FOOL'S EYE VIEW
Investment Trust Bargains

By James Carlisle
August 19, 2002

If you don't fancy picking shares yourself, then the traditional Foolish approach is to invest via an index tracker. These combine low charges with a broad spread of investments. Another option is to go for an investment trust. These can also have very low charges, but they also give you the chance to tailor your spread of investments to your needs.

The first and foremost thing to know about investment trusts is that they are actually companies. Just like any other company, they issue shares to raise money from investors and then go off and invest that money. The only difference is that instead of investing in factories or shops or what have you, they invest in the shares of other companies (that are building factories or shops or what have you). This has several very important implications.

Costs

Firstly, they have to act in the interests of their shareholders, which basically means keeping their costs as low as possible. As they get bigger, they get proportionately cheaper to manage, and the benefits of this have to be passed on to shareholders. So the biggest investment trusts tend to have the lowest costs and that means there's less money leaking out of them. Other things being equal, you'd therefore expect them to perform that little bit better.

Discounts

The second point is that investment trust shares are traded on the stock market just like any other shares. If you want to invest in one, then you'll need to buy the shares from someone else (instead of receiving freshly issued units as you would from a unit trust). So the price that you pay for your investment is determined by how the market values the shares and that won't necessarily match the underlying value of the fund's investments. In fact, because they have charges (even though they're relatively small), the market tends to price investment trust shares at a small discount to their underlying value. Other things being equal, the bigger the discount the better.

Dividends and dividend growth

The third point is that since investment trusts are companies, you should research them just as you would any other company. We've already looked at keeping costs low (as any good company should) and the discount to underlying value. You should also check to see that you're happy with the way that the trust is managed and make sure that it isn't carrying too much debt. You can research this by looking at the annual accounts (which they have to publish because they are, of course, companies).

You also need to consider the dividends. Just as with any company that means the actual level of this year's dividend compared to the share price (the 'dividend yield') and the rate at which you expect the dividend to grow in the future. Generally speaking, the higher the former the lower the latter, and vice versa, but you should aim for a balance of income and growth that suits your purposes. Beyond this, and to the extent that it's possible, you'd like to find lots of income and lots of growth!

Where to invest

Investment trust sectors range from 'Country Specialists: Europe', through 'Sector Specialist: Tea Plantations' (I kid you not!) to the more mainstream 'Global and 'UK' sectors. It's these latter sectors that are likely to prove most suitable for private individuals and they include the following:

Global Sectors                 UK Sectors

Global Growth                  UK Growth
Global Growth & Income         UK Growth & Income
Global High Income             UK High Income

The sector names are self-explanatory. If your focus is income then you'll naturally lean towards the 'Income' sectors. If you're looking for growth, then you might choose from all three types. Although the 'Growth' sectors are the obvious choice, 'High Income' can be used to provide growth if you re-invest the income.

The other thing to work out is whether you want just UK companies, or a spread across the world. If it's the latter, then you need to be a little careful, since the geographical spread of different trusts in the 'Global' sectors will vary. The Association of Investment Trust Companies' (AITC) Monthly Information Service, available on its website, includes data on this.

Working out the right geographical spread for you is more of an art than a science. There's more about it here, but for most private investors in the UK, an emphasis on the UK will make sense, with some exposure to the US and Europe and maybe a touch in the Far East.

Choosing investment trusts

So, beyond what it invests in, we're looking for an investment trust that:

(a)  is very big (so that its costs are relatively low)
(b)  has a big discount (so you get more 'bang for your buck')
(c)  has an appropriate balance of dividend yield and expected dividend growth (and preferably lots of both).

You also need to be wary of anything that looks too good to be true, since it certainly will be. If a trust has a dividend yield of 20%, for example, then it's almost certainly an indication that the dividend will have to be reduced. I would also keep things simple and stick to the 'conventional funds' rather than the split capital funds. Some of the conventional funds are packaged units of split capital funds and, call me suspicious, but I'd tend to steer clear of these too.

On this basis, I had a trawl through the AITC's Monthly Information Service for July and, from the mainstream sectors, the following investment trusts caught the eye.

                       Total    Total  Discount    5-Year  Dividend
                      Assets  Expense       (%)  Dividend     Yield
                         £'m    Ratio              Growth       (%)
                                  (%)                Rate
                                                   (% pa)

Global Growth
Foreign & Colonial     2,091     0.34      7.2       6.9        2.0
Scottish Mortgage      1,204     0.39     16.3       3.0        2.3
Witan                  1,342     0.25     10.4       3.2        2.7

Global Growth & Income
Murray International     428     0.81     14.5       3.1        5.0

UK Growth
Edinburgh Investment   1,095     0.49     12.1       2.7        4.1
Fleming Mercantile       920     0.60      2.6      12.5        3.5

Given the dangers of reading too much into the recent dividend growth rate (which can be affected by all sorts of things in the short-term), the most important factors are the total expense ratio (which is linked to size) and the discount. On that basis, the pick of the crop at the moment might be Scottish Mortgage if you're not looking for lots of income or Edinburgh Investment if you are -- so long as you're happy with their spread of investments (Scottish Mortgage is invested 48% UK, 9% Continental Europe, 23% North America, 9% Japan and Pacific and 9% currently in cash and fixed interest).  Of course, there's no harm in spreading your investments over several different trusts to get just the blend of assets and income that you want and also diversify your risks (but make sure that it doesn't add too much to your costs).

What do you think of these selections, Fool? Do you like the look of any particular investment trusts at the moment yourself? Share your thoughts on the Investment Trusts and Unit Trusts discussion board.

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