Investment Trusts vs Funds

When it comes to investment funds vs trusts the difference between the two can seem hard to fathom. But the most important distinction is open ended and closed ended which we’ll come onto shortly.

Overall the two are very similar. And you don’t have to commit to one as you can comfortably have both in a portfolio.

As with all investing, your capital is at risk and past performance is no guarantee of future returns. You might get back less than you originally invested. We’re not qualified to give financial advice or recommendations and so if in doubt be sure to get trusted independent advice tailored to your own financial situation.

Key differences:

Investment Trusts

  • Closed ended – a fixed number of shares are in issue
  • Shares are exchanged on the free market
  • Share price is decided by the market and could be more or less than the net asset value
  • Income – Trusts can hold back up to 15% of earnings to sustain their dividend in hard times
  • Gearing – Trusts are allowed to borrow money to amplify gains and losses
  • Typically slightly cheaper management fees

Investment Funds

  • Open ended – investors can buy or sell as they like and the fund will grow and contract in response
  • Shares are bought from and sold back to the fund manager
  • Shares are priced at the net asset value
  • All income is passed directly on to shareholders
  • No gearing

What is a Closed Ended Investment Trust?

An investment trust is a company that has its own capital reserves from an Initial Public Offering (when it is first listed on a stock exchange) that it uses to buy an sell equities such as shares. Investors like you can then buy shares in the trust.

This tends to be very simple and cost-effective because the trust is listed on the London Stock Exchange and only has a fixed number of shares in issue.

The key separations from an open ended fund is that shares in investment trusts are sold on the open market rather than through a fund manager. Because of that the share price of an investment trust is decided by the market and can be priced higher or lower than the actual value of the holdings – the net asset value.

That fund manager is also granted extra abilities like using gearing to increase gains and losses – borrowing money to buy shares – and holding back 15% of income in order to uphold dividend payments if earnings decrease suddenly.

What Is An Open Ended Investment Fund?

With open ended funds money is paid in by investors and and then goes through a fund manager who chooses what to do with the full pot. That may seem simpler on the surface but it does create additional complexities. For instance, the fund can shrink and grow depending on how many investors join and how much they have paid in.

You buy or sell your investment from the fund. This can create an issue with liquidity because if a large investors decides to withdraw, the underlying assets may have to be sold. That takes time and depending on where the market is could result in a loss.

The downfall of former star fund manager Neil Woodford came when Kent County Council decided to withdraw from his flagship Equity Income fund. As the fund did not have the liquidity to pay out the £263 million invested he had to freeze all withdrawals, trapping many investors into his sinking ship.

On the other hand, open ended investment funds can potentially offer more liquidity as you are buying and selling from the fund manager rather than the open market.

Open ended fund unit prices are determined by the net asset value of the holdings which is calculated at the end of each day. You therefore won’t pay a premium or a discount for the underlying value of the assets.

Diversification

Both investment trusts and open ended funds are very good methods of long term investments. This is especially the case with retail investors and pension funds who don’t want the ordeal of managing their own portfolio and are instead happy to buy into a managed portfolio.

For small scale retail investors buying single stocks has a lot of issues. You have to pay transaction fees with most brokers – often about £10 per trade – and you also need to diversify your holdings across a range of assets. At least several stocks, but also different industries and asset classes like bonds ideally. You also need to have the knowledge of how to do this effectively – how you balance risk and reward and what your investment goals are.

Investing is always long term and past performance is no guarantee of future returns, but if you hold just a few stocks your overall volatility – the amount your portfolio will rise and fall day to day – could be very significant.

With that comes also a need for the psychology of investing – which still applies if you buy trusts and funds. You need to control your emotions so that you can make the right choice no matter which way your portfolio is heading. Humans naturally have a fight or flight response which means we frequently buy when the price is high and sell when it is low.

None of these things are a one-time exercise either. With active investing you will probably want to keep and eye on your portfolio and rebalance frequently. If your tech holdings have grown massively then you won’t have the same diversified mix you started with if your other holdings haven’t grown at the same rate.

Both investment trusts and open ended funds can be bought easily through a broker. In fact, Hargreaves Lansdown has a big focus on keeping costs down for funds with free trades and ongoing management discounts. And as these open ended funds and trusts are invested in many different companies – often including different asset classes like bonds, oil and gold – you can be diversified straight away even if you only buy a single share of a trust or fund.

Those funds or trusts are then managed for you in return for an ongoing management fee.

What’s more is you can go on to buy into multiple different investment trusts and open ended funds so your investments are spread across hundreds of assets. Although if you got to that point you might be better off using passive index trackers and taking advantage or their lower fees – but more on that later.

Net Asset Value

Open ended funds have a set price based on their Net Asset value – meaning the value of all the assets they own. Because of that you can’t really get a bargain.

With trusts the share price of a trust is just as speculative as the price of the shares it owns as they are both determined by the market. Because of that, shares in trusts can sometimes be priced lower than the value of shares held in that trust.

Supposing the average price of all the shares owned by a trust were £10, but you could buy a share of the trust for £8, then you would be getting a discount of 20% below the Net Asset Value.

How does that happen? Investors could get carried away with a sexy technology stock and dramatically increase its price. An investment trust with shares in that sexy tech stock among hundreds of different stocks seems boring and misses out on the hype, despite the fact that the value of the shares it owns has increased.

Of course that is largely academic because you are not then able to claim the shares the trust owns, you can only buy and sell your shares in the trust and receive dividends. You cannot buy shares in Bailie Gifford’s Scottish Mortgage Investment Trust and then demand your cut of their Tesla stock.

But overall buying stocks at a discount through a trust can give you some security.

Investment Trusts Vs Funds Fees

The other point about trusts is they tend to be quite cheap. Hopefully you are already aware of the huge importance of portfolio fees when looking where to invest. Many investors think 1 – 2% is a bargain, especially for a so-called “star fund manager” but the reality can be very costly.

Given gains of 5 – 10% are pretty good, then in a good year you could be handing over 20% of your gains to your fund manager.

And here’s the real secret sauce.

Fund managers are humans too – even the gurus. They might have a good run of a few years and then cash out on that reputation. But 95% of fund managers ultimately fail to beat the market.

They take your investment and hopefully match the market and charge a premium fee. Those fees represent an opportunity cost – 10 – 20% of your gains each year wiped out which severely impacts future gains thanks to compounding. On the other hand a passive index fund will match the market for far less cost. No fund manager to pay, no marketing materials to create, very low fees.

But aren’t investment trusts using fund managers too?

Hell yes. In fact investment trusts have yielded some true celebrities like Nick Train – the so-called British Warren Buffett – and James Anderson of the Scottish Mortgage Investment Trust.

But are they ripping you off too?

Nick Train’s closed ended Finsbury Growth and Income Trust charges just 0.7%. Scottish Mortgage is even lower at 0.38%.

Gearing

One of the drawbacks of trusts is called gearing when the trust managers are allowed to borrow money to by shares. This is known as leverage. Leverage is the exciting but dangerous tactic used by traders to amplify gains by increasing their initial principle investment with borrowed cash. The result is volatility – you stand to gain more but also lose more.

Imagine a growing market where a manager thinks the market could go up 20% in a year. They can get a loan of £10,000 for a 5% interest rate. If he was right about the market then the trust investment is now worth £12,000. He can repay the loan with interest of £500 and walks away with a profit of £1500.

Given the huge sums of money investment firms work with you can see how that borrowed money could yield significant gains.

But what if they were wrong and the market dropped 20%? The investment would be worth £8000 and the same £500 interest rate would apply and so the result would be a loss of £2500.

Let’s not forget the classic Buffet advice: “Rule 1 to investing – don’t lose money. Rule 2 – see rule number 1”. That fund manager would then be left with a smaller amount to invest. Even with no leverage, if you lose 20% in the market you then have to make more than 20% to get back to where you were because your principle investment has shrunk.

Generally over time markets do continue to go up and so a small amount of gearing is usually beneficial. But when drops occur they can be more painful.

Income Investing

Both investment trusts and open ended funds tends to have a clear set of goals. One of the most important and clearly defined tends to be income vs growth.

With long term investing, growth typically comes at higher risk. Growth also normally means low or no dividends as these are young companies reinvesting their income to grow the business rather than distributing profits to shareholders. Higher risk means higher volatility as these companies can take deep dives before they recover, if they do ever recover.

Income investing is all about dividends and these tend to be large and established companies. As such their share price doesn’t fluctuate that much compared to a growth stock. Income investors typically don’t look so much at the share price and more at the dividend which should hopefully be paid regularly and increase over time.

As such the very name of an investment trust or open ended fund will typically give you a good idea of whether it is focused on income or growth (or even income and growth in Nick Train’s case), but if in doubt you can check the fact sheet.

Another benefit of investment trusts is because of their fixed size they are allowed to save up 15% of their income so that in times of poor performance they can maintain their dividend. That’s important for income investors.

Investing in Trusts and Funds: Which To Go For

We are unable to provide any investment advice – and nor should you be looking for it from the internet. Often that’s like asking a barber if you need a haircut – the answer is always whatever product that particular website is trying to promote.

Many people search for the best performing investment trusts or funds which is usually a bad approach as past performance is no guarantee of the future. Websites analyzing performance typically only look at a short time frame of a few years. Real gains in the stock market are made over decades, not years, and so you need to be prepared to weather storms many years down the line – and they will be quick and unexpected.

However, trusts and funds do normally offer a diversified approach to investing with a good degree of risk management. Therefore you should read extensively around any investment product’s fact sheet and find out what their goals are and how they manage risk.

Then you must consider fees. You cannot control the markets but you can control the fees you pay. As mentioned above, just a few percent of management fees a year can severely impact your gains over time. And if you lose you still have to pay.

It may well be that a passive investing approach through index-tracking Exchange Traded Funds could be better for you as they match the market for a very low fee instead of trying to beat it for a high fee.

Make sure any investment product you go for is authorised and regulated by the Financial Conduct Authority and watch out for any performance guarantees.

If in doubt consult professional, independent financial advice – from an expert who is also regulated by the Financial Conduct Authority.

Stewart Vickers
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