What Is an Investment Trust and How Does It Work?
Gain a clear understanding of investment trusts. Learn their structure, how they operate as a collective fund, and how to invest.
An investment trust is a collective investment vehicle, allowing investors to pool capital for a diversified portfolio of assets like stocks, bonds, and real estate, under professional management. This provides exposure to a broad range of investments and aims to generate returns through capital appreciation and income distributions.
Defining an Investment Trust
An investment trust is structured as a public limited company, with its shares traded on a stock exchange. Investors acquire shares in this company, which holds a portfolio of various investments. This makes it a pooled investment vehicle where assets are diversified.
The company operates under the oversight of a board of directors, elected by its shareholders. This board appoints an external investment manager to handle the day-to-day investment decisions and manage the trust’s portfolio. In the United States, these entities are often categorized as a type of closed-end fund, distinguishing them from traditional mutual funds or Unit Investment Trusts (UITs). For US tax purposes, if structured correctly, they can be treated as pass-through entities, meaning income and gains are taxed at the investor level, not at the trust level.
Operational Mechanics of Investment Trusts
The appointed investment manager selects and manages the underlying investments with the objective of meeting the trust’s stated investment goals, whether capital growth, income generation, or a combination. The manager’s expertise is central to the trust’s ability to navigate market conditions and achieve its financial targets.
Investment trusts generate returns for their shareholders primarily through two avenues: capital appreciation and income. Capital appreciation occurs when the value of the trust’s underlying investments increases, leading to a higher overall asset value for the trust. Income is generated from dividends paid by stocks, interest from bonds, or rental income from properties held within the trust’s portfolio. This income is then typically distributed to the trust’s shareholders.
The value of an investment trust’s assets is regularly assessed to determine its Net Asset Value (NAV). NAV is calculated by subtracting the trust’s liabilities from the total market value of its assets. The NAV per share is then derived by dividing the total NAV by the number of outstanding shares. The shares of an investment trust are traded on a stock exchange, meaning their price is influenced by market supply and demand, which can differ from the NAV.
Distinguishing Features
A defining characteristic of an investment trust is its “closed-ended” structure. This means the trust issues a fixed number of shares through an initial offering, and these shares are then traded among investors on a stock exchange. Unlike open-ended funds, the trust itself does not typically create new shares to meet investor demand or redeem existing shares when investors wish to sell. This fixed capital structure allows the investment manager to maintain a consistent portfolio without being forced to sell assets to meet redemptions, especially during market downturns.
Due to this closed-ended nature, an investment trust’s share price can trade at a premium or discount relative to its Net Asset Value (NAV). A premium occurs when the share price is higher than the NAV per share, indicating strong market demand for the trust’s shares. Conversely, a discount means the share price is lower than the NAV per share, suggesting less demand for the shares. These fluctuations are driven by market sentiment, the trust’s performance, and supply and demand dynamics.
Another unique feature is “gearing,” which refers to the trust’s ability to borrow money to invest in additional assets. This strategy aims to enhance returns by leveraging capital, particularly in rising markets. However, gearing also amplifies potential losses if the underlying investments perform poorly. The trust’s board sets limits on the amount of gearing, and the investment manager decides how and when to employ it.
Investment trusts can also utilize “revenue reserves,” allowing them to retain a portion of the income generated from their investments rather than distributing it all immediately. This reserve can be used to smooth out dividend payments to shareholders, providing a more consistent income stream even in years when the underlying portfolio’s income might fluctuate. This flexibility can be attractive to investors seeking stable income.
Acquiring Investment Trust Shares
Acquiring shares in an investment trust follows a process similar to buying shares in any other public company. Since investment trusts are listed on stock exchanges, their shares can be bought and sold through a licensed stockbroker or an online investment platform. This direct market access means investors can trade shares throughout the trading day at prevailing market prices.
To purchase investment trust shares, an investor needs to establish an investment account. This could be a standard brokerage account, or for tax-advantaged investing, an Individual Retirement Account (IRA) or a 401(k) plan, if allowed. Once the account is established and funded, investors can place buy orders for the desired shares through their chosen platform or broker.