One of the biggest differences between investment trusts and unit trusts is that investment trusts can borrow money to invest which is called gearing. If done effectively, gearing can significantly increase returns both in terms of growth and income generated from the underlying portfolio. The advantage about gearing in the current environment is that borrowing is very cheap, especially for investment trusts. Banks will tend to offer investment trusts money at very competitive rates, currently around 1.5 per cent, which compares very favourably with equities yielding 4 per cent to 5 per cent. That means returns can be significantly enhanced.
However gearing can also have the opposite effect (should stocks go down in value) but the important thing to remember is that if markets look volatile, the fund manager can reduce gearing and alternatively increase the gearing level dependent on whether or not the fund manager is bullish about the market.
This is one aspect of investment trusts which gives a sense of security to investors. The fact that an investment trust is a company in its own right, each must have a board of directors that oversees the running of that trust. These directors are there to ensure that the interests of shareholders are protected. This means the fund manager is working specifically to the objectives of the trust and is being monitored by independent directors.
As we know, investment trusts work differently from Oeics in that they are a company in their own right, with a fixed number of shares – for example, there is only a finite number of shares that can be purchased and this is why investment trusts are often referred to as closed-end funds. Like any other stock on the market, the price of these shares depends on the balance between the supply of shares and the demand for them. In order to measure the value of the underlying stock, investors refer to the net asset value.
So when looking at an investment trust, investors should look at the NAV per share (which is the value of the underlying portfolio, divided by the number of shares in issue) and the share price at which the trust is trading. Any difference between the two is known as either the discount or premium to NAV. For example, if you bought an investment trust at a 10 per cent discount, you would be paying 90p for underlying assets worth £1.
Some investors are nervous of investment trusts that trade below the value of their underlying assets (trading at a discount) but the advantage is that these discounts can potentially bring an enhanced return. Investment trusts are purchased at a discount to their actual fair value so if, and when, the discount narrows there is an additional boost. When looking at income-producing investment trusts however, due to higher demand there are much narrower discounts with many trading at premiums.
