The power of investment trusts

Harnessing the power of investment trusts for long-term returns

Peek inside the personal investing accounts of the City’s professional investors and you will likely find them chocked full of investment trusts. Private investors, on the other hand, when selecting investments for their ISAs or pensions, have tended to opt for the wide choice in funds such as unit trusts, the low costs of passive investments such as exchange traded funds (ETFs), or the adrenaline-fuelled adventures of individual shares. But, in recent years, it seems a shift is emerging: private investors are switching on to the power of investment trusts for their portfolios.

In 2021, 16 new investment trusts were launched¹, and record amounts of new money were invested, bringing the total to over 400 to choose from. As it stands today, the assets managed by this 150-year-old corner of the industry have ballooned by nearly threefold in just ten years.²

In particular, investors are beginning to understand that the unique features that come with investment trusts serve the long-term investor well – those looking for a sensible approach to building wealth for the future. Here’s why they are an essential piece of kit for your portfolio.

1) POOLED INVESTMENTS REDUCE RISK

First and foremost, long-term investors are best placed in pooled investment funds that diversify individual company risks by holding a number of stocks, as picking winners is extremely difficult to do.

A few years back, academic Henrick Bessembinder analysed every stock in the US stock market going all the way back to 1926. He found that just 4%³ of stocks were responsible for all gains in the US stock market over the entire period, a sobering fact. Not only are the winners hard to find, you also need to side-step a lot of losers too if you are to build wealth. Ultimately, investments in single shares can go all the way down to zero. With pooled investments, this outcome is extremely unlikely, as the potential sins of one are cushioned by the virtues of many others.

What is more, investment trusts have stock pickers at the helm – professionals who use a wealth of experience and technical expertise to select the best stocks from a particular market for the portfolio.

2) INVESTMENT TRUSTS ARE STRUCTURED FOR A LONG-TERM VIEW

Now we get into the nuances of investment trusts. They are actually structured quite differently to unit trusts which gives them certain advantages.

When you want to invest in a unit trust, shares are created, and your money is invested across assets in the portfolio. Similarly, when you want out, the shares are cancelled, and assets may need to be sold in order to return your investment back to you. During market downturns, this can be problematic for returns, as a potential stampede of investors running for the door may require the fund manager to sell assets at a time when it is inopportune.

Investment trusts, on the other hand, have a set amount of money to invest, mostly raised at launch, with shares that are traded separately on a stock exchange. As an investor, if you want to invest, you must buy its shares from another investor. It means for the investment trust’s stock pickers, they are able to take a truly long-term view and not concern themselves over potentially needing to sell investments to fund redemptions.

3) LONG-TERM RETURNS ARE BOOSTED BY BORROWING

For the long-term growth-seeking investor, investment trusts have a special trick up their sleeve: they can borrow extra money to invest. This is known as gearing. Much like using a mortgage to buy a house, it extends the financial reach of the investment trust, serving to boost gains over the long run; although, it also exaggerates falls, hence why it is often referred to as a ‘double-edged sword'.

While, over the short run, markets frequently go through periods where they fall in value, over the long run they rise. It is why gearing is one of the factors that contributes to investment trusts tending to beat unit trusts over longer periods of time. If we look across 16 major investment sectors where funds are comparable: over 10 years, investment trusts beat open-ended funds in 12 out of the 16 sectors.⁴

4) INCOME IS SMOOTH AND PREDICTABLE

For the long-term income-seeking investor, investment trusts have another trick up their sleeve: they have a special rainy-day pot called a revenue reserve, enabling the trust to put away up to 15% of the dividends it receives from its underlying investments in any given year. This means during the good years when the dividend harvest is plentiful, they are able to hold back some earnings, so that when the harvest falls on harder times, they are able to top up the yield paid to investors.

As a result, investment trusts can smooth the income payments made to investors, and will often offer consistent rises. It’s why many investment trusts have raised their dividend year-in, year-out for decades. Indeed, Alliance Trust is one of seven investment trusts that have raised their dividend for more than 50 years in a row.⁵

5) AN INDEPENDENT BOARD KEEPS INVESTMENT TRUSTS ON THE STRAIGHT AND NARROW

Unlike unit trusts, investment trusts have an independent board of directors that oversee the running of the trust and its stock picking. It means the shareholders’ best interests are kept at heart, with directors ensuring the trust’s fees remain competitive and that it stays the course with its investment mandate. If performance is bad, they will question the investment managers, and may even remove the trust and give it to a different financial institution to run instead. It is why so many of them have been in existence for decades, some for more than 100 years.

ALLIANCE TRUST FOR YOUR PORTFOLIO

Alliance Trust is one of the oldest and largest investment trusts in the UK, with a history dating back to 1888 and assets of more than £3bn. Using a team of nine stock pickers with complimentary styles, it invests in the shares of a wide range of companies in stock markets all around the world. It’s how it aims to deliver attractive capital growth for your future financial goals, and a rising level of income for today’s spending needs.

Marcus De Silva is a Freelance Investment Writer