Investment trust ISAs

Investing in the equity markets can be something of a roller-coaster ride and building a diversified portfolio of stocks and shares is the best way to reduce the volatility in your portfolio and maximise returns over the long-term.

Most of us lack the both the experience and time to do this, so buying an investment trust is a sensible way of accessing a ready-made and professionally managed basket of equities.

How they work

Investment trusts are the oldest form of collective investment around. The first one, the Foreign & Colonial Investment Trust, was set up to fund the expansion of the railways in South America.

Nowadays, however, the majority are set up purely to invest in the shares of other companies. As collective investments they pool investors’ and spread it across shares in a range of companies.

This reduces the level of your investment risk because not all of your cash is riding on a single share. It also means that you can afford to buy into a diversified portfolio of shares at once without committing thousands of pounds.

In this way they are similar to unit trusts, albeit with several important differences.

Similar, but not the same

Unlike unit trusts, investment trusts are listed companies, just like other shares, and have independent boards of directors, which means that investors get more of a say in how their investment is run.

Annabel Brodie-Smith, communications director at the Association of Investment Companies (AIC) explains: “There is an advantage to being a shareholder in a company rather than just an investor in a pooled fund of units. Company boards are democratically elected and the directors are accountable to the shareholders, who can challenge the board’s actions and vote against proposed business decisions.”

The board can vote to remove underperforming managers and replace them with another fund management team whereas a unit trust will only ever replace a manager internally.

Being a listed company does come with a number of pros and cons, however.

Unit trust managers can create new units to meet investor demand and cancel them when investors withdraw funds. They also set the price of these units daily after calculating the value of the underlying portfolio of investments, which is known as the fund’s net asset value (NAV).

As listed companies, investment trusts have a finite number of shares, or closed-ended in industry-speak, and the price of these shares is determined by the normal vagaries of supply and demand that are a feature of stockmarket investing.

If an investment trust is very popular its share price can trade above its NAV, or at a premium. Conversely, and far more commonly, the share price will trade below its NAV, or at a discount.

This can work both ways for investors. If you buy an unloved investment trust trading on a 10 per cent discount it means you will get £1-worth of shares for every 90p you invest. If this discount narrows, or even moves to a premium, this can provide a nice uplift to performance. On the flipside, if you buy an investment trust trading at NAV and it moves to a 10 per cent discount, you will take a 10 per cent hit on your returns even before you consider how the underlying holdings have done.

This uncertainty does lead many investors to favour unit trusts, but investment trusts do have other flexibilities that set them apart.

Unlike unit trusts, investment trusts are allowed to borrow money to fund further investment. This is known as gearing, and its effect on investors can be both positive and negative. If the trust borrows to buy shares in a rising market, the returns will be magnified and the debt incurred by the borrowing can be repaid fast. But if those shares stagnate or fall in value, investors will lose and the trust will still have a debt to repay.

Mike Woodward, deputy head of investment trusts at F&C Investments, says: “Obviously gearing is a bit of a double-edged sword, but you shouldn’t be getting into the stock market unless you think it’s going up and if it is going up, the ability to gear is a very useful one.”

Star performers

Over the longer term, average investment trusts do tend to perform better than unit trusts for a number of reasons, including the ability to gear and the fact that most have significantly lower charges.

Many of the best known investment trusts charge an annual management fee of under 1 per cent compared to the standard 1.5 per cent levied on most unit trusts. You will face stockbroker fees for buying the trust, but many investment managers will waive these in the run-up to the ISA deadline.

“In many cases, if the trust fails to meet set performance criteria, the fund manager doesn’t earn their fee and that can be a powerful incentive to meet performance targets,” adds Woodward.

Choosing your Isa

There are literally scores of investment trusts to choose from, ranging from more mainstream UK or global equity trusts to those investing in more specialist areas, such as technology, property and agriculture.