with many boasting multi-decade records of annual dividend increases.
2. Growth-oriented trusts — prioritise capital appreciation over income, investing in companies expected to deliver above average earnings growth. These might focus on specific themes like tech, healthcare breakthroughs or emerging consumer trends. Some concentrate on particular regions like Asia Pacific or Latin America, while others invest globally.
3. Alternative asset trusts — have proliferated in recent years, offering exposure to infrastructure projects, renewable energy installations, private equity, debt investments and property portfolios. These trusts provide access to asset classes typically reserved for institutional investors.
4. Specialist trusts — focus on niche areas like biotechs, natural resources or specific sectors. While potentially more volatile, these can offer explosive growth when their chosen sector performs well. Some trusts employ complex strategies using derivatives, while others take activist approaches.

Start investing in investment trusts

Investing in investment trusts requires less capital than many investors assume. The process involves several straightforward steps that mirror investing in individual stocks.

First, you'll need to open an investing account. Then, research, which forms the foundation of any successful investment trust selection. Examine the trust's investment objective, strategy and the asset classes it invests in. Review the fund manager's track record, considering both absolute returns and performance relative to benchmarks and peers.

Analyse the trust's current premium or discount, dividend history if income matters to you and ongoing charges. The Association of Investment Companies is an excellent resource, as it provides comprehensive data on all investment trusts, making comparisons straightforward.

Consider how each trust fits within your broader portfolio. Investment trusts might complement your existing holdings rather than duplicate them. Think about your timeline, risk tolerance and whether you're prioritising income, growth or a combination of the two. Diversifying across different trusts investing in various asset classes and regions typically provides better risk-adjusted returns than concentrating in a single area.

Once you've selected your trusts, simply search for it on our platform. You can buy at market price for immediate execution or set a limit order to purchase only if its shares reach your target price. Many investors start with a single trust to understand how they work before gradually building a diversified portfolio.

Pros and cons of investment trusts

As with all financial products, investment funds have their own unique advantages and drawbacks.

Pros of investment trusts

• Long-term focus — managers can invest patiently without worrying about redemptions, allowing them to hold illiquid assets and ride out short-term volatility for potentially superior long-term returns
• Ability to use gearing — borrowing to invest can amplify returns during rising markets, providing a better performance compared to ungeared alternatives
• Dividend consistency — revenue reserves allow trusts to maintain or grow dividends even when underlying income fluctuates, creating reliable income streams ideal for pensioners
• Discount opportunities — buying quality trusts at discounts to net asset value provides a margin of safety and a dual return potential, from both portfolio performance and the discount narrowing
• Access to specialist assets — investment trusts offer exposure to private equity, infrastructure, debt investments and other alternative assets typically unavailable to individual investors
• Independent oversight — boards of directors provide governance and scrutiny of management performance, acting on the behalf of shareholders' interests
• No dilution from inflows — unlike open-ended funds, strong performance doesn't force managers to deploy sudden cash inflows, preserving portfolio quality and strategy integrity

Cons of investment trusts

• Discount volatility — share prices can fall below net asset value and discounts can widen, causing losses even when the underlying portfolio performs well
• Gearing risk — borrowing magnifies losses during market downturns and creates ongoing interest costs that must be paid regardless of performance
• Complexity — understanding premiums, discounts, gearing levels and their implications requires more sophistication than investing in simpler open-ended funds
• Trading costs — buying and selling incurs broker commissions and bid-ask spreads, making frequent trading expensive compared to switching between open-ended funds
• Limited liquidity — smaller or specialist trusts may have low trading volumes, making it difficult to buy or sell significant positions without affecting the price
• Higher ongoing charges — investment trusts often have higher expense ratios than passive index funds or ETFs, particularly for specialist strategies
• Market price volatility – trading on exchanges means prices fluctuate throughout the day based on supply and demand, creating additional volatility beyond portfolio movements
• Performance risk — active management doesn't guarantee outperformance, and many trusts underperform their benchmarks after fees

Investment trusts summed up

• Investment trusts are closed-ended companies listed on stock exchanges, giving fund managers the flexibility to take long-term positions without worrying about investor redemptions forcing asset sales
• Their share prices can trade at premiums or discounts to net asset value, creating both opportunities to buy quality portfolios cheaply and risks that discounts may widen even when underlying investments perform well
• Unique features like gearing and revenue reserves enable investment trusts to potentially amplify returns and smooth dividend payments, but gearing also magnifies losses during market downturns
• With access to everything from global equities to alternative assets like infrastructure and private equity, investment trusts offer portfolio building blocks for investors willing to understand their additional complexities