Analysing... Investment trusts

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The investment trust movement is a venerable one, with the oldest ones having started life in the 19th century, many of them set up by Scottish solicitors and accountants for the purpose of investing client funds abroad in a safe diversified way.

Later on they were listed on the stockmarket and marketed to the public at large. While there have been some stumbles along the way - notably with some of the more highly geared variants of the genre - they have on the whole done a good job for their investors.

Before looking at how to analyse products like this, we need to look at the purpose they should serve. In the first place, a relevant question is perhaps whether many of them serve a purpose at all, in an era when it is simplicity itself to buy an exchange traded fund (ETF) that tracks an index, which has low fees, no gearing and no issues over manager performance to worry about.

However, many trusts offer a quirkier exposure than indices, and there is no doubt that a number of trust managers have the knack of producing solid investment performance on a regular basis. The argument in favour of investment trusts, just as in some ways it is for unit trusts and OEICs, is that they can get you exposure to corners of the market that an ETF would not normally reach. But that argument is getting harder to justify as time goes on, more index variants are created and more ETFs are set up.

Looming large over decisions as to whether to buy investment trusts is the question of the discount or premium to net asset value at which they sell. Investment trusts are 'closed-end' funds. In effect they start life with a fixed amount of money and a set number of shares in issue.

For more on what they offer you, visit our focus on investment trusts.

The basic yardstick for an investment trust is net asset value (NAV). This is the value of the portfolio, after deducting expenses and minus any liabilities, divided by the number of shares in issue. This gives a per share figure for NAV, which can be compared with the share price.

Frequently trusts sell at a discount to NAV, for the same reason that investment holding companies and conglomerates do: the management of the portfolio is indirect and an allowance for risk has therefore to be factored in. This usually manifests itself in the shares standing at a discount. The better the manager, the lower the discount. Some trusts even stand at a premium to NAV, albeit rarely.

Discounts vary throughout the stockmarket cycle as well. In bull markets, investment trust discounts tend to narrow and even disappear entirely: in bear markets they widen. Catch a trust on a big discount at the start of a bull market and you get double whammy effect on performance; the portfolio, and hence NAV, rises in value, and the discount narrows too, producing a turbocharged share price.

The level of discount also reflects the market's view of the trust's manager, his or her historic performance, and whether or not they can continue to deliver.

Another factor to watch is the level of gearing within the trust. Investment trusts are allowed to borrow, but gearing has the effect of magnifying both gains and losses in the portfolio, producing a potentially more volatile course for NAV.

What this means is that investing trusts can become an exercise in balancing several different types of risk: the risk that the market as a whole will rise or fall; how the trust's portfolio will perform against the market; the level of the discount and where it might be heading; whether the manager's past track record can be replicated in the future; and the element of extra volatility or risk inherent in the trust's gearing.

All of these factors can be quantified with relative ease, although judgments do need to be made over the quality of the manager and what importance to place on each factor. But many investment trust investors use them because they want a 'file and forget' type of investment that will simply compensate for their own lack of investment expertise.

Sometimes this is not quite what they get. Arguably, although investment trust investors will likely participate in a reasonably diversified portfolio, a host of other variables can affect the subsequent performance of the trust's shares.

Peter says

I like the concept of investment trusts, and many private investors are attracted to them as well, partly because of the ease of investment, through savings schemes and the like. But this should not, in my view, obscure the fact that there are more variables, and hence risk elements, to take into account than many trust investors may expect.

This is one reason, I suspect, for the growing popularity of exchange traded funds, in which you have fewer of these variables to deal with. With an ETF, what you see is what you get. Index-tracking performance, low fees, and no other factors to worry about.

Investing in a trust requires investors to be capable of getting to grips with the nuances involved, which are more complicated than they might appear at first sight. They are not necessarily for the inexperienced.