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Edison Explains

Types of trusts Our first note in our investment trust series explained what investment trusts are. This note examines the types of investment trusts that are available. How do we define an investment trust’s portfolio were tax-exempt. investment trust’s type? Although this is no longer the case, comparatively few There are several ways of looking mainstream fixed income funds use the investment trust at the different types of investment structure, partly because investors are already well served trust available, focusing on asset by a large number of open-ended bond funds. class, investment policy or management style. Many of the closed-ended funds that do invest in bonds Management style has a bearing on how a fund’s were set up before 2009 in locations like the Channel manager interacts with various market indices. Islands. Technically speaking, these funds are investment companies rather than investment trusts, because they Some fund managers may use to are outside of the UK investment trust regime. either try to beat an index like the FTSE 100, or to provide a consistently positive (absolute) return. Because of the considerable choice of mainstream bond funds in the open-ended sector, those investment trusts Others may passively track an index, replicating its and investment companies that invest in fixed income- holdings and performance to give investors broad type instruments tend to be more specialist. Fixed exposure to that index. These index trackers – or index income-type instruments refer to debt-related assets like funds – are much more common in open-ended funds convertible bonds, asset-backed securities or senior and there are currently no explicitly index-tracking secured loans. investment trusts. What other assets do trusts commonly buy? Fund managers who focus heavily on macroeconomic factors operate a ‘top down’ style of investment. Funds In addition to shares and bonds, the number of that rely on rigorous financial analysis and detailed investment trusts and investment companies investing in knowledge of specific companies, rather than predictions ‘real’ assets, like commercial property and infrastructure born from macroeconomic factors, are said to use a projects, is growing. ‘bottom up’ approach. Real assets are arguably better suited to the closed-end So, one way we define a trust is through its investment structure of investment trusts than the open-ended style, but we may also look particularly at alternative. what the trust decides to invest in. The Edison Insight This is because real assets, like office majority of investment trusts still invest all or blocks or hospitals, often come with hefty most of their assets in shares, whether in a ‘While there are many price tags, and cannot be broken up single country, a region, or globally. excellent investment effectively if investors wish to withdraw trusts investing in shares, their money. What assets beside shares do the real area of growth for investment trusts invest in? the sector over the past The illiquid nature of real assets make Some, though not many, investment trusts decade has been in them somewhat risky, as, when asset invest in bonds. Investors who buy bonds alternative assets. classes are out of favour, the investment Investors can now choose are lending money to a government or trust investor may only be able to sell their from a wide range of company in return for an income in the form shares at a large discount to net asset strategies, targeting value. of interest payments. growth or income, from Until 2009 it was less tax-efficient for UK- specialist credit to private Why are investment trust domiciled investment trusts to hold bonds, equity, infrastructure structures better suited to real as bond interest was taxable, whereas property.’ Sarah Godfrey, assets? capital gains from shares within an Edison investment companies analyst

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With an open-ended fund, the manager creates or What are split-capital trusts? liquidates units when investors want to buy or sell. Split-capital trusts provide investors with a choice of share When more investors want to sell than buy, the manager classes to match their needs. Split-capital trusts usually will have to sell some of the underlying assets in order to have a fixed life, and have at least two classes of share for meet these redemptions. This is less of a problem if the investors to choose from. fund invests in ‘liquid’ assets, like shares or bonds, which These may include income shares, where investors can be sold relatively easily and in small amounts. receive all the dividends during the trust’s life, or zero- However, closed-ended funds holding ‘illiquid’ assets, like dividend preference shares (ZDPs), which have no an office building, often take a considerable time to sell entitlement to income during the trust’s life, but pay out a these assets. If market conditions are unfavourable, the predetermined value at maturity. manager may therefore choose to limit investors’ ability to Capital shares generally pay no income but entitle holders withdraw their funds, rather than being forced to accept a to all remaining assets once other shareholders have lower price than the asset is worth. been paid back: these are more risky as there is no An investment trust has a fixed pool of capital, and its guarantee that any assets will remain. shares may be bought and sold in the market, Split-capital trusts were embroiled in a crisis in 2001, as a independently of the underlying portfolio. So investment result of several trusts having invested heavily in each trust managers do not have to sell ‘real’ assets to pay other, leading to a spiral of collapsing values as markets back their investors like they do in open-ended funds. fell. Many of these trusts – particularly those offering However, the price of the investment trust’s shares will ZDPs, which up to that point had never failed to meet their vary according to market sentiment. An investor who final capital entitlement – were sold to investors as low-risk wants to sell their shares in unfavourable market . conditions may have to accept a price that is some way The crisis was a reputational blow both for the advisers below the value of the underlying assets. However, the who recommended them and the investment trust value of the portfolio itself is unaffected by this. industry. Today, there are comparatively few split-capital What about trusts that invest in private trusts in existence, but those that there are, continue to equity? offer investors a useful element of choice over how they receive their returns. refers to unlisted companies that are not quoted on a , another ‘illiquid’ asset class where investment trusts are well represented. Private equity ‘general partner’ funds typically have minimum investment levels of $1–10m,restricting access to sophisticated ‘limited partner’ investors, including pension funds, endowments, high net worth individuals and family offices. These funds require long-term investment, because it may take several years for the private equity manager to put together a portfolio of attractive private companies in which to put the limited partners’ money to work. Individual investors can get access to private equity investment through listed private equity funds, investment trusts or companies that invest either directly in private equity deals, or in portfolios of private equity funds (a ‘’). These listed private equity funds provide investors with simple, liquid access to private equity, addressing the accessibility and liquidity posed by direct private equity investments. However, despite strong underlying performance (funds in the AIC Private Equity sector have on average produced double-digit annual gains over the past three, five and 10 years), most listed private equity funds trade at a wide discount to (NAV), often also in double digits. 26/03/19