Investment Trusts: one of the City’s best-kept secrets

Why invest?Investment trusts have been described as the City’s best-kept secret. But thanks to changes in financial regulation, small investors are going to be hearing a lot more about themin the future. So what are they exactly?

If you have any long-term savings, such as a pension or a stocks and shares Individual Savings Account (ISA), the chances are that at least some of your money is invested in a fund. The idea is simple: you pool your money with lots of other investors and give it to an expert to manage. This way, your money is spread across a wider range of investments than you could easily invest in yourself, which is one way to reduce the risk that you’ll lose money.

The most popular funds in the UK are unit trusts and Open-Ended Investment Companies (OEICs), which are both types of ‘open-ended’ fund. But there’s another type of fund that many investors have barely even heard of, let alone used. This is the investment trust, and these have many useful features that make them an excellent addition to the portfolio of any investor – not just City experts already in the know.

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So starting today, over the next three months we’re running a series of articles in which we’ll tell you everything you need to know about investment trusts, from the basics of how they work and how to invest in them, to how you can find one to suit your needs and long-term savings goals.

What are Investment Trusts?First, let’s look at the key features of investment trusts. An investment trust is simply a type of public company. Like other public companies, it issues shares that are listed on the stock exchange. And like most companies, its goal is to make money for the people who own it – its shareholders. An investment trust does this by investing in a portfolio of assets. Usually these are shares in other listed companies, but investment trusts can invest in anything from bonds to property to private equity.

Because an investment trust is listed, its share price rises and falls in line with demand for the trust’s shares. This means the price of the trust and the value of its underlying portfolio – known as its net asset value (NAV) – can diverge. If the share price falls below the NAV, the trust is said to be trading at a ‘discount’. If it rises above the NAV, it is trading at a ‘premium’.

On one hand, this adds an extra layer of risk. As an owner of the trust, you can’t guarantee that the share price will always reflect its underlying value. But it can also provide opportunities: if a trust is trading at a discount of 10%, say, then you are effectively buying £1’s worth of assets for 90p. You could then potentially benefit both from the underlying assets rising in price and from the discount narrowing.

This ‘closed-ended’ structure is one key difference between investment trusts and unit trusts. Managers of open-ended funds create or destroy ‘units’ as investors buy or sell their funds. This means the units always reflect the value of the underlying portfolio. However, it also means that unit trust managers have to buy or sell assets as money flows in and out of their funds.

Investment trust managers are free of this pressure and can instead buy and sell when they believe it’s the best time to do so. This can be particularly useful when investing in less liquid areas, such as commercial property or certain emerging markets.

An investment trust also has an independent board of directors. These directors are responsible for the interests of shareholders so, for example, they can fire an underperforming portfolio manager if necessary. It also means that as a shareholder in an investment trust, you get to vote on issues such as the appointment of directors and changes to investment policy. So, arguably, you have more of a voice than an investor in a similar unit trust.

Income, Growth – or both?Another feature of investment trusts is that, unlike open-ended funds, they can retain up to 15% of income received in any year. These reserves can be used to supplement future dividend payouts. So during the good times they can put money aside to maintain and grow dividends during harder times. Investment trusts can also distribute capital profits as dividends if they wish.

However, investment trusts aren’t just for investors looking for income. They can also employ ‘gearing’ or ‘leverage’. This simply means using borrowed money to boost potential returns. To see how it works, just think of a mortgage. If you buy a £200,000 house outright, then sell it for £220,000, you’ve made £20,000. That’s a 10% return on your initial £200,000.

But say the same £200,000 house is bought with a £100,000 deposit, plus £100,000 borrowed from the bank. The house then sells for £220,000. After repaying the £100,000 loan, you are left with £120,000. The profit is still £20,000, but you only put down £100,000 of your own money. So your return is 20%, rather than 10%.

This works the other way too, which is why gearing increases risk. If the house price had dropped to £180,000, then you lose 20% in the second example, rather than 10% in the first. So the ideal time to ‘gear’ up is when the market is recovering or rising, while it’s better to cut back when a market looks over-priced and ready to fall. Someone more focused on capital growth – such as a younger investor with several decades to go until retirement – might therefore be interested in a highly geared trust that chases growth aggressively. Investment trusts cover a wide range of markets and strategies, both within the UK and overseas, with options to suit every type of investor. Some trusts focus on a specific country, such as India, Japan or Brazil, or a specific sector, such as small companies. Others offer broader exposure, investing across all emerging markets, or Asia as a whole, for example.

So how do you invest?As with any other listed company, you buy shares in an investment trust through a stockbroker. You can also invest directly with J.P. Morgan and maximise your tax efficiency (avoiding further liability for tax on dividends or capital gains) using a J.P. Morgan ISA or a J.P. Morgan Self-Invested Personal Pension (SIPP). Or if you are saving for a child, you could consider a J.P. Morgan Junior ISA. The level of tax benefits and liabilities will depend on individual circumstances and may change in the future.

Now that we’ve discussed the basics of investment trusts, next week we’ll look at how you can use them to help you meet your savings goals. Of course, to do that, you have to know what those goals are. So in the second part of our series, we’ll talk about how you go about setting financial goals and look at how your attitude to risk, and the time available, will affect the sort of investments you might choose. We’ll also show you how togo about building an investment portfolio that will give you the best chance of achieving your goals and look at how you can use investment trusts to diversify your assets in order to reduce your risks without hurting your potential returns. Look out for it in next week’s issue. And if you’d like to know anything else on investment trusts in the meantime, visit the J.P. Morgan Asset Management investment trust website.

Why haven’t I heard about Investment Trusts?The typical British investor knows very little about investment trusts. That’s because most people in Britain invest their money through an independent financial adviser (IFA). Historically, many IFAs (though not all) have made their money not through charging clients up front, but by being paid a commission fee by product providers such as fund managers. This commission fee is subtracted from the clients’ overall returns. Unlike open-ended funds, investment trusts generally do not pay commission to IFAs. As a result, IFAs who rely on commission (rather than those who charge a fee up front) have been reluctant to recommend them.

This is changing from next year due to the ‘Retail Distribution Review’ (RDR). Under the new rules, the Financial Services Authority (FSA) is banning commission, so that IFAs will have to charge clients directly. The hope is that the more transparent fee structure will enable investors to understand exactly how much they are paying for financial advice, while also liberating IFAs from potential accusations of conflicts of interest. Given that investment trusts will be competing with the open-ended variety on a more level playing field, it seems likely that both investors and their IFAs will hear more about these sorts of investment vehicles in the future.

That’s why we think it makes sense to familiarise yourself with the concepts involved in investment trusts, so that you understand both the opportunities and the risks associated with the sector before the new regime kicks in at the start of 2013.

Sources *JPMorgan Global Emerging Markets Income Trust plc Annual Report 2012, **JPMorgan Claverhouse Investment Trust plc Annual Report 2011, ***JPMorgan Elect plc Annual Report 2011, †JPMorgan European Smaller Companies Investment Trust plc Annual Report 2012.‡Association of Investment Companies as at 30/09/12 in terms of assets under management and number of investment trusts. Issued by JPMorgan Asset Management Marketing Limited which is authorised and regulated in the UK by the Financial Services Authority. Registered in England No. 288553. Registered Office: 25 Bank Street, Canary Wharf, London E14 5JP, United Kingdom.