A matter of trust

The average investment trust has returned 33 per cent more than its unit trust counterpart over the past five years. Sonia Speedy ponders whether advisers should be looking more closely at the asset class

Investment trusts do offer attractive characteristics. Factors such as not paying commission and having an independent board of directors to help keep running expenses low means that costs are often significantly less than in unit trusts or Oeics.

Adrian Shandley, managing director of Premier Wealth Management, says the ongoing management charges on investment trusts are often at least 0.5 per cent cheaper.

But even with IFAs moving towards more fee-based business models, many advisers believe investment trusts will continue to struggle against their open-ended counterparts.

Yet the ability to make use of gearing means that in strong markets, good returns can be amplified, making investment trusts strong performers in favourable markets.

Because investment trusts are companies, the independent board of directors adds an extra tier of corporate governance while the status of a quoted company brings added regulatory requirements.

Shandley points out that the investment trust structure has other benefits too, such as the ability for the independent board to fire underperforming fund managers, while the managers themselves do not have to deal with the vagaries of fund flows.

He says: “When markets are bad, the fund manager of the investment trust does not have to sell good investments to liquidate holdings to be able to pay redeeming investors.”

According to the Association of Investment Companies (AIC), there are currently 316 investment trusts in the UK, including offshore closed-ended investment companies. Together they have assets worth £95bn, up from £73.6bn in December 2005.

AIC figures also show that a £100 lump sum invested in the average investment trust returned £231.94 over the five years to July compared with the average unit trust’s £173.

Last year, the AIC changed its name from the Association of Investment Trust Companies to the Association of Investment Companies to reflect the changing investment company universe and encompass offshore-domiciled investment companies, which are not technically investment trusts but often thought of as such.

Similarly, it extended its membership to include Aim-listed investment companies that have the principal purpose of delivering returns via a diversified investment portfolio.

James Saunders Watson, head of sales and marketing for investment trusts JP Morgan Asset Management, says investment trusts offer advisers good long-term returns and solutions that they may not be able to find in the open-ended marketplace, such as in the specialist investment arena.

“The investment trust is an extremely cost-efficient, clean, long-term investment vehicle,” he says.

But investment trusts do have complicating factors, including the fact that the price investment trust shares trade at does not directly reflect the underlying value of the investment. Likewise, use of gearing adds to risk levels.

Patrick Connolly, certified financial planner at JS&P Towry Law, says that despite its firm being entirely fee-based, it does not make use of investment trusts for three reasons.

“One is the discount and the premium effect – the fact that the price of them is reliant on demand and supply rather than the underlying assets.

“Two is the gearing, which creates more risk and our investment philosophy is all about managing risk within our client portfolios.”

But the third reason is particularly important to JS&P Towry Law. Managing around £1.7bn of funds on a discretionary basis, liquidity is important for the firm.

Connolly says: “If we go in and out of a fund, we will go in and out with millions of pounds at a time. With unit trusts or Oeics, it’s easy to buy them – they create more units. When you sell them, they cancel your units so liquidity for us on the unit trust side is not such a big issue.

“With an investment trust, if we want to buy £10m of a particular trust, we have to find someone who is willing to sell £10m and on the same basis if we need to sell £10m we need to find someone who is willing to buy £10m. For us, that causes too big an issue.”

One of the main reasons why the investment trust sector has achieved fewer inflows than unit trusts is the fact that they do not pay commission to intermediaries.

So does the trend towards fees present a new opportunity for the asset class?

Connolly does not predict that the advice industry’s move away from commission towards fees will bolster adviser’s appetite for investment trusts. “I would agree that we are moving more towards a fee-based world but I think we are a long time yet before the vast majority of IFAs get there. Those that get there quicker will still largely be relying on renewal commission and calling them fees,” he says.

However, some investment trust supporters believe the move towards fee-based advice does present an oppor- tunity for bolstering investment trust popularity.

Alan Steel Asset Management also makes limited use of investment trusts despite being predominantly fee-based. “If we’re doing a really diversified portfolio, we’ll maybe have one or two but the bulk of it will be unit trusts rather than investment trusts,” says Alan Adam, a financial consultant with the firm.

The firm sees the potential for investment trusts to be trading at a discount when a client goes to sell as a downside but particularly highlights the risks associated with gearing.

“Most people who go into equity-type investments appreciate they are going into a risky investment anyway. Sometimes with gearing, they are often not aware that the risk profile could be increased quite dramatically by what it’s doing,” Adam says.

But Saunders Watson argues that the potential for investment trusts to sell at a discount offers opportunities. “It’s quite nice to be able to buy £1 of assets for 90p and that’s what the discount enables you to do,” he says.

He also says managers are now more sensitive to discount volatility, with companies introducing discount control mechanisms to help dampen down volatility levels.

Job Curtis, value and income team director at Henderson Global Investors, says it is easy to find discounts on good quality investment trusts of around 10 per cent. “As long as you’ve got that happening with the same manager managing an open-ended product, it would be intelligent to favour the close-ended product because you are buying 100p of assets for 90p,” he says.

Curtis says discounts did rise across the sector in May and June. However, investment trust shares have not done as badly as the underlying assets during the more serious recent market correction seen in July and August. Indeed, the average investment company discount has barely moved over the last three months and was sitting at 7.3 per cent at the end of August.

While investment trusts may not be as straightforward as other collective investment vehicles and require advisers to stay well abreast of the market, they can offer useful opportunities for those advising high-net-worth clients n Bristol-based IFA Whitechurch Securities is a strong exponent of the use of investment trusts within managed client portfolios, including the use of controversial split-capital investment trusts (split-caps).

Gavin Haynes, managing director, says investment trusts are “no better or worse” than open-ended funds but simply offer different characteristics.

“They can provide an added level of diversification and access to some interesting areas of the stockmarket,” he says.

Haynes says split-caps are an area many advisers will not consider, even though it is a valid concept. The split-cap scandal early this decade – which saw some investment trust companies employing excessive gearing and cross-holdings between different trusts – had badly tarnished the sector.

But Haynes believes there is still a place for split-caps with simple structures and good quality portfolios and Whitechurch invests in zero-dividend preference shares as a core part of its stockmarket strategy.

“We continue to believe that higher quality, lower-risk blue-chip zero- dividend preference shares are well positioned to achieve realistic and sustainable returns, with stockmarkets trading on historically cheap valuations.

“Our view at present is that there are zero holdings looking good value on a risk/reward basis. However, we do not consider the zero sector as low risk.”

Haynes says good quality zeros are offering potential returns of 7-8 per cent compound annual growth.

“This appears attractive in an environment of 2.5 per cent inflation. I believe that these zeros have a place in balanced client portfolios that are seeking capital growth in conjunction with moderate stockmarket risk.

“The zeros chosen will be very high quality with a transparent portfolio focused on the UK equity market and we will avoid trusts that are highly geared and those that have a large percentage of their portfolio invested in other trusts.”

How investment trusts differ from unit trusts

  • Although a similar unit trust and investment trust can look almost identical, the structure behind it is quite different.
  • Investment trusts are quoted companies and have a fixed number of shares regardless of demand. As a result, these shares can trade at a premium or a discount to net asset value. Unit trusts are not companies.
  • An independent board of directors oversees an investment trust, unit trusts do not have such a board.
  • Investment trusts can make greater use of gearing.
  • Investment trusts are typically cheaper than similar unit trust offerings.