Have it all with investment trusts

Investment trusts often beat their open-ended fund rivals on performance (particularly over the long term), charges and transparency of holdings, and so are heavily used by discerning investors. But the problem is that they often don’t have huge marketing budgets - and they are rarely recommended by independent financial advisers (IFAs) as they don't pay commission. But a change in the rules governing financial advice could open up investment trusts to wider markets.

The Financial Services Authority (FSA) has stipulated in its Retail Distribution Review (RDR) that investment trusts should be included in the spectrum of retail investment products considered by IFAs from 2013. Previously, investment trusts have not been recommended by IFAs as they haven't paid commission. From 1 January, IFAs are required to charge clients fees for advice rather than be remunerated by commission.

The investment trust industry hopes to take more business from IFAs. If it does, then this should benefit existing holders of investment trusts. The increased demand (even if it is only small) may have an effect on investment trusts' discounts. It may also lead to more investment trust product launches, bringing competition to the market.

However, the many small, illiquid investment companies within the closed-ended sector will struggle to win a place on IFA buy lists post-RDR. Some industry commentators believe any investment trusts under £100m will be too small to benefit. The large liquid trusts may get a boost, though.

Investment trust advantages

Investment trusts are closed ended in structure - they have a fixed number of shares in issue, so for every buyer there must be a seller. The company does not expand or contract in size depending on fund inflows and outflows, as is the case in the open-ended sector.

This can be a structural advantage for investment trusts because it means that fund managers can take a long-term view without the worry of having to sell good stock to meet redemptions (as happens in open-ended funds). This closed-ended structure can be particularly useful in illiquid assets such as commercial property.

Another advantage of investment trusts is that they are independently run with boards of directors. The directors' duties are to you, the shareholder, and they are often shareholders themselves. This board structure makes a difference because there are fee negotiations going on. With an open-ended fund such as a unit trust or an open-ended investment company (Oeic), fees are what the market can bear.

However, the "investment trusts are cheaper" argument is not as strong as it was. RDR is having a significant impact on reducing fees in the open-ended world with many providers introducing commission-free share classes for clients of IFAs, who will have to pay fees for advice from January 2013. While these lower-fee share classes are not available to self-directed investors, they will influence the choices that IFAs make for their mass-market clients. This may mean that, for IFAs, investment trusts may not retain their competitive edge. The Association of Investment Companies has suggested that boards should look into lowering management charges – to make sure that they offer value when compared with other fund types such as mass-market Oeics and exchange-traded funds (ETFs).

Over the past year, a number of investment trusts, such as Harry Nimmo's Standard Life UK Smaller Companies trust, have made moves to streamline charging structures in anticipation of RDR, by removing performance fees. Some investment trusts' ongoing charges can be as low as the charges that you find among passive investments such as ETFs.

Performance comparison

Investment trusts often have better performance than open-ended funds, particularly over the long term. As you can see from the table below, the average investment company measured on share price total return turned £100 into £243 over 10 years to 31 August 2012, compared with £192 from the average open-ended fund - the average return from all the Investment Management Association (IMA) fund sectors. It is not a clean sweep for investment trusts, however - over one and five-year periods the open-ended funds win.

How investment trusts compare

The ability of investment trusts to borrow to invest (known as gearing) can contribute to better performance, but can add to the risk because it can magnify losses if the fund manager gets it wrong.

The performance differential between the two fund types can be particularly evident where a fund manager runs two mirror funds, one an investment trust and the other an open-ended fund, but with the same investment strategy and benchmarks. Take Edinburgh Investment Trust, managed by Neil Woodford, compared with the two open-ended funds that he manages: Invesco Perpetual Income and High Income. The investment trust beats the two open-ended funds by significant margins. The same pattern emerges when you compare the two UK smaller companies funds run by Harry Nimmo at Standard Life. The investment trust again has superior performance.

Discount issues

Detractors of investment trusts point out that investment trust shares can trade at a price below or above the value of the underlying assets - the disadvantage of this is that their performance can be more volatile. Proponents of investment trusts argue that discounts can be used to the advantage of investors, enabling them to take advantage of investor sentiment to buy assets at a price below their fair value. They add that buying investment trusts at a discount can force you to think differently from the herd and be contrarian.

If you are looking for an investment trust you should look at trusts that are trading at a discount to their net asset values (NAVs). This will lead you to markets where the discounts are wide on investment trusts, meaning other investors have shied away from them. The potential for a discount to widen further is a risk, though. Plus the lure of the discount does not always point to the right investment decision. Some investors say "I won't touch a trust on a premium". But this may mean you miss the boat with a good investment. Take the examples of giant global growth trusts Alliance Trust and Murray International. According to research by Oriel Investment Funds, since 2 June 2008 when Murray International first moved to a premium, Alliance Trust has generated a total share price return of 30 per cent compared with 27 per cent for the FTSE World £ Index. Over that same period, Murray International delivered a share price total return of 73 per cent and saw its premium move from 2 per cent to 8 per cent.

The 40 per cent relative price outperformance of Murray International over the four years is not simply because Alliance Trust performed poorly in NAV terms - it didn't, nor simply because Murray International performed exceptionally well. It is also because, since June 2008, despite having issued more than £250m of new stock via tap issues - and contrary to scaremongers' high conviction expectation that a discount would duly emerge - Murray International's premium has actually risen. This story shows that a knee-jerk reaction to sell a trust as soon as it hits a premium does not always pay off. In fact, we recommended that investors buy into Murray International at a 4 per cent premium in our November 2011 fund tip.

How to buy investment trusts

Some investment houses allow you to invest in their trusts direct, for example via regular investments in an investment trust savings scheme (see 'Saving with Investment Trust Schemes').

One issue for those who prefer investment trusts to open-ended funds is that, while their management charges are often lower and there are no initial fees, they are traded like shares and so attract dealing charges. You can buy an investment trust from a stockbroker or investment fund platform. The online platforms tend to cut dealing fees below traditional brokers' levels - they also allow you to hold all your investments in one place.

However, despite RDR fast approaching not all fund platforms include investment trusts in their offerings. The handful of fund platforms that offer investment trusts alongside open-ended funds include:

■ Alliance Trust Savings (www.alliancetrustsavings.co.uk) charges a flat £12.50 per trade for investment trusts. However, doing this as regular online monthly investing by direct debit slashes the charge to £1.50 per deal, while automatic dividend reinvestment costs £5. If you hold shares in Alliance Trust across your accounts you may be eligible for discounted dealing charges. There is an additional quarterly administration charge of £10 + VAT if you hold your investment trusts in a stocks-and-shares individual savings account (Isa) or investment dealing account. If you hold your investment trusts within a Sipp, the annual administration charge is £135 +VAT.

■ Hargreaves Lansdown Vantage (www.hl.co.uk) charges £11.95 per investment trust trade (for one to nine trades per month, more trades brings the price down), and this fee applies for both one-off investments and regular investing. If you hold your investment trusts within an Isa wrapper, there is an annual charge of 0.5 per cent of their value, capped at £45 per year. If you hold your investment trusts within a self-invested personal pension wrapper there is an annual charge of 0.5 per cent a year (capped at £200 a year). The Hargreaves Lansdown platform is really best suited to open-ended fund investing rather than investment trusts, but is useful if you plan to hold the two together.

■ The Share Centre (www.share.com) offers a stocks-and-shares Isa in which you can hold investment trusts alongside open-ended funds. It charges a quarterly management fee of £12.50 +VAT. Investment trust dealing costs 1 per cent (£7.50 min). If you trade often there are packages available with lower dealing charges. Regular investing and dividend reinvesting each cost 0.5 per cent (minimum £1).

Ten largest investment trusts