Keep your closed-end options open

Some years ago the Association of Investment Trust Companies embarked on a training programme for intermediaries. The perception was that, if advisers understood investment trusts better, they would be prepared to recommend them to their clients in preference to unit trusts. The results were mixed. While a small band of advisers embraced the concept as a real alternative in the field of collective investments, the reality was that most preferred to stick with the investment product they knew and understood.

Subsequent events have given some support to this conservative approach. The growing complexity of capital structures within the investment trust market made the consequences of falling markets that much greater. One result has been the discussion over whether or not investment trusts should become regulated financial products.

And there have been other recent developments. Guidelines on corporate governance have been established and transparency has become as much an issue here as anywhere. Moreover, the regulator has declared that the ability of investment trusts to borrow money for investment must now be taken into account when assessing their suitability for client portfolios.

But does this invalidate investment trusts as an asset class within portfolio planning? The answer I believe is definitely “no”, but that is not to say they can be handled in the same way as other investment products. The reality is that the range of options available in this market should satisfy investors, from those who are relatively cautious to the raciest risk-taker. The difficulty comes in understanding where individual trusts sit within the overall investment spectrum and in determining which is suitable for a particular client.

Investment trusts are close to my heart. I have been involved with them for many years, as a director of an investment trust and an active manager of portfolios solely using this sector of the market. I have sat on committees charged with improving the standard of reporting to investors and their advisers and have always maintained a close association both with trust managers and with their trade body, the AITC. Even I must acknowledge that they are not a complete substitute for unit trusts. While many arguments in their favour exist, you need to understand them well if you are to achieve appropriate results.

Among the plus points over unit trusts is the generally lower charges. The fees payable to the investment manager and the actual costs of running the trusts are usually lower than those of unit trusts, for perfectly understandable reasons. Since management fees and other expenses can be considered a tax upon performance, this gives investment trusts an advantage but not an overriding ascendancy over other investment vehicles.

There is also the fixed capital structure. Not only does this make investment trusts cheaper to administer, it also makes the task of the investment manager that much simpler. When running money, knowing that cash can flow in or out of a fund is a constraint and even a source of concern. Knowing your pot is finite can have considerable value.

The range of investment options available to managers is also greater than that allowed to the open-ended management community, although this is now changing. Some potential investments are simply unsuited to an open-ended structure. Unquoted investments, for example, are both difficult to value and to realise, so allowing them as a component of an open-ended fund is clearly dangerous. Property can also be troublesome when it comes to valuation and sale.

The ability to borrow money is an issue when it comes to using an investment trust. The gearing effect of a portfolio part-funded by debt should work in favour of the ordinary shareholder during rising markets. But when share prices fall it will have a detrimental effect. Ultimately you remain at the mercy of the judgment of the manager. There is evidence that most gearing is used wisely, with managers borrowing to take advantage of expected short-term moves. In truth few investors fully understand the powers available under whatever borrowing policies are laid down by the board, and are in no position to check the nature – and cost – of any debt incurred.

Having served on the board of an investment trust, I can understand there is an advantage in having an independent body of people to pass judgment on the performance of the manager. In the past, boards have proved reluctant to change horses in mid-stream, but this is changing. Indeed, if anything, the pendulum seems to be swinging the other way. The independence of an investment trust board should be a plus, but it does introduce another element of uncertainty into the mix.

In the end it is performance that counts. But the fact that investment trust share prices can fluctuate according to supply and demand distorts performance. It is fine being able to report that a manager has succeeded in raising the value of assets per share in a trust by 10% when the market has risen by 5%. But if the discount widens by 5%, the client sees no benefit.

Looking at recent performance figures for investment trusts, no clear message emerges. Just as different segments of the unit trust market will achieve ascendancy at various times, so investment trust performance is at the mercy of underlying market conditions – with one additional factor. The nature of the share capital will play a part. That said, only one warrant – arguably the most volatile of share classes – features in the top tables.

The one area that has performed well over the longer term is property. With real estate investment trusts now firmly in the frame for the future, the choice should widen. As for the other winners, it is comforting to see that vanilla trusts are present in greater numbers than the more esoteric varieties. That the large, international general trusts are absent should, perhaps, be no surprise. But for the sophisticated client and the knowledgeable adviser, investment trusts remain an opportunity.

BRIAN TORA
Head of the Gerrard intermediary division