What is an investment trust?

There are numerous investment trusts to choose from with some offering broad exposure to a global basket of shares and others focusing on specialist areas.

However, they are more complicated than other investment funds so it’s important to understand how they operate before you invest.

What are investment trusts?

Investment trusts are similar to unit trusts, in so far as they pool your contributions with money from other investors to buy a basket of shares that’s managed on your behalf by a fund  manager. However, they are structured very differently to unit trusts and are subject to different rules.

While unit trusts are open ended, with no limits to the number of ‘units’ available for investors to buy, investment trusts are closed ended, with only a limited number of shares to buy.

This is because investment trusts are actually publicly listed companies that invest in the shares of other companies on behalf of their investors.

When you are buying shares in an investment trust, the price of these shares is based on both the performance of the companies they invest in as well as the supply and demand.

How does an investment trust work?

When you purchase shares in an investment trust your money is pooled with other investors and used to purchase a diverse range of shares and assets. In simple terms:

• You buy shares in an investment trust

• The money from your shares is put into one big pot, with the money from other shareholders - this is called the fund

• The fund is then used to buy shares and assets by the fund manager

• The value of these shares and assets fluctuate and are bought and sold over time

Investment trusts, like unit trusts, tend to be lower risk than buying shares in a single company because your money is invested across a variety of companies. This does not eliminate the risk to your money but means that the performance of a single share has less impact because there are many others to counteract it.

What is a fund manager?

The fund manager is the person responsible for the day-to-day management of the investment trust's fund. He or she chooses where the fund is invested as well as when to buy and sell assets. 

The fund manager is usually appointed and monitored by the investment trust's board of directors. The board of directors is  also responsible for setting the wider investment strategy that the fund manager will follow.

The investment strategy outlines how the fund manager should invest the trust's money, how much risk they can take, what types of assets they can invest in and their long-term plan.

Where can investment trusts invest?

Investment trusts can invest in a variety of different asset classes. These include:

• Equities/shares e.g. utilities, technology, banking

• Cash e.g. pound sterling, US dollar

• Fixed income securities including corporate and government bonds

• Property

Like unit trusts they may focus on a specific geographic region or industry, or they may have a mandate to deliver growth or income to investors.

The investment trust's fund manager will usually have experience of investing in certain asset classes or investment areas and a track record of how their investments have performed in each area.

What is gearing?

Gearing is another name for borrowing money to allow you to buy more investments.

Unlike unit trusts, investment trust managers can borrow money in addition to the money already invested in their fund to get greater leverage and chase bigger returns.

This can boost returns if the investment performs well, but if it doesn’t losses will be magnified.

If you worry that gearing may put your money at too great a risk then there are many investment trusts that don't use it as part of their investment strategy.

What is Net Asset Value?

When you’re researching investment trusts you’ll come across the term Net Asset Value (NAV).

This is the value of the fund per share, which means the total value of an investment trust's shares and assets minus its liabilities and debts divided by the total number of shares that people hold in the unit trust.

Most trusts publish their Net Asset Value (NAV) per share on a daily basis. Comparing the NAV to the share price can give you an idea of the demand for shares in the trust.

Shares that are in demand will be more expensive than their NAV and are deemed to be trading at a 'premium' . If there is a good supply of shares they are likely to be traded at a price below the NAV and are considered to be trading at a ‘discount’. 

How much money could you make?

There will always be a huge variation in the returns offered by investment trusts. This is because they will be investing in different areas and with different investment strategies. 

Whatever the trust you go for, returns will be determined by two main factors: 

• Performance: The performance of the assets your investment trust has invested in will go a long way to determining its value. Investment trusts spread their investments across a large number of holdings , meaning their value is less likely to soar or plummet in a short period of time.

• Supply and demand: Investment trusts have a fixed number of shares in the market; this means that supply and demand can influence the cost of their shares and the value of their underlying assets.

Find out more about the different pros and cons of investment trusts here.

Do investment trusts pay dividends?

Investment trusts can share the income they earn amongst investors with regular dividend payments. If this is important to you, check before you invest. 

Those that do pay dividends usually pay them annually, twice a year or quarterly, but some high performing investment trusts have paid dividends on a monthly basis.

You can usually take dividend payments as income or reinvest them for further growth.

However, it’s important to know that dividend payments are not guaranteed. Also, unlike unit trusts, investment trusts are not obliged to return all their income to investors. They can hold back up to 15% of income earnings each year which can then be used to increase income payments to investors in leaner years and smooth returns.

What are the risks?

You could lose some or all of your money if your investments perform badly, as they are linked to stock market performance.

Supply and demand can also be a risk to your investment because if demand for your investment trust shares plummets, the amount you could sell them for will be much lower than if demand was soaring.

You can limit the risk to your money by choosing an investment trust that has a more cautious investment approach, for example by investing in lower-risk asset classes and avoiding gearing.

Find out more about the risks of investment trusts before making a decision by reading Should you invest in investment trusts.

How much do  investment trusts cost?

Like all investments there is a cost to putting money into an investment trust, although they can be cheaper than other pooled  investments like unit trusts. Common fees and investing costs include:

• Management fees: These are the fees levied by the fund manager for their services managing the investment trusts fund.

• Annual charges: This is an annual charge which covers the cost of investing the fund itself and usually ranges from 0.5% to 1%.

• Performance fees: Some investment trusts levy performance fees when the trust outperforms a particular benchmark, for example, if a trust doubled in value then an extra fee could be charged, if it did not reach that level then it would not be applied.

• Flat rates: Some investment trusts now levy flat rates rather than % fees; if you have a large amount to invest this can be more cost effective.

You can compare the costs of investing in different trusts by looking for its ongoing charges figure (OCF). This includes the fees for managing the trust, plus other regular recurring costs. For trusts that charge performance fees look for an OCF with performance fee included.

Do you pay tax on investment trusts? ?

Dividends and profits from your investment trust are taxable. Dividends are payments made by companies to their shareholders and are treated as a type of income.

Profits made from investment trusts are subject to normal Capital Gains Tax rules.

Here is more information on how investments are taxed

You can avoid paying tax on your investment trust, however, by holding it in a stocks and shares ISA. Your investment will be sheltered from tax as it grows and will be paid tax free when you cash it in.