Funds: Keep an open mind over closed funds

Investment trusts have been making money for investors for almost a century and a half. Yet, in recent times, they have struggled to contend with the larger and faster-growing unit trust and open-ended investment company (Oeic) markets, which now offer investors much more choice. If you want to invest in a straightforward UK growth fund, for example, there are now more than 300 unit trusts and Oeics to choose from. In the investment trust universe, there's fewer than 30.

Yet there are still a loyal few who believe that investment trusts offer investors a much better deal. They're often cheaper than open-ended funds; they have slightly more investment flexibility; and they each have their own board, in order to ensure that investors' money is being managed responsibly.

Here, we demystify the confusing world of investment trusts and explore whether they really are better than their more popular competitors.

What are investment trusts?

Like unit trusts and Oeics, investment trusts are mutual funds, managed by a professional fund manager. Unlike unit trusts and Oeics, however, investment trusts are "closed-ended", which means that the fund manager has a fixed pot of money to manage, rather than having to deal with regular inflows and outflows from his fund.

So, while investors in unit trusts literally hand their money to the fund manager to invest, investors in investment trusts simply buy shares in the fund. The share price then tends to move broadly in line with the underlying performance the fund manager achieves.

Annabel Brodie-Smith, head of communications at the Association of Investment Companies, says the closed structure gives investment trusts an advantage over open-ended funds.

"Investment trusts come into their own in choppy market conditions like we have seen recently," she says. "The closed-end structure allows managers to take a long-term view with their portfolio, whereas open-ended managers can face redemptions, which means they may have to sell some of their best shares."

Last year's collapse of confidence in the commercial property sector provided a good example of this. As investors rushed to cash in their holdings in commercial property unit trusts, the fund managers were forced to sell some of their properties. Commercial property investment trust managers were able to sit tight and ride out the storm.

What are the main advantages of investment trusts?

Investment trusts tend to have lower charges than open-ended funds. Brodie-Smith points out that around one-third of investment trusts cost investors less than 1 per cent a year, while most open-ended funds charge closer to 2 per cent. Over 10 or 20 years, paying half as much in charges can save hundreds, even thousands, of pounds.

Another advantage of investment trusts is that they have slightly more regulatory flexibility than unit trusts. For a start, they have the ability to borrow money, which means they can magnify the gains (as well as losses) they achieve. Undoubtedly, those trusts that borrow ("gearing") are higher risk, but not all investment trusts take advantage of this freedom.

Finally, investment trust enthusiasts claim that their unique governance structure is an advantage. Every trust has a board of directors, who meet a few times a year to discuss the fund's performance and strategy.

Gavin Haynes of Whitechurch Securities, the Bristol-based financial advisers, says that while investment trust boards used to be relatively passive, they now tend to do a good job for investors. "Until recently, you could question how active the boards really were," he says. "But today, you're seeing fund managers having their mandates taken away by the board for underperformance."

What are the problems with investment trusts?

The biggest issue with investment trusts is that their share price very rarely corresponds exactly to the value of the underlying assets. This means that, while a fund manager could have grown his portfolio by 20 per cent in a year, the share price may have gone up by only 10 per cent – leaving the shares at a 10 per cent "discount" to the value of the trust. Similarly, if shares in an investment trust are in high demand, they may end up at a premium to the value of the trust's assets.

The problem with discounts and premiums is that they tend to be constantly moving. This can work in your favour – if you buy your shares when the discount is large and sell when it has narrowed, for example – but it can also work against you.

Haynes says that, for longer-term investors with a financial adviser who monitors the market, this should not pose a problem. In fact, it offers more of an opportunity. However, if you need to sell out of your investment in a hurry and don't have the luxury to time your sale, it's possible you'll lose out from the discount.

Brian Dennehy of Dennehy Weller, the Kent-based financial advisers, says that this is one of many characteristics that have put him off investment trusts. "They haven't got the degree of clarity that the vast majority of clients and advisers would want," he says.

In particular, Dennehy says, investment trusts lack transparency, and he complains that it's much harder to find out what an investment trust manager is up to. He adds that the sector is also still suffering from some severe reputational issues since the split-capital investment trust débâcle, which saw thousands of investors lose millions at the start of the decade.

However, Haynes says that, in fact, the result of the splits crisis was to force the industry to raise its standards. "Certainly there were issues of transparency in the past," he says. "Investment trusts have been around since the Victorian era and the amount of information available to shareholders can vary. But the lack of transparency was highlighted by the split-cap crisis and the things have certainly improved over the past five years."

Are they right for me?

The number of people regularly saving into investment trusts has been on the slide over the past decade, but they are still quite a popular choice for parents saving for their children. Over a 15- or 20-year period – or even longer – the issue of discounts tends to be less important, and the low charges can make a real difference. Trusts such as the Foreign & Colonial Investment Trust, which is the sector's oldest fund, and the Witan Investment Trust are popular with families and are a good first step for any equity investor.

These generalist funds have diverse portfolios of equities in regions across the world. Others with a similar mandate include the Scottish Investment Trust, Alliance Trust and Scottish Mortgage, which have all been in existence for decades.

Investment trusts are also ideal for more sophisticated investors who like to trade their portfolios regularly. Haynes says there can be good money to be made by buying trusts when their discounts get very wide, if you expect them to come back into favour.

He adds that in some cases it is possible to get access to talented managers for less than you would pay to invest in their open-ended products. For example, Standard Life's UK Smaller Companies fund, run by Harry Nimmo (see The Analyst, page 11), will cost you an annual management fee of 1.5 per cent a year, while the Standard Life UK Smaller Companies investment trust, also managed by Nimmo, charges just 1.25 per cent a year.

Unfortunately, many financial advisers are reluctant to sell investment trusts, as they don't pay commission to advisers. So, if you want to buy investment trusts through an intermediary, make sure you seek out one who works on a fees basis.

To find out more about investment trusts, visit www.theaic.co.uk, or visit www.trustnet.com/it for performance statistics. To find a financial adviser in your area, visit www.unbiased.co.uk.