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January 16, 2006 3:09 pm

Investment trusts

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A small but significant band of investors have been attracted to investment trusts as they offer exposure to a diverse portfolio of shares and have the potential to generate high returns at a relatively low cost. There are currently more than 300 investment trusts quoted on the London Stock Exchange. But some potential investors may still be reeling from the fallout of so-called “split-capital” investment trusts, specialist investment trusts which consisted of several classes of share. Tens of thousands of investors lost hundreds of millions of pounds in these particular trusts after many heavily indebted splits collapsed. Investors may also be unnerved by the Treasury’s recent decision to shy away from tightening the regulation of investment trusts.

So what are investment trusts?

They are funds listed as companies on the stock exchange that are set up to invest in the shares of other companies. They pool investors’ money and the trust’s appointed fund manager may then invest it in a range of companies from different sectors and regions. As these funds are listed companies, they have boards of directors, which act on the behalf of shareholders’ interests.

How do they work?

Investment trusts are closed-ended – that is they normally raise money just once by issuing shares at launch. By contrast, open-ended funds such as unit trusts or Oeics grow or contract in size depending on inflows and outflows of investor money. With an investment trust, investors buy shares in the trust, they do not buy directly into the underlying fund. So, if investor demand is strong this will not increase the size of the underlying fund. Instead such strong demand will normally feed through into a higher share price. Share prices of very popular investment trusts tend to trade at a premium to the total value of the underlying assets. Unpopular funds will trade at discounts. Investment trusts can also borrow more heavily than unit trusts. Significant borrowings will increase returns in rising markets but exacerbate losses in a downturn.

Should I get one?

Investment trusts can invest in up to 200 different stocks and can therefore offer a good spread of investment risk. They can offer investors access to certain stocks that might be difficult to invest in privately, such as relatively illiquid stocks, emerging markets or smaller and unquoted companies. Also as they are listed companies, they do not pay commissions to intermediaries so their charging structures tend to be competitive.

Who are they aimed at?

Investment trusts are generally popular with investors who are willing to take a long-term view and who are willing to take on a little more risk. Experts say they often appeal to investors who have a personal interest in picking stocks and seeking out interesting opportunities.

Who offers them?

There are more than 300 investment trusts in the market, offered by most investment providers.

How much would I have to invest?

They are traded like shares in any listed companies so you could buy just one share in a trust, although dealing costs mean this would make little sense. Most trusts also have savings schemes, some of which can start from as little as £30 a month.

What sort of returns can I expect?

This depends on the stock market, the underlying investment approach of the trust and the skills of the fund manager. Over the past year the share price of the average investment trust has risen 30.5 per cent.

How would I choose one?

Identify clear objectives before you choose. Some investment trusts aim to maximise income, while some aim exclusively for capital growth and others combine the two. There are some large funds that have a wide spread of investment and others that are more specific to sector or region. Some investors start by investing in a trust focusing on UK equities and may then diversify to overseas markets.

How much do they cost?

The charges on investments trusts are fairly low relative to other funds such as unit trusts or Oeics. A quarter of trusts have total expense ratios – the total annual drag on performance – of less than 1 per cent, while 55 per cent have TERs of under 1.5 per cent.

What about the price of shares?

The price of shares in an investment trust is determined by the underlying performance of the fund and investor demand. If demand is low, the share price discount could widen, damaging returns. The fact that investment trust share prices trade at discounts or premiums adds another layer of volatility to these funds. Investment trusts historically trade at a discount to net asset value, the total value of the underlying assets in the trust.

Any other downsides?

These investments fall outside the remit of the Financial Services Authority which could unnerve some investors, although as listed companies, investment trusts are regulated by company law and the listing rules. The Treasury last week backed away from tightening the regulation of these types of investments despite calls to at least bring them within the Financial Services Ombudsman Service.

Investors have a lower level of consumer protection than with other collective investment schemes such as unit trusts and they may not qualify for compensation in the event of a repeat scandal such as split-capital trusts.

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