Investment trusts and exchange-traded funds (ETFs) are two popular vehicles for investors seeking to diversify their portfolios. Both options offer access to a wide range of assets, but they differ in several key aspects. Understanding these differences can help investors make more informed decisions.
Structure and Legal Form
Investment trusts are closed-end funds. They are established as public limited companies (PLCs) and listed on a stock exchange. This means they have a fixed number of shares, which investors can buy and sell on the open market. The structure allows investment trusts to invest in less liquid assets without worrying about constant inflows and outflows of capital.
ETFs, on the other hand, are open-end funds. They are also listed on stock exchanges, but unlike investment trusts, they can issue and redeem shares continually. This means the number of shares can increase or decrease depending on demand. The structure of ETFs provides more flexibility and liquidity, making it easier for investors to enter and exit positions.
Management Style
Investment trusts often have an active management style. A professional fund manager or a team of managers makes decisions about which assets to buy and sell, aiming to outperform the market. This active management can potentially lead to higher returns but also involves higher fees due to the expertise and effort required.
ETFs are typically passively managed. They aim to replicate the performance of a specific index, such as the S&P 500. This means the ETF manager’s role is to track the index as closely as possible, with minimal intervention. Passive management usually results in lower fees compared to actively managed funds, making ETFs more cost-effective for investors.
Pricing and Valuation
The pricing mechanism for investment trusts can be complex. Since they are closed-end funds, their share price is determined by supply and demand on the stock exchange. This can result in the share price trading at a premium or discount to the net asset value (NAV) of the underlying assets. The NAV is the total value of the fund’s assets minus liabilities, divided by the number of shares outstanding.
ETFs trade close to their NAV due to their open-end structure. The process of creating and redeeming shares ensures that the market price of an ETF stays close to its NAV. Authorized participants, typically large financial institutions, play a crucial role in this process. They can create or redeem shares in large blocks, known as creation units, to take advantage of price discrepancies between the ETF and its underlying assets.
Dividend Policies
Investment trusts can have flexible dividend policies. They can retain a portion of the income generated by their investments and pay out dividends periodically. This retained income can provide a cushion during periods of lower returns, allowing investment trusts to maintain a steady dividend payment.
ETFs usually distribute all the income they receive from their underlying assets to shareholders. The frequency of these distributions can vary, with some ETFs paying dividends monthly, quarterly, or annually. The policy of distributing all income can lead to fluctuations in dividend payments, depending on the performance of the underlying assets.
Gearing
Investment trusts have the ability to use gearing, or leverage, to enhance returns. Gearing involves borrowing money to invest in additional assets, with the aim of amplifying gains. However, it also increases the potential for losses if the investments do not perform as expected. The use of gearing makes investment trusts more suitable for investors with a higher risk tolerance.
ETFs generally do not use gearing. Their passive management style and focus on replicating an index mean they aim to provide returns in line with the index’s performance. While there are leveraged ETFs available, which use derivatives to amplify returns, they are more complex and typically intended for short-term trading rather than long-term investment.
Fees and Charges
Investment trusts usually have higher fees compared to ETFs. The active management style of investment trusts requires more resources, leading to higher management fees. Additionally, investors may incur other charges, such as performance fees, which are linked to the fund’s success in outperforming its benchmark.
ETFs are known for their low-cost structure. The passive management approach results in lower management fees, and there are no performance fees. However, investors should still be aware of other costs, such as brokerage fees for buying and selling ETF shares, and the bid-ask spread, which is the difference between the buying and selling price of the ETF on the exchange.
Performance and Risk
The performance of investment trusts and ETFs can vary significantly due to their different management styles. Actively managed investment trusts have the potential to outperform the market, but this comes with higher risk and higher fees. The success of an investment trust largely depends on the skill of the fund manager.
ETFs, being passively managed, are designed to match the performance of their underlying index. They offer predictable returns in line with the index, making them less risky compared to actively managed funds. However, this also means that ETFs will not outperform the market, as their goal is to replicate it.
Investment Strategies and Focus
Investment trusts often have a specific investment strategy or focus. They may target particular sectors, regions, or types of assets, such as real estate or private equity. This specialization can provide investors with exposure to niche markets and the potential for higher returns. However, it also requires investors to have a good understanding of the specific strategy and its associated risks.
ETFs offer a wide range of investment options, allowing investors to gain exposure to different indices, sectors, regions, and asset classes. The broad range of ETFs available makes it easy for investors to build diversified portfolios that align with their investment goals and risk tolerance. The simplicity and transparency of ETFs make them a popular choice for both novice and experienced investors.
See Also: Why Are Etfs a Better Investment Product Than Unit Trusts?
Transparency
Investment trusts provide regular updates on their holdings and performance, but they may not disclose their entire portfolio on a frequent basis. This can make it more challenging for investors to have a complete understanding of the trust’s current investments and risks.
ETFs offer a high level of transparency. They typically disclose their holdings on a daily basis, allowing investors to see exactly what assets the ETF holds. This transparency helps investors make informed decisions and ensures that the ETF is tracking its intended index accurately.
Liquidity
The liquidity of investment trusts can vary depending on the size of the trust and the market demand for its shares. Some investment trusts may have lower trading volumes, leading to wider bid-ask spreads and less liquidity. This can make it more difficult for investors to buy or sell shares without impacting the share price.
ETFs generally offer high liquidity due to their open-end structure and the role of authorized participants. The ability to create and redeem shares in large blocks ensures that ETFs can accommodate large trades without significant price impact. This high liquidity makes ETFs an attractive option for investors who require flexibility and ease of trading.
Tax Efficiency
Investment trusts can be less tax-efficient compared to ETFs. The active management style and the potential for capital gains from trading activities can result in higher tax liabilities for investors. Additionally, the structure of investment trusts can lead to situations where investors incur tax liabilities even if they do not sell their shares.
ETFs are generally more tax-efficient due to their passive management and in-kind creation and redemption process. This process allows ETFs to minimize the realization of capital gains, reducing the tax burden for investors. The lower turnover of assets in ETFs also contributes to their tax efficiency.
Historical Context and Evolution
Investment trusts have a long history, with the first investment trust, the Foreign & Colonial Investment Trust, established in 1868 in the United Kingdom. This long history has allowed investment trusts to evolve and adapt to changing market conditions, offering a wide range of strategies and asset classes to investors.
ETFs are relatively newer, with the first ETF, the SPDR S&P 500 ETF, launched in 1993 in the United States. Despite their shorter history, ETFs have grown rapidly in popularity due to their low-cost structure, transparency, and ease of access. The evolution of ETFs has led to the development of a diverse array of products, catering to different investment needs and preferences.
Regulatory Environment
Investment trusts and ETFs operate under different regulatory frameworks, which can impact their operations and investor protections. Investment trusts are regulated as investment companies and must adhere to rules set by regulatory bodies, such as the Financial Conduct Authority (FCA) in the UK or the Securities and Exchange Commission (SEC) in the US.
ETFs are regulated as open-end funds and must comply with regulations specific to mutual funds and exchange-traded products. In the US, ETFs are subject to the Investment Company Act of 1940, while in Europe, they must comply with the Undertakings for the Collective Investment in Transferable Securities (UCITS) directives. These regulations aim to protect investors and ensure the integrity of the financial markets.
Investor Suitability
Investment trusts may be more suitable for investors with a higher risk tolerance and a longer investment horizon. The active management style, use of gearing, and potential for higher returns make investment trusts appealing to experienced investors who can navigate the associated risks.
ETFs are well-suited for a wide range of investors, from beginners to seasoned professionals. The low-cost structure, transparency, and ease of access make ETFs an attractive option for those seeking diversified exposure to different markets and asset classes. The predictability of returns and lower risk profile of ETFs also make them suitable for conservative investors.
Global Availability
Both investment trusts and ETFs are available to investors worldwide, but their popularity and availability can vary by region. Investment trusts have a strong presence in the UK and Europe, while ETFs are more prevalent in the US and are rapidly gaining traction globally.
The global availability of ETFs has been facilitated by the development of cross-border trading platforms and regulatory harmonization. This has made it easier for investors to access a wide range of ETFs listed on different stock exchanges, providing greater flexibility and diversification opportunities.
Conclusion
Investment trusts and ETFs offer distinct advantages and disadvantages, catering to different investment preferences and strategies. Investment trusts provide the potential for higher returns through active management and the use of gearing, but they come with higher fees and risks. ETFs offer low-cost, transparent, and diversified exposure to various markets and asset classes, making them an attractive option for a broad range of investors.
Understanding the key differences between investment trusts and ETFs can help investors make informed decisions that align with their financial goals and risk tolerance. Whether one chooses to invest in an actively managed investment trust or a passively managed ETF will depend on individual preferences, investment objectives, and market conditions. Both vehicles have their place in a well-diversified portfolio, and a balanced approach can help investors achieve their long-term financial aspirations.
