What are the risks when choosing an investment fund?

Investment / Savings
Rosie Murray-West looks at the risks when choosing an investment fund.

Investment trusts, also known as investment companies, have long been the Cinderella of the personal finance world. While their open-ended sisters are known for their glitzy marketing and star fund managers, these trusts tend to be a less well understood and less popular option for investors. That is a shame, because investment trusts have a lot to offer, including lower charges and potential out-performance. However, before you buy, it is important that you understand how these funds are priced so that you avoid potential pitfalls.

In many ways investment trusts and unit trusts are similar. Both are run by a professional manager who picks and chooses a portfolio of assets on the behalf of clients. These assets might be bonds, shares or property, and as well as the input of an expert the arrangement has the advantage that clients’ money is spread over a broader range of assets than would be possible for a single investor.

Many fund managers run two similar products – one an investment trust and the other a unit trust. The two are likely to have similar aims and similar portfolios. The difference between the two products lies in the way that they are structured, bought and sold. An investment trust is a listed company. It issues a fixed number of shares which can then be bought and sold on a stock market. The price of these shares, like any others, is determined by demand and supply in the market. Because a fixed number of shares is issued, these funds are known as ‘closed ended’.

Unit trusts or OEICS (Open Ended Investment Companies), on the other hand, are what are known as open-ended funds. The fund’s assets are split into units and when more people want to buy than want to sell, more units are issued. The value of the units always reflects the value of the assets that the fund holds.

Despite the two types of fund offering almost identical portfolios in many cases, performance can vary significantly between the two. In 2013, Canaccord Genuity carried out a survey of the five-year performance of open ended funds and comparable units trusts. In many cases the funds compared were managed by the same person. In all but one of 19 cases the investment trust had performed better, with average annual returns 2.24 per cent higher than equivalent open-ended funds.

Why the difference in performance? One reason is that investment trusts have historically been cheaper because they haven’t had to pay commission to financial advisers – a game that has now been changed by the impact of the Retail Distribution Review, which means that advisors largely no longer work on a commission basis. Another reason, though, is that investment trusts can take on gearing – borrowing additional money for investment – which unit trusts cannot do. This means that their returns are often boosted by strong stock market performance – when shares rise strongly, the investment trust’s gains are multiplied.

Investment trusts also have the luxury of being able to take a long term view. When a unit trust has members who want to sell their units it has to liquidate assets. As they tend to want to do this when the market is falling – generally a bad time to sell assets – it can drag performance down.

Investment trust managers can also smooth out the dividend income that they pay. While unit trust managers have to distribute their profits annually, investment trusts can keep back up to 15 per cent of their income in reserve for a rainy day. It is this policy that means that some investment trusts have increased their dividends every year for a startlingly long time. “Investment companies have the flexibility to squirrel away some of the income they receive each year and save this for tougher times,” explains Annabel Brodie-Smith from the Association of Investment Companies (AIC) which represents the interests of investment trusts. “This feature has enabled many investment companies to increase their dividends to meet the needs of income investors through thick and thin,”

Figures from the AIC out earlier this year, showed that a quarter of its members had increased their dividends every year for a decade. Some of the oldest trusts, such as Foreign & Colonial and Alliance Trust, have a track record of increasing their dividends every year for over four decades.

Risks of investment trusts

However, investment trusts do also have drawbacks. While gearing can be seen as a positive for an investment trust, it multiplies losses as well as gains, meaning that some people see investment trusts as a riskier prospect. They may also be more volatile because of their gearing, which can be tricky over shorter time periods.

There is also an added complexity when it comes to the pricing of trusts. While the value of the units in an open-ended fund is always the same as the value of its assets, the share price of an investment trust varies depending on how many people want to buy it. This means that an investment trust can sometimes trade at a discount or (more rarely) a premium to the value of its assets. While this may sound as if you are getting a bargain, the discount can widen still further.

While a large discount can mean that an investment trust is good value, it can also mean that people lack confidence in the manager or sector, or that the trust is performing poorly. Similarly, if a trust is trading at a premium it could be an opportunity to sell your holding and make money, or it could represent outstanding confidence in a manager whose strategy will make it soar further.

How to pick an investment trust

When choosing an investment trust there are several things you have to look at. The first is the discount or premium to net asset value, as mentioned above. Discounts have narrowed in recent years, so if an investment trust looks good value there may be a worrying reason why. Try to find out the reason for it – look at performance in recent years, as well as any changes to management or strategy. Look at the yield, too, as this is the income that you will get from your investment. Finally you can look at the charges you pay on the fund by finding what the ongoing charges are – expressed as a percentage. Charges will eat into your returns, but it isn’t necessarily the case that the cheapest investment trusts are the best value.

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