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Introduction to investment trusts

Looking for an investment with a reputation for delivering decent returns for reasonable charges? Investment trusts could be just the ticket.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice. Tax rules can change and their effects on you will depend on your individual circumstances.

What you’ll learn:

  • What the main types of equity and bond funds are.
  • What the difference is between active and passive investing.
  • What multi-asset and multi-manager funds are.

Before investors can make a decision on whether investment trusts are right for them, it's important to understand what they are and how they work.

What is an investment trust?

Investment trusts, like any other investment, involve risk of loss - their value can fall as well as rise and you may get back less than you invest.

An investment trust at its simplest is just another type of fund, like a unit trust or Open-ended Investment Company (OEIC), in that it's a type of pooled investment. However unlike unit trusts and OEICs, an investment trust is a quoted company and listed on the Stock Exchange. But its sole business is to invest on behalf of its investors.

What they invest in

Just like other fund types, investment trusts offer a wide range of opportunities to investors. There are a large number of global trusts that spread money across several stock markets around the world. Or, you can opt for an investment trust in the one market - say the UK, or a region like the Far East.

Wherever you see an opportunity for long-term investment, you'll usually find an investment trust specialising in that area. But be aware that when buying foreign investments there'll be currency risks to consider. A falling pound will increase your gains from foreign investments in sterling terms, while a rising pound has the opposite effect, lowering the value of your returns.

Investment trusts vs unit trusts

A key difference between investment trusts and others funds such as unit trusts and OEICs is that they're closed-ended, in that there's a limited number of shares in existence. When investors want to buy into a unit trust or OEIC, the manager makes it possible by creating new units and then invests this new money. Likewise, when investors want to sell, the manager may have to sell investments, or parts of them, to enable the cancellation of units.

But as investment trusts are closed-ended, if you come in as a buyer after a trust’s launch, you can only do so if an investor wants to sell their shares.

Find out more about funds

Premiums and discounts

Market demand dictates an investment trust's share price, which can move either above or below the value of the assets that it holds called the Net Asset Value (NAV). When the price moves above the value of the fund, it's trading at a premium. When the price falls below the NAV, it's trading at a discount. Buyers often look for trusts trading at a discount because they can pick up the shares at a cheaper price than at other times. For example, if a trust is trading at a 10% discount, you can get an investment which itself represents £100 worth of shares for £90 and in addition, from an income perspective, you'll continue to receive dividend income derived from £100 worth of assets.

However, remember if you invest when it’s at a premium, you'll be paying over the odds.

Obviously, a trust trading at a discount isn't such good news for sellers. But remember that, as with all types of investments, buying a shareholding in an investment trust should be for the long term, at least five years but preferably longer. This means investors shouldn't be too alarmed at discount changes. Over the long term, the growth in the trust should hopefully offset any negative effects from changes in the discount, though of course, this potential upside can never be guaranteed.

Investment trusts and gearing

Unlike unit trusts, investment trusts are allowed to borrow money to invest in more assets on behalf of their shareholders. This is known as 'gearing'.

The money raised from gearing is used to increase the size of the trust's investments. Investment trust managers may want to do this when they see a rise, or potential rise, in a particular sector or stock's share price. More shares in an investment with a rising value will boost investments, bringing greater potential for both income and growth. But when share prices are falling, gearing can just as easily exaggerate any losses. So in other words while this additional risk i.e. gearing, could deliver better returns, equally it could cause even greater losses.

How about dividends?

Investors have a choice over whether their dividends are reinvested or received as income.

Income received from dividends paid by an investment trust is usually taxed at the same rate as for other company shareholding distributions. Under the Dividend Allowance, there is a tax-free allowance of £2,000; any dividends above this amount are charged at 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.

Be aware that HMRC views reinvested dividends in the same way as a straightforward dividend payment – you're still subject to tax on them. It's down to all investors to make sure they declare their dividends. Tax rules can change in future and their effects on you will depend on your individual circumstances.

It's worth noting too that as investment trusts are essentially companies, they can also hold back some dividends generated by the portfolio, which open-ended funds can't do. This allows investment trusts to smooth payments by keeping back some income during the better years, which can then be paid out when the underlying portfolio disappoints during poorer periods.

What about charges?

Just like unit trusts and OEICs, investment trusts provide professional management in return for an annual fee. The good news for investors is that they have a reputation for low charges. Investment trusts don't pay commission to a third party, nor do they charge an initial entry fee. And the annual management fee can be appreciably lower than unit trusts and OEICs, sometimes by as much as 1%.

However, unlike unit trusts and OEICs, investment trusts are structured like a public limited companies and listed on the stock market, so you can buy and sell shares in them as you would any other listed company.

As a result, with investment trusts there is usually a bid-offer spread (where the quoted buying price will be more than the selling price), whereas many open-ended funds have single pricing.

Tax wrappers

Profits you make from selling shares in investment trusts are subject to capital gains tax (CGT), although there's an annual exemption - for the current tax year 2018-19 it is expected that the first £11,700 of gains made by an individual is exempt from CGT. But investment trusts can usually be held in a stocks and shares ISAs, where income and gains are sheltered from tax. In the 2018-19 tax-year, you can put up to £20,000 in your ISAs.

Investors can also buy investment trust share holdings in a pension plan, such as a Self-Invested Personal Pension (SIPP). If you want to open a SIPP through Smart Investor, you can sign up to be notified when it becomes available.

Most investors qualify for income tax relief on money they put into their SIPPs on an amount that either matches their annual earnings or the maximum annual limit of £40,000, whichever is lower. Once in a SIPP, assets are sheltered from income tax and CGT. There'll usually be an income tax charge when you take pension benefits out beyond the 25% tax-free allowance.

Be aware that you won't be able to access your SIPP investments until you reach age 55, rising to 57 by 2028. And tax and pension rules may change in the future. The value of this, and any favourable tax treatment to you, will depend on your individual circumstances, which, of course, may also change.

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