There is also a sub-category of investment trusts called 'split capital investment trusts'. These were the centre of a major scandal a few years ago. Because they are somewhat of a specialist area and relatively small in number we're ignoring them for the purposes of this article.
How do Investment Trusts work?
The easiest way to understand investment trusts is to think of them as a company. This is because that is exactly what they are. Just like any other company, they issue shares to raise money from shareholders and then invest that money. The difference between investment trusts and normal 'trading' companies is that they invest their money in the shares of other companies, rather than in physical assets such as factories or mobile phone networks. Since they are like a company, they are also able to borrow money to invest (which is not allowed for unit trusts or OEICs). However, only a few take advantage of this to any significant extent.
The value of all types of investment fund is made by reference to their net asset value (NAV) per share or unit. This net asset value per share is basically the total value of the trust's portfolio of investments divided by the total number of its own shares or units.
For unit trusts and OEICs, the net asset value is calculated daily in accordance with FSA regulations and you buy and sell units at their 'offer' and 'bid' prices respectively. Investment trust shares are traded on the stock market just like any other company and so their prices can change on a minute by minute basis, according to how many shares investors are buying and selling.
Discounts and premiums Investment trusts calculate their 'net asset value per share' at regular intervals (some daily, some monthly and so on). You might expect their share prices to be the same as their net asset value. However, for a variety of reasons they tend to trade at a discount to this. One reason is that you could buy the same portfolio of shares yourself directly in the market, without suffering the ongoing management charge.
These discounts make investment trusts slightly more risky, since the value of your investment is affected by the amount that the 'discount to NAV' changes during the period of your investment, as well as the performance of the assets they hold.
If the discount gets smaller, or 'narrows', then you will make a bit more money (or lose less). If the discount gets bigger, or 'widens', the effect will be reversed. However, if you're intending to hold an investment trust for several years or more, any movement in the discount should (hopefully) be dwarfed by the performance of its assets.
Generally speaking, the size of the discount shows you how popular an investment trust is, although it can be misleading if the fund's discount is not calculated on a regular basis, because you could be comparing the current price with an asset value calculated many weeks previously. A large discount, say 15% or more, suggests a fund is out of favour. Smaller discounts, say 5% or less, or even a premium (where the price of the trust exceeds the value of its assets) indicates that the fund is currently popular with investors.
Since you buy investment trust shares just as you would shares in a normal company, the charges are similar. So, you suffer stockbroker's commission on buying and selling. However, if you use a cheap broker, it should be relatively small. On top of commission, you lose a small amount because of the difference between the bid and offer prices of the shares of the trust. However, again, this tends to be a relatively small amount, especially for the largest trusts. You also have to pay stamp duty of 0.5% on purchases.
In addition to the charges for buying and selling investment trust shares, you pay an annual management fee and other ongoing administration costs. These costs are normally offset by the income a trust receives from its investments, and the difference is distributed to the trust's shareholders as its dividends. The full amount of these charges, known as the Total Expense Ratio (TER), tends to be lower than for unit trusts and OEICs, especially for the largest investment trusts (those with assets of £500m or more).
One reason for the lower costs is that investment trusts are not allowed to advertise, which saves them money. On top of this, because they are closed-end funds, they don't have to deal with money coming into and leaving the fund, something that open-ended funds have to contend with. Overall, given their lower costs, here at the Fool we generally prefer investment trusts over their unit trust and OEIC cousins.
Part 11: Exchange traded funds