The image of investment trusts as dated and inaccessible fails to do them justice, as investors are increasingly discovering. By Ellie Duncan and Tom Higgins.
Open-ended funds have often been the default choice for many UK investors over the years, but in 2021, investors gave a vote of confidence to investment trusts, resulting in industry assets in the UK reaching a record £277.6 billion (€333 billion).
This followed a record fundraising in 2021 that reached £15.1 billion of new money. The previous high was in 2014, when £10.2 billion was raised.
These figures from the Association of Investment Companies’ (AIC) paint a picture of a vessel that’s in vogue among investors – a far cry from the old image of investment trusts as complex, inaccessible and obscure.
In the past ten years, total assets in the sector have increased by more than two-and-a-half times, the AIC says. Yet despite their surging popularity at the moment, investment trusts are rooted in history. Some of them are centuries old.
With that timeframe in mind, you’d be forgiven for thinking that investment trusts are archaic or utilise dated investment principles. In reality, investors have begun to realise that the structure of investment trusts makes them a dependable source of income, offering exposure to illiquid assets and alternative opportunities while also competing with regular investment funds on fees.
Investment trusts, sometimes known as closed-ended funds, fundamentally work in the same way as open-ended funds in that they pool together investors’ capital and seek to grow it. Yet there are key differences in the pricing, structure and sales of closed and open-ended funds.
When an investor buys into an open-ended fund, new shares are created and are retained by the investor until they decide to sell them back. A closed-ended fund differs in that only a set number of shares can be issued. These are then traded on an exchange, much like any other business.
For investors, this pivotal difference can be used to help generate returns.
Steve Hunter, head of business development at Momentum Global Investment Management, says the closed nature of trusts may be their most valuable credential.
He says that having a fixed amount of capital and being able to issue only a pre-agreed and limited number of shares means that the structure is ideal for less liquid investments such as infrastructure and property projects where the assets are difficult to sell.
“Additionally, the structure allows trusts to borrow or ‘gear up’, on a pre-agreed limited basis, against its investment capital to invest further into projects with a view to boosting overall returns for investors over and above the cost of this capital,” says Hunter.
This provides a distinct advantage over open-ended funds, as trusts can capitalise on a positive situation with a particular stock or market trend without having to offload existing investments to raise capital. In contrast, the borrowing powers of open-ended funds are more limited.
Structural differences permeate to the highest levels of the business. Trusts are companies, and as such have their own board of directors, voted for by shareholders, who set the strategy for the investment and work with the appointed investment team to deliver for investors.
Hunter explains: “As with any board, they are key in the reporting and monitoring of progress. This addition can be extremely useful both in governance and in adding an extra layer of independence for investor protection.”
The parallels between investment trusts and companies go as far as to place shareholders [a trust’s investors] “at their heart”, adds Hunter. By their very nature, trusts can “change and adapt to both market and shareholder demands”.
This sense of longevity is evidenced through continued adaptability and performance, he says, and the tenet of flexibility to changing market trends “will very much be a continued factor” in how investors view and use trusts.
In particular, investors can use trusts to react to changing market forces, says Hunter. “With inflation on the rise, savvy investors are naturally looking broader than the traditional assets of equity and fixed income and more towards the alternative space in infrastructure, specialist property, private equity and specialist financial, which could encompass anything from music royalty investments to private loans. Investment trusts are often ideal vehicles to access these elements.”
As well as liquidity benefits, investment trusts have the ability to hold back reserves to ensure a more stable dividend profile for those that pay them, says Nick Wood, head of fund research at Quilter Cheviot.
Each year, an investment trust is permitted to retain up to 15% of the income earned from its portfolio in its revenue reserve. This perk became apparent in the UK equity income category in 2020, Wood says, as trusts were largely able to keep dividends at similar levels or even increase them, as was the case with dividend ‘heroes’ such as the City of London trust.
“Open-ended funds, however, do not have this benefit and they were much more impacted by the onset of the pandemic and the cancellation or suspension of many company dividends that have become a feature of markets such as in the UK,” he says.
The types of investment available through a trust may be what interests investors the most. However, Wood says the presence of an independent board is a key advantage of closed-ended over open-ended structures.
A well-rounded board might comprise investment and business managers, finance officers, risk and compliance leads, and sales and marketing executives.
“When a trust is struggling due to either weak management or changing preferences from the market, the board can make changes in the way the trust is run, including by appointing a new investment manager or changing the investment objective.
“The board is there to act in the interests of shareholders and are independent. That includes potentially changing the manager, acting when there is an excessive discount or premium, and setting the parameters under which the investment managers must manage. Ultimately it is the board who is responsible for the performance of the trust and if it is not as expected or desired, they are well within their right to make a change in management,” he says.
These boards are also growing to become more inclusive and representative of investors. Research by Investec’s biannual ‘Skin in the Game’ report found that 34.5% of investment trust directorships are held by women. In comparison, only 8% of the roles were held by women in 2010.
Acting in the interests of shareholders also entails getting the best deal, says Annabel Brodie-Smith, communications director at the AIC. She points towards eight investment companies that have already reduced their management fees.
“This included the well-known big global equity income company, Murray International, which has £1.75 billion of assets. The company has reduced its tiered management fee to 0.5% per year up to £500 million of net assets and 0.4% per year of net assets above £500 million.”
Brodie-Smith says that arrangements like this, known as a tiered fee, mean that as the company increases in size, “the fee decreases, so shareholders benefit from the economies of scale”.
Spectre of inflation
If investors continue to seek diversification through alternative assets, then there may be an opportunity to make the most of the investment trust structure by gaining exposure to illiquid and alternative assets as inflation rises.
Brodie-Smith says: “In the current inflationary environment, investment companies investing in assets like infrastructure or property can offer an income contractually linked to inflation. The infrastructure sector currently has an attractive, relatively stable yield of 4.6% and is highly rated, trading on a 11% premium.”
She adds that demand for such investments is likely to continue further into 2022.
“We have already seen existing alternative investment companies raising money – Cordiant Digital, which invests in digital infrastructure, the ‘plumbing’ of the internet, recently raised £200 million,” she says.
Investment trusts are also increasingly affording shareholders with ESG exposure alongside inflation-hedging measures, with sustainable investing fast becoming a “key factor” for investment trusts, according to Hunter. “Many of the drivers for change lie in significant infrastructure projects such as renewable energy and energy storage as we journey towards a zero-carbon goal,” he says.
Ten years ago, assets in ESG investment trusts totalled £378 million, but at the end of 2021, the figure stood at £20.93 billion – a 55-fold increase, notes Brodie-Smith. “Investment companies’ suitability for hard-to-sell assets like renewable energy, social housing or social enterprises makes them highly appropriate for investing in environmental or social impact strategies,” she adds.
Based on this, it’s possible to assume investment trusts represent a superior option versus open-ended funds, but both aren’t without their benefits and drawbacks.
Fundamentally, investment trusts are more volatile “due to their ability to go to discount or premium” says Wood – but if this, along with its other qualities, align with an investor’s profile, then it may be a suitable approach to take.
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