What is an Investment Trust?

If you are new to the world of financial services and investments, you’ll encounter a myriad of technical terms and abbreviations that constitute what might be perceived as an esoteric financial lexicon. One of the first terms you will come across is that of an Investment Trust, but what exactly is an Investment Trust and how does it work? the following article will give you a quick overview and touch on a couple of related concepts.

In short, an investment trust is typically a closed-ended collective investment vehicle which is traded on the stock markets as a public limited company, but that doesn’t really explain much, so more on that later. They are primarily operated in the UK and so the examples outlined here will be assumed to be UK based.

Investment Trusts are essentially companies (not technically trusts) which have been set up to invest in the shares of other companies. Their value therefore represents the assets in which they are invested rather than the company's own property, personnel or ideas. They are designed to give individual investors the opportunity to invest in wider range of companies, and at a lower cost, than they would be able to achieve on their own.

They are termed collective investments because they achieve this aim by providing a vehicle by which they can allow many investors to pool their money and together to invest in a large range of underlying assets. As institutional investors they have access to investments which may not be within the reach of the individual investor and they are logistically able to invest in a greater variety of assets. The scale on which they trade also means that they benefit from economies of scale as well as bulk discounts on costs and charges. Therefore, the relative cost that is passed down to each investor in the trust is lower than if they were to trade on their own.

The fact that Investment Trusts are closed-ended means that there are a finite number of shares that have been issued for the trust (as with a listed company). This number will be set out in the Initial Public Offering (IPO). As with a company, further shares can be subsequently issued by the company but these will normally result in the value of each share being reduced. This is a key distinguishing feature between Investment Trusts and the other common investment vehicles, Unit Trusts and Open-Ended Investment Companies (OEICs, otherwise known as an Investment Company with Variable Capital, ICVCs) which are both open-ended and therefore have a total number of units which will fluctuate as people buy and sell. With open-ended investments this fluctuation occurs because the investor is trading directly with the fund manager (not other investors) and therefore either putting their money into the ‘pot’ to make it bigger, or taking it out to make it smaller. Furthermore, Investment Trusts differ from Unit Trusts in that they can borrow money and incur debts to fund the purchase of assets.

As they are essentially companies, Investment Trusts have a board of directors (although in a non-executive capacity because they are not actually employed by the Investment Trust). The board will guard the interests of the trust, but decisions on which actual investments should be made are take by the Fund Manager. Investors will not have a direct say on individual investment decisions but each Investment Trust will have a theme or objective which will provide criteria to guide the Fund Manager in how to manage the fund. The investor will have therefore chosen whether to invest in an Investment Trust based on this theme. The theme’s criteria will ensure that the Fund Manager selects the companies, in which the trust will invest, based upon factors such as their geographical focus, industrial sectors, how developed they are (start ups etc) - all affecting the risk and potential yield of the fund.

As a public limited company, Investment Trusts are traded on the stock exchange the shares fluctuating on price based upon supply and demand. It is therefore the case that the price of a share in an Investment Trust does not necessarily represent a proportion of the value of that Investment Trusts underlying assets or investments. That value is calculated as the Net Asset Value (NAV) - the value of all assets less costs incurred - and is often quoted as a value per share. If this value is higher than the share price the Investment Trust is defined as trading at a discount; if it’s lower then it is trading at a premium.

It is also worth noting that Investment Trusts that meet Her Majesty’s Revenue and Customs (HMRC) criteria will qualify for tax exemptions that ensure that investors do not get taxed Capital Gains Tax on any shares they trade and therefore avoid being taxed twice as the trust’s income will have already been taxed.

Without going into too much detail here there are a couple of specific types of Investment Trust that you may come across. Split Capital Investment Trusts have a limited life span and a structure which allows them to issue different types of share, with differing risk, based on criteria such as whether dividends are paid, application of capital protection, prioritisation at the point of pay out and the presence of a ceiling on any income. The higher risk shares will usually have less limitations on the capital they receive but also less capital protection if the investments go down and they will not be prioritised at the pay out. Real estate investment trusts (REITs) are companies that invest in real estate. Companies can qualify for the status and therefore avoid double taxing if they distribute 90% of their income to investors.

As an interesting aside, the first collective investment fund to be established was in fact an Investment Trust. The Foreign & Colonial Investment Trust, was created in 1868 by the founder of the Royal Brompton Hospital Philip Rose. It initially invested in Government Bonds but started investing in equities (company shares) in 1925, and is still going today, listed on the London Stock Exchange.

Now that you are hopefully more familiar with the concept of Investment Trusts you may want to find further information on actually making an investment but it is always recommended that you speak to a qualified individual such as a Financial Adviser before taking any investment decisions.