Investment trusts are nothing new. In fact, some of the oldest have been around for over a century, with the likes of Scottish Mortgage and Witan founded in 1909. As of April 2023, 450 of these companies are listed on the London Stock Exchange with a combined market capitalisation of some £260bn. While sizeable, this figure is dwarfed by the £1.4tn of assets held within Investment Association covered retail funds.
Going through the same launching process as any listed company, the Initial Public Offering (IPO) acts as the first round of fundraising from which money raised is invested into a pool of assets, the performance of which drives the company’s earnings and thus the share price over time. Unique to the UK, the valuations of these companies are generally valued through the comparison of the share price to the Net Asset Value (NAV) per share, with a share price premium to NAV seen as expensive and vice versa.
Multiple benefits exist as a result of the listed investment trust structure, from an independent board looking after shareholder interests, accessing illiquid assets unable to be held in open-end funds, smoothing of dividends and the use of borrowing to enhance returns. While all beneficial there are some drawbacks in the form of greater volatility and a smaller investable universe.
Independent boards of directors are often seen as a key benefit of investment trusts. Elected to look after operations of the company, from the management of the assets to dividend policy, these often highly experienced industry professionals offer an extra layer of governance to ensure shareholder interests are being met.
Likely to be the greatest benefit of the investment trust’s permanent capital structure is their ability to hold illiquid assets. Unlike open-end funds which must provide liquidity to investors at regular intervals, investment trusts permanent capital base prevents this issue. As a result, they can hold highly illiquid assets, providing investors access to a diverse range of assets from wind farms to private loans. With the shares trading on recognised exchanges, investors can gain exposure to illiquid assets with the liquidity of holding a share listed on a recognised exchange.
For income investors, the investment trust has some particularly valuable tools at their disposal. While open-end funds are required to distribute 100% of their net income, investment trusts are only required to distribute 85%, enabling retention of income reserves able to be later released to smooth and grow the dividend over time. These reserves can become significant with the likes of Merchants Trust (MRCH) holding more than 50% of the target dividend in reserve. The ability to draw down from this pot, as happened through 2020 when dividends were suspended by many companies, enables consistency of income and its growth for investors. Through time this has considerable benefits with the likes of MRCH and City of London Investment Trust (CTY) growing their dividends for 41 and 56 consecutive years, respectively. To highlight the scale of this, a £1,000 initial investment in CTY at the beginning of the 56-year period would have generated £45,600 of income over the period compared to just £3,700 from a savings account. Admittedly a highly unlikely holding period for any investor, this highlights the power of compounded dividend growth over long time horizons.
The capacity to deploy gearing, or borrowing, by an investment trust provides another advantage of the structure over their open-end peers. By borrowing and investing at higher rates of returns, the company has the capacity to generate further returns on the underlying assets. Generally limited to 30% of the asset base, the capacity enables an uplift in returns without significant increases in risk. Beneficiaries are mostly found in the real assets space where the higher levels of borrowing are generally found.
While the benefits are abundant, drawbacks remain. Most notably in the form of limited options in some of the more popular sectors alongside the potential for greater volatility.
In the UK equity income sector alone, the 74 open-end constituents vastly outnumber the 20 investment trusts on offer. The US-focused sector shows a much starker difference with just seven options in the North America Investment Trust sector against more than 250 options in the IA North America sector. Options are therefore thin in some of the larger sector allocations seen within client portfolios.
Increased volatility is likely to be the largest negative of the investment trust structure, with borrowing having the potential to increase gains and losses alongside the enhanced price swings of a trust moving from a trading premium to a discount around the performance of the asset portfolio. In times of market stress, investors are prone to dispose of their most liquid assets, increasing the probability for falls in an investment trust’s share price to exceed that of the underlying portfolio of assets, or NAV. While an issue for current holders, it creates opportunities for cash heavy investors seeking out a bargain.
While investment trusts don’t suit every investor portfolio, they can play a valuable role in portfolios. Currently trading at the widest discounts seen since the financial crisis, there looks to be some attractive opportunities in the space.
This article was taken from the
Spring 2023 issue of
1875. To subscribe to our investment publications, please visit
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Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance.