Our first note in our investment trust series explained what investment trusts are. This note examines the types of investment trusts that are available.
‘While there are many excellent investment trusts investing in shares, the real area of growth for the sector over the past decade has been in alternative assets. Investors can now choose from a wide range of strategies, targeting growth or income, from specialist credit to private equity, infrastructure property.’ Sarah Godfrey, Edison investment companies analyst
How do we define an investment trust’s type?
There are several ways of looking at the different types of investment trust available, focusing on asset class, investment policy or management style.
Management style has a bearing on how a fund’s manager interacts with various market indices. Some fund managers may use active management to either try to beat an index like the FTSE 100, or to provide a consistently positive (absolute) return.
Others may passively track an index, replicating its holdings and performance to give investors broad exposure to that index. These index trackers – or index funds – are much more common in open-ended funds and there are currently no explicitly index-tracking investment trusts.
Fund managers who focus heavily on macroeconomic factors operate a ‘top down’ style of investment. Funds that rely on rigorous financial analysis and detailed knowledge of specific companies, rather than predictions born from macroeconomic factors, are said to use a ‘bottom up’ approach.
So, one way we define a trust is through its investment style, but we may also look particularly at what the trust decides to invest in. The majority of investment trusts still invest all or most of their assets in shares, whether in a single country, a region, or globally.
What assets beside shares do investment trusts invest in?
Some, though not many, investment trusts invest in bonds. Investors who buy bonds are lending money to a government or company in return for an income in the form of interest payments.
Until 2009 it was less tax-efficient for UK-domiciled investment trusts to hold bonds, as bond interest was taxable, whereas capital gains from shares within an investment trust’s portfolio were tax-exempt.
Although this is no longer the case, comparatively few mainstream fixed income funds use the investment trust structure, partly because investors are already well served by a large number of open-ended bond funds.
Many of the closed-ended funds that do invest in bonds were set up before 2009 in locations like the Channel Islands. Technically speaking, these funds are investment companies rather than investment trusts, because they are outside of the UK investment trust regime.
Because of the considerable choice of mainstream bond funds in the open-ended sector, those investment trusts and investment companies that invest in fixed income-type instruments tend to be more specialist. Fixed income-type instruments refer to debt-related assets like convertible bonds, asset-backed securities or senior secured loans.
What other assets do trusts commonly buy?
In addition to shares and bonds, the number of investment trusts and investment companies investing in ‘real’ assets, like commercial property and infrastructure projects, is growing.
Real assets are arguably better suited to the closed-end structure of investment trusts than the open-ended alternative.
This is because real assets, like office blocks or hospitals, often come with hefty price tags, and cannot be broken up effectively if investors wish to withdraw their money.
The illiquid nature of real assets make them somewhat risky, as, when asset classes are out of favour, the investment trust investor may only be able to sell their shares at a large discount to net asset value.
Why are investment trust structures better suited to real assets?
With an open-ended fund, the manager creates or liquidates units when investors want to buy or sell. When more investors want to sell than buy, the manager will have to sell some of the underlying assets in order to meet these redemptions. This is less of a problem if the fund invests in ‘liquid’ assets, like shares or bonds, which can be sold relatively easily and in small amounts.
However, closed-ended funds holding ‘illiquid’ assets, like an office building, often take a considerable time to sell these assets. If market conditions are unfavourable, the manager may therefore choose to limit investors’ ability to withdraw their funds, rather than being forced to accept a lower price than the asset is worth.
An investment trust has a fixed pool of capital, and its shares may be bought and sold in the market, independently of the underlying portfolio. So investment trust managers do not have to sell ‘real’ assets to pay back their investors like they do in open-ended funds.
However, the price of the investment trust’s shares will vary according to market sentiment. An investor who wants to sell their shares in unfavourable market conditions may have to accept a price that is some way below the value of the underlying assets. However, the value of the portfolio itself is unaffected by this.
What about trusts that invest in private equity?
Private equity refers to unlisted companies that are not quoted on a stock exchange, another ‘illiquid’ asset class where investment trusts are well represented.
Private equity ‘general partner’ funds typically have minimum investment levels of $1–10m,restricting access to sophisticated ‘limited partner’ investors, including pension funds, endowments, high net worth individuals and family offices.
These funds require long-term investment, because it may take several years for the private equity manager to put together a portfolio of attractive private companies in which to put the limited partners’ money to work.
Individual investors can get access to private equity investment through listed private equity funds, investment trusts or companies that invest either directly in private equity deals, or in portfolios of private equity funds (a ‘fund of funds’).
These listed private equity funds provide investors with simple, liquid access to private equity, addressing the accessibility and liquidity posed by direct private equity investments.
However, despite strong underlying performance (funds in the AIC Private Equity sector have on average produced double-digit annual gains over the past three, five and 10 years), most listed private equity funds trade at a wide discount to net asset value (NAV), often also in double digits.
What are split-capital trusts?
Split-capital trusts provide investors with a choice of share classes to match their needs. Split-capital trusts usually have a fixed life, and have at least two classes of share for investors to choose from.
These may include income shares, where investors receive all the dividends during the trust’s life, or zero-dividend preference shares (ZDPs), which have no entitlement to income during the trust’s life, but pay out a predetermined value at maturity.
Capital shares generally pay no income but entitle holders to all remaining assets once other shareholders have been paid back: these are more risky as there is no guarantee that any assets will remain.
Split-capital trusts were embroiled in a crisis in 2001, as a result of several trusts having invested heavily in each other, leading to a spiral of collapsing values as markets fell. Many of these trusts – particularly those offering ZDPs, which up to that point had never failed to meet their final capital entitlement – were sold to investors as low-risk investments.
The crisis was a reputational blow both for the advisers who recommended them and the investment trust industry. Today, there are comparatively few split-capital trusts in existence, but those that there are, continue to offer investors a useful element of choice over how they receive their returns.
