A fund is an investment vehicle that allows a large number of people to pool their money together in order to invest in a range of different securities such as stocks and bonds. In the UK, individuals can invest in different kinds of funds. There are two main fund categories: open-end funds and closed-end funds. Investment trusts fall under the the closed-end fund category.
Buying & Selling Investment Trusts
Open-end funds can theoretically offer a limitless number of shares for investors to buy. These funds also stand ready to purchase back those shares when investors want to cash out. Investment trusts, on the other hand, are “closed-ended”. This means that they issue a fixed number of shares at their launch (much like the IPO of a newly public company), and then do not subsequently buy shares back or issue new shares, except in rare circumstances.
Investment trust shares trade on stock exchanges just like the shares of any other public company. Like stocks, investment trusts trade at different market prices throughout the day. (This is unlike open-end funds, which are priced once each day.) Investors also generally pay brokerage commissions to buy and sell investment trust shares, just as they would for the shares of any publicly traded company.
Unless you buy in on the investment trust IPO, any shares you purchase in an investment trust will usually be bought over an exchange, at the prevailing market price. Thus, rather than purchasing shares from or selling them back to the fund company, you are trading with other investors at a market price.
With traditional open-end funds, you can be assured that the price you pay or receive when you buy into a fund is directly linked to the fund’s net asset value (NAV). Closed-end funds operate differently.
With an investment trust, the market price should reflect the NAV, but is ultimately based on the forces of supply and demand prevailing in the market for the trust’s shares. If demand for an investment trust is high, shares may trade at a premium to their NAV. If demand for an investment trust is low, shares may trade at a discount to their NAV. Many investment trusts trade at discounts to the value of their underlying assets.
From the asset manager’s perspective, investment trusts are attractive because they give the management company the ability to earn management fees on a stable pool of capital until the trust is wound up. (Remember, if shareholders sell, they sell to other investors, while the original invested money stays inside the fund.) The format also lends itself to investments in less liquid markets and securities as the investment trust manager will not be forced to trade based on inflows or outflows of cash.
Investment Trusts and Gearing
Investment trusts have also traditionally been differentiated from their open-end peers by their ability to borrow money, or “gear” their portfolios. Open-end funds, on the other hand, have restrictions on gearing.
Gearing increases a fund’s upside potential but also considerably magnifies its downside risk. Take for example, an investment trust with £100 million in assets that borrows an additional £100 million, then invests the entire sum (£200 million) in the equity market. A 50% return on that £200 million investment would equal £100 million. Once the trust repays its loan, it is left with £200 million (its original £100 million, plus the £100 million it earned on its investments). That’s a 100% return, which seems highly desirable. But on the flip side a 50% loss on that same £200 million would equate to a £100 million loss. The fund’s entire capital base would be wiped out, and investors in this example would be left with nothing.
