FOOL SCHOOL
Investment Trusts

March 21, 2005

The easiest way to understand closed-ended funds, or investment trusts, is to think of them as a company. This is because that is exactly what they are! Just like any other company, they issue shares to raise money from shareholders and then invest that money. The difference between investment trusts and normal "trading" companies is that they invest their money in the shares of other companies rather than in physical assets such as factories or grocery stores or mobile phone networks. Since they are like a company, they are also able to borrow money to invest (which is not allowed for unit trusts and OEICs). However, only a few take advantage of this to any significant extent.

How They Work and Charging Structure

You buy the shares in the same way as you would a normal company, that is, by contacting a stockbroker. Some of the larger investment trusts also run schemes whereby you can invest regular amounts or lump sums via an ISA.

Since you buy investment trust shares just as you would shares in a normal company, the charges are generally the same also. So, you suffer stockbroker's commission on buying and selling. In a way, this is comparable to an initial charge and an exit charge on a unit trust. However, if you use a cheap broker, they should be relatively small. On top of commission, you lose a small amount as the difference between the bid and offer prices of the shares of the trust. However, again, this tends to be a relatively small amount. You also have to pay stamp duty of 0.5% on purchases.

In addition to these charges for buying and selling investment trust shares, you pay an annual management fee and other ongoing administration costs. The full amount of these is probably a little more difficult to work out than those on unit trusts and OEICs, because the figures are buried in the accounts. However, they tend to be lower than the charges on unit trusts. This is because investment trusts have lower costs. For a start, they're generally not allowed to advertise which saves them money. On top of this, they don't have to deal with money coming into and leaving the fund which open-ended funds like unit trusts have to deal with. Finally, because, as companies, they have to be run in the interests of their shareholders, their management charges are strictly controlled by the directors. The effect of this is that as the investment trusts get bigger, they cost proportionately less to run. The largest investment trusts tend to have very low charges, comparable to index trackers.

What are Discounts?

Imagine a simple investment trust, the Blue Chip Trust (BCT). It has invested £13,000,000 in three shareholdings: Vodafone, Rolls-Royce and Tesco. However it has borrowed £1,000,000 (unlike unit trusts, investment trusts are allowed to do a bit of borrowing).

The net asset value, often called NAV is the total assets of the trust minus the total debts. The NAV of BCT is £12,000,000 (£13,000,000 minus £1,000,000).

Now let's assume that there are 10,000,000 shares of BCT itself (that is, the total held by all the investors in BCT). The net asset value per share or NAV per share would be £1.20 (that is, the NAV of £12,000,000 divided by the 10,000,000 shares). So, for every share you buy, you buy an underlying entitlement to £1.20 of net assets. Often people drop off the per share and just say the NAV of a trust is 120p. You know they're talking in per share terms because it would be a very small trust otherwise.

So, the NAV per share of BCT is 120p. What do you think the share price will be? How about 120p? Well, it's a good guess but, unfortunately, it's not quite right. This is where discounts come in. You almost always find that the share price of an investment trust is a bit less than its NAV per share. For instance, you might find that shares in BCT are trading at 100p. This means it is "trading on a discount of 16.7%." This 16.7 per cent is the percentage amount by which the share price is less than the NAV per share. In other words, it is the difference between the share price and the NAV per share (that is, 120p - 100p = 20p) divided by the NAV per share (of 120p). 20p divided by 120p comes to 0.167 which (multiplying by 100) comes to 16.7 per cent.

Every now and again, you find an investment trust trading at a premium. In this case, the share price is more than the net asset value of the trust. So, if BCT is trading at a premium, it might have a share price of 130p. This would be a premium of 8.3%. This is calculated in just the same way as the discount. It is the difference between the share price and the NAV per share, divided by the NAV per share.

Investors are sometimes happy to pay a premium for an investment trust if they think it "is doing really well". This might be because it has an impressive recent track record or because it is in a particularly whizzy sector. In fact, there is a large body of evidence which shows that past performance is no guide to future performance, so the "doing really well" is likely to be short-lived. So why pay more for your assets than you would have to pay if you bought them directly in the stock market yourself? The bottom line is that you should be very wary of buying an investment trust at a premium to its NAV.

You can see the NAVs (and/or discounts) of investment trusts in the share pages of broadsheet newspapers. They are also shown on sites like Trustnet. Generally, the NAV per share figures underlying the calculations are updated daily and are fairly accurate. However, if you are considering buying an investment trust, it would be sensible to check several sources so that you are confident that there is agreement on the NAV per share and discount.

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