I was quoted in the Sunday Times at the weekend, explaining why I think some investment trusts should be treated with caution.
The combination of expensive (premium) valuations and gearing can make some investment trusts a very risky proposition.
An investment trust is a collective investment fund run as a public limited company.
They are closed-end funds, which means they have a fixed number of shares. As a result, the share price of investment trusts can trade at a premium or discount to the net asset value of the fund, depending on investor demand.
The Sunday Times article pointed out that some investment trusts are currently trading at a large premium, suggesting the fund is expensive.
Within the article, several examples of trusts with large premiums were given, including F&C Commercial Property with its 16% premium to net asset value.
In essence, investors are paying over the odds to access the fund.
An investment trust trading at a premium is not necessarily a problem, assuming it is still trading at a premium when you decide to sell. It could however be trading at a discount by then, if investor demand for the fund has fallen, which means losses can be multiplied.
Another way in which investment trusts can multiply losses is through gearing.
Unlike unit trusts and open ended investment companies, investment trusts can borrow money to invest, a process known as gearing (or leverage, in the US).
Gearing tends to be good news in rising investment markets, where returns are boosted as a result of money being borrowed to invest more, but bad news in falling markets.
I cited the example of Merchants Trust in the article, which has 19% gearing.
This makes it one of the most highly geared funds in the UK equity income sector. The fund trades on a premium of 1.9% and has underperformed its sector over the past three years.
Commenting in the Sunday Times on the subject of investment trust gearing, I said:
“Once you factor in the risks associated with gearing and the difficulties of the discount/premium structure, open-ended funds tend to be a better option for most retail investors.”
Before investing in any fund, investment trust or open ended fund, you should take care to understand all of the risks involved.
