Revealing the mystery of investment trusts

Cash savings have their limitations. For a realistic chance of generating an income from your capital – especially in retirement – your adviser may recommend investing on the stock market. Investment trusts are one way to go about this – but what are they, and how do they work?

An investment trust is a type of collective vehicle for – you guessed it – investing. It will be a listed company (with shares quoted on the UK Stock Exchange) and this company will do business by investing in the shares of other companies, securities, property and other assets. If it performs well at this, then its own share price should rise accordingly (and vice versa) – but see below for why it’s more complex than this in practice.

As an investor, you can benefit from the investment trust’s performance by buying shares in the company. The number of shares will be limited, and shareholders’ interests will be looked after by the trust’s independent board of directors – as with any listed company. The board will also appoint an investment manager to manage the underlying investments, again in the sole interests of the shareholders.

Discount or premium? Understanding investment trusts

As a quoted company, the share price of an investment trust depends on more than just the value of its underlying assets – its ‘net asset value’. The share price also depends on another key factor: the supply and demand for its shares on the stock market.

When the market price of the trust’s shares is less than its net asset value (NAV), it is said to be trading at a discount. However, if its share price is higher than the underlying stock market value of the trust, it is trading at a premium.

Being able to ‘trade at a discount’ is one of the main advantages of investment trusts. This gives you, as an investor, the chance to magnify your profits. For example, if you buy a trust when the discount is big and then sell when it narrows (or is trading at a premium) then your returns will be boosted accordingly.

Of course, if you get this transaction wrong (buying wide only for the discount to increase) you will lose out. As you can see, this aspect of investment trusts brings additional risk as well as opportunity, so it is important to understand the discount/premium concept before you consider investing.

Some investment trusts trade at a premium consistently. This can be for a number of reasons for this. For example, the trust may have few shares in issue, or be very popular, or may offer a unique underlying investment portfolio. Some trusts can also control the level of discount and premium at which their shares trade, to try and protect investors. You should thoroughly investigate any investment trust that interests you as to how they manage discount and premium trading.

How investment trusts use gearing

There is another aspect of investment trusts that sets them apart from other vehicles (e.g. unit trusts). Investment trusts are able to borrow money to buy more shares, whereas unit trusts cannot. If confident in his choice of investments, a manager may use this borrowing (also know as ‘gearing’) to buy extra investments which could make a greater return than the cost of the borrowing. This kind of strategy is often seen in rising markets. Of course, there is inherent risk here too: just as gearing is a blessing in a rising market, it can do a lot of damage in a falling one.

For this reason, not all investment trusts will use gearing. Those that do use it will have strict controls in place on how much they can borrow.

Dividends: how investments trusts can be a good source of income

One of the biggest attractions of investment trusts is their potential as a source of retirement income. Most investment trusts pay dividends to their shareholders, and some maintain reserve accounts in order to sustain or increase the level of these pay-outs every year. If you can find a trust that does this, then you can potentially increase your income from it annually even if the actual share price falls – because what matters (from an income point of view) is the dividend, which is paid per share you own.

Alternatively, instead of being used as income, dividends can be re-invested in the trust to deliver growth in the capital sum – again, sometime even when the actual share price falls. For this reason they may also be an option for building up a pension prior to retirement – perhaps as one component of a self-invested personal pension (SIPP).

Why consider an investment trust in retirement?

With interest rates at all-time lows, it has become harder than ever to use savings to deliver meaningful returns. If you have capital to invest, and are looking for a way to generate an income that is greater than cash deposits, an investment trust may be something to consider. Furthermore, the payment of dividends has the potential to generate income for you even when the share price is falling – however, you need to find the right investment trust to achieve this.

Do also bear in mind the other caveats outlined here: with the potential for greater growth comes the associated risk of your investment losing value in the short-term. You should therefore talk to your financial adviser about whether an investment trust is suitable for you. Your adviser can also find the most appropriate trusts to choose from, and advise you on how much of your money you should invest.