Definition of Investment Trusts

Investment Trust or ‘Investment Trust Company’ is a term you may see when researching investment opportunities or collective investment vehicles.

But what does Investment Trust mean? And what are the characteristics of an Investment Trust?

The definition of an investment trust

An investment trust is a collective investment which pools the money of many investors, spreading it across a diversified portfolio of individual assets. It is a type of ‘fund’.

However, not all funds are investment trusts. Other distinct legal forms include:

Legal form

The name ‘investment trust’ refers to the legal structure that the asset manager uses to create and manage the investments. However, in this particular case, the name is very misleading.

While investment trusts did initially operate as common law trusts, ambiguity over this status led them to become public limited companies instead. Therefore it’s more useful to picture an investment trust as a listed business.

This is why most investment trusts carry the ‘plc’ suffix after their name. For example; Edinburgh Investment Trust Plc. Most will be quoted companies, i.e. listed on a regulated stock exchange.

Characteristics of an investment trust

Investment trusts are permitted to borrow funds to allow them to make larger investments.

As I explain in my investors guide to spread betting, leverage can increase the risk of an investment. This makes many leveraged investment trusts inappropriate for investors with cautious or moderate risk appetites.

If an investment trust is quoted, then investors can buy shares at any time during trading hours through a stockbroker of your choice. This is an advantage over OEICs and Unit Trusts which usually only trade at a single point each day.

Gains made by the trust from buying or selling shares are generally exempt from tax. However, the trust will pay a 30% corporation tax rate on its interest or foreign income before it can pay dividends to investors.

Investment trusts are closed-ended, which means that the number of shares in issue is fixed, and does not automatically grow or shrink when investors buy shares in the trust.

The drawbacks of being close-ended

Investment trusts operate like any traditional quoted company and have a fixed number of shares. Cash enters the fund when the shares are originally issued. At that time, the manager purchases assets, and then the gates are closed.

Any future investors don’t trade directly with the company, they buy and sell shares with other market participants.

If an investor wants to buy £500m shares in an investment trust, they would need to pay whatever price on the market to incentivise shareholders to sell to them.

This means that if too much money begins to chase too small an investment trust, the prices of shares begin to increase – despite no change in the value underlying assets in the fund.

Likewise, when investors flee an investment trust, they are sometimes prepared to sell for less than the underlying value of assets per share, which depresses the value of an investment trust share below the underlying value of its assets.

When an investment trust trades at a price higher than its underlying net asset value (NAV) this is called ‘trading at a premium’. This effectively makes any investment poorer value, as an investor is forced to overpay for the holding.

The premium or discount on an investment trust can change, which adds an additional layer of price volatility ontop of the underlying movements in the trust’s holdings.

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