What are investment trusts?

Investment trusts have been around for 150 years with the aim of allowing savers to reduce the risk of investing by pooling their money with other investors and diversifying broadly in the stockmarket.

But despite this admirable goal, plus the fact they have a strong track record and generally carry low management costs, investment trusts are often dismissed by investors as being old-fashioned and lacking vim.

So what are these funds and should you be adding them to your portfolio?

Investment trusts are essentially stockmarket-listed companies set up purely to buy shares in other companies with the aim of protecting shareholders' capital, while delivering profit, and for many, paying dividends year after year.

First-time investors are normally directed to unit trusts or open-ended investment companies (OEICs) instead, but investment trusts, of which there are about 400 to choose from, offer similar attractions to these rival collective investments, even for the stockmarket novice with relatively little cash to invest.

Mick Gilligan, head of research at stockbroker Killik & Co, is a fan of investment trusts.

He says: "For the completely uninitiated, I would say they are a way of getting an instant portfolio, by buying just one share, of underlying companies.

"Therefore, you have diversification and it's very straightforward because you can buy the shares online through a platform or broker and buy and sell them at any time of the day."

Trading at a premium

The key difference between an investment trust and a standard fund is that they have a limited number of shares. The fund manager can buy and sell assets when he or she sees fit, not just when investors join or leave the fund, as with open-ended funds.

Gilligan says: "This means fund managers can take a longer-term view or buy less liquid assets."

Strong demand for shares does push up prices, however, which means an investment trust share can end up trading at a 'premium'. This means if you buy at this point you are paying a higher price than the value of the underlying investments.

Conversely, if an investment trust falls out of favour, it will normally trade at a 'discount', meaning the shares trade at less than the value of the assets, which can be a potential bargain for a buyer - as long as the discount later narrows.

For the completely uninitiated, I would say they are a way of getting an instant portfolio, by buying just one share, of underlying companies."Mick Gilligan

Gilligan believes one of the results of the Retail Distribution Review, which has banned commission to advisers, is that many will now recommend investment trusts as part of a portfolio.

Previously, unit trusts and OEICs got the lion's share of attention because fund managers paid commission to advisers who tipped them, but now they are on a more equal footing.

However, Gilligan says advisers tend to recommend the larger trusts, which means many are now trading at a premium.

He says: "At the other end, there are lots of very small investment trusts that have big discounts that might be good to look at."

His firm puts out a weekly email on the trusts that have attractive discounts they predict may narrow - as well as pointing out those at a premium that look a bit expensive.

Buying back shares

Trusts have the ability to take action if discounts widen dramatically, by buying back shares; similarly, they can issue more shares if premiums grow too large.

Another advantage they have over unit trusts is they can 'gear up' or borrow money to buy more shares in sectors they expect to do well. Borrowing this way can increase the returns for shareholders, but if the assets fall in value, it also increases the potential losses.

Since they are companies, investment trusts also have boards of directors, and these are useful for keeping an eye on the fund managers and their investment strategies.

They have the right to fire a fund manager who isn't performing. Plus, as an investor you also have the same ability as any shareholder in a company - whether it is Marks and Spencer or GlaxoSmithKline - to vote on issues such as director appointments or to attend the annual general meeting and make your views known.

Different investment trusts have different goals, so you need to select the one that meets your own objectives. Beginners often dip their toe in the water with 'generalist' funds, which are large, typically global funds invested in blue-chip shares.

I think the more specialist investment trusts can be useful additions to some portfolios and the large generalist trusts can offer reasonably low-cost diversified investing."Justin Modray

In the current low-interest-rate world, the hunt for income is pushing many investors towards the more income-oriented trusts, which are usually the giants of the industry that have been around for many decades.

Whichever one you pick, you can buy it just like a share through a stockbroker or online platform.

You can also hold them in a tax-efficient individual savings account (ISA) or a self-invested pension plan (SIPP), but there will be annual plan charges to consider.

Regular savings plan

Many of the funds also offer their own regular savings plans, which can be started direct with the manager with a low minimum investment, typically £500 for a lump sum and £20 to £50 for regular saving. Because these are shares, there is stamp duty of 0.5% on purchases.

Investment trusts often promote themselves as being lower cost than unit trusts - their annual management charges are often well under 1% compared to 1.5%-plus for unit trusts - but the gap is starting to narrow as unit trust groups wake up to the competition.

That said, investment trusts are also responding, with some reducing their fees.

Justin Modray, founder of financial website candidmoney.com, believes unit trusts should still be the first port of call for most novice investors, but he agrees investment trusts still have a role.

He says: "I think the more specialist investment trusts can be useful additions to some portfolios and the large generalist trusts can offer reasonably low-cost diversified investing."