Investment trusts are not as popular as unit trusts, but they can be cheaper and a good option for some. Find out how they work.
A beginner’s guide to investment trusts; how they work
The basic principle behind an investment trust is relatively straightforward. It’s the jargon that’s off-putting — so bear with me!
- An investment trust spreads your money around: it buys shares in different companies, or it may buy a range of bonds (which are basically IOUs for loans to a government or company) or whatever the asset is that the investment trust has chosen to invest in. If it invests in shares, it will often buy shares in dozens of different companies. If it’s commercial property, it will invest in different office blocks, factories and/or retail developments etc.
SAVVY TIP: If you want to put money into an investment trust that invests in shares, there are lots of factors that can influence the amount of risk you’re taking on. One will be how widely it spreads investors’ money between different companies. If you have two identical investment trusts, the only difference being that one invests in 50 companies and the other in 10, the one that invests in 50 companies should be less risky.
- An investment trust issues shares: When you put money into a unit trust, you buy units (as the name implies). But an investment trust is different and it issues shares in exactly the same way that an ordinary company would. You can buy – and sell – these shares on the stock market.
- An investment trust is ‘closed ended’: This means that only a fixed number of shares are issued and the number of shares remains the same. Unit trusts and OEICS (which stands for open ended investment companies) are different because they can issue more ‘units’ if they become very popular, to cope with the demand – and cancel some units if there are fewer investors.
SAVVY TIP: Don’t worry too much about the jargon, what’s important is that you understand that this can make investment trusts more volatile as the share price will vary according to whether or not a particular investment trust is popular with investors.
- Your money may be managed by a professional fund manager: He or she decides which investments to buy and which to sell (and when to do it). Part of the money you invest is used to pay the fund manager’s fees. Some investment trusts are ‘trackers’ which means that they mirror the ups and downs of a particular stock market index, such as the FTSE 100 index or FTSE All-Share.
SAVVY TIP: Fans of investment trusts like the fact that the fees you pay every year are generally a lot lower with investment trusts than with the much more popular form of pooled funds, which are unit trusts and OEICS.
What makes investment trusts different?
Although investment trusts may appear similar to unit trusts and OEICS (which are the types of funds you’d typically have in a stocks and shares ISA) there are some major differences:
- Investment trusts can borrow against their value: It’s called ‘gearing’ and the principle is the same as taking out a mortgage. Instead of borrowing against the value of property, investment trusts borrow against the value of the assets (such as shares in companies) that they already own.
SAVVY TIP: Gearing is great if you’re making money because it magnifies the gains, but it also increases the losses. Say an investment trust has £100 million, of which £20 million is borrowed and £80 million is investors’ money. If it falls in value by £20 million, investors’ money loses 25% (£20 million is 25% of £80 million), even though the overall fund has only fallen by 20%.
- Investment trusts can trade at a discount or premium: In the same way that the share price of high street companies fluctuates on the stock market, so the value of shares in investment trusts can trade at a discount or premium.
SAVVY TIP: If an investment trust is trading at a premium, it means the shares can be worth more than the money invested in it. If it trades at a discount, the shares are worth less.
Try information on Preparing to invest on the Association of Investment Companies’ website.
SavvyWoman email newsletters: If you found this information useful why not sign up now to receive free fortnightly email newsletters with money saving tips and help? You can sign up at the top of any page on the website and your details won’t be passed to any other company for marketing purposes.