Investment trusts offer a unique way to diversify your portfolio and potentially achieve your financial goals. But how exactly do they work? This article will delve into the key features of investment trusts, explaining their structure, investment strategies, and potential benefits and drawbacks.
Structure
Unlike open-ended mutual funds, investment trusts are closed-ended companies listed on stock exchanges. This means they issue a fixed number of shares that trade throughout the day, similar to individual company stocks.
Closed-Ended Nature
The closed-ended nature of investment trusts means they don’t issue or redeem shares based on investor demand. Instead, shares are bought and sold on the stock market. This can result in the share price trading at a premium or discount to the net asset value (NAV) of the trust’s underlying assets. The NAV represents the total value of the trust’s assets minus any liabilities, divided by the number of shares outstanding.
Stock Exchange Listing
Being listed on a stock exchange adds a layer of transparency and liquidity, allowing investors to buy and sell shares with relative ease. However, the price at which shares trade can be influenced by market sentiment, investor demand, and overall market conditions, leading to price fluctuations that may not always reflect the NAV.
Management
A key feature of investment trusts is their management structure. A board of directors oversees the trust, appointing a professional fund manager to make investment decisions. This structure allows for a more long-term investment approach compared to open-ended funds that may need to sell holdings to meet redemptions.
Board of Directors
The board of directors is responsible for safeguarding shareholders’ interests, setting the trust’s investment strategy, and ensuring regulatory compliance. They also select and monitor the performance of the fund manager. This governance structure aims to align the management’s interests with those of the shareholders.
Professional Fund Manager
The appointed fund manager has the expertise and experience to make informed investment decisions. They conduct thorough research and analysis to select assets that align with the trust’s investment strategy. The fund manager’s role is crucial, as their decisions directly impact the trust’s performance.
Gearing
A key advantage of investment trusts is the ability to use gearing, also known as borrowing money, to amplify returns. This can magnify gains in a rising market but also magnify losses in a falling market.
How Gearing Works
Gearing involves borrowing funds to invest more than the equity capital available in the trust. For example, if an investment trust has £100 million in equity and borrows an additional £20 million, it now has £120 million to invest. If the investments perform well, the returns on the borrowed funds can enhance the overall returns to shareholders. Conversely, if the investments perform poorly, the losses are also magnified.
Risks of Gearing
The use of gearing introduces additional risk. In a declining market, the trust must still service its debt, which can lead to significant losses. It’s important for investors to understand the level of gearing used by a trust and how it fits with their risk tolerance.
Investment Strategies
Investment trusts can invest in a wide range of assets, including stocks, bonds, real estate, and alternative assets. Their focus can range from specific sectors or regions to a globally diversified portfolio.
Types of Investment Strategies
1. Equity Investment Trusts: These trusts primarily invest in stocks. They may focus on a particular region (e.g., UK, Europe, Asia) or sector (e.g., technology, healthcare).
2. Bond Investment Trusts: These trusts invest in fixed-income securities such as corporate or government bonds. They aim to provide a steady income stream with lower volatility compared to equities.
3. Property Investment Trusts: These trusts invest directly in real estate or real estate-related securities. They can provide exposure to commercial, residential, or industrial properties.
4. Mixed-Asset Investment Trusts: These trusts diversify across different asset classes, combining equities, bonds, and alternative investments to balance risk and return.
5. Alternative Investment Trusts: These trusts focus on non-traditional assets such as private equity, infrastructure, commodities, or hedge funds.
Benefits of Diversification
By investing in a range of assets, investment trusts can spread risk and reduce the impact of any single investment’s poor performance. This diversification can enhance the potential for steady, long-term growth.
Trading
You buy and sell shares in an investment trust on the stock exchange, just like any other listed company. The price may fluctuate based on supply and demand, creating a potential difference between the buying and selling price (bid-offer spread).
See also: What is the Most Trustworthy Investment Company?
Bid-Offer Spread
The bid-offer spread is the difference between the price at which you can buy shares (offer price) and the price at which you can sell shares (bid price). A wider spread can add to the cost of trading, particularly for less liquid trusts. It’s important to consider this spread when evaluating the overall cost of investing in an investment trust.
Liquidity
The liquidity of an investment trust depends on its size, the volume of shares traded, and market conditions. More liquid trusts generally have narrower bid-offer spreads, making it easier to buy and sell shares without significantly impacting the price.
Benefits
Investment trusts offer several benefits, including professional management, diversification, and the potential for long-term growth through strategic use of gearing.
Professional Management
Investment trusts provide access to professional fund managers with the expertise to make informed investment decisions. This can be particularly valuable for investors who lack the time or knowledge to manage their own portfolios.
Diversification
By pooling resources from many investors, investment trusts can achieve a level of diversification that might be difficult for individual investors to replicate on their own. This diversification helps to spread risk across a wide range of assets.
Long-Term Growth
The closed-ended structure and use of gearing allow investment trusts to take a long-term view and potentially enhance returns. This can be particularly advantageous during periods of market volatility, as the trust does not need to sell assets to meet redemptions.
Drawbacks
While investment trusts offer several advantages, they also come with potential drawbacks that investors should consider.
Gearing Risks
As mentioned earlier, gearing can amplify losses in a declining market. Investors need to be aware of the level of gearing and understand the associated risks.
See also: Risks of REITs: Everything You Need To Know
Bid-Offer Spread
The bid-offer spread can add additional costs compared to some open-ended funds, particularly for less liquid trusts. This can impact the overall returns, especially for investors who trade frequently.
Complexity
Investment trusts can be complex and may require a longer investment horizon to achieve their full potential. Investors need to be prepared for potential short-term volatility and have a clear understanding of the trust’s investment strategy and risk profile.
Conclusion
Investment trusts can be a valuable tool for investors seeking a professionally managed, diversified portfolio. However, it’s crucial to understand their structure, investment strategies, and potential risks before investing. Consider your investment goals, risk tolerance, and investment timeframe before adding investment trusts to your portfolio. Consulting with a financial advisor can help you determine if an investment trust aligns with your overall financial strategy.
By comprehensively understanding the workings of investment trusts, savvy investors can make informed decisions that align with their financial goals and risk tolerance, leveraging the benefits while being mindful of the potential risks.
