Investment trusts are no longer the bastion of retail investors, a study by Cass Business School showed that wealth managers are increasingly looking to these instruments as well.
One of curious functions of investment companies is their use of gearing, which if the markets are on a bull run allows trusts to top up their holdings using leverage and boost returns. However, if a trust uses its gearing facility and the markets go down, losses are magnified.
Laura Suter, personal finance analyst at investment platform AJ Bell said: "A total of eight UK-focused investment trusts have gearing of 20% of more, meaning investors in these funds are exposed to more risk. Gearing works to effectively amplify any rise or fall in the trust’s value.
“This could pay off if the UK sees a much-anticipated ‘Brexit bounce’ following the conclusion of any deal. Likewise, it means these investors could face a shock fall in their trust’s value if the market sees a slide downwards on a No Deal Brexit or other shock outcome that spooks markets.”
While Ms Suter is clearly writing for the retail investor audience, there are some aspects which go some way to explain the hesitance wealth managers have displayed regarding these instruments. While using leverage is not unheard of in the open-ended fund space, it is less common compared to their closed-ended counterparts. ETFs will often track an index that uses leverage (see Lyxor’s new yield curve products), while absolute return funds will often use derivatives to make money when markets go down, for instance. ‘Income booster’ funds may offer high yields but they achieve this by putting call options on some of their holdings so if employed will lose the capital appreciation of the stock.
Another aspect of trusts that seems off putting to wealth managers is trading at a discount/premium. One trust manager who asked not to be named, claimed that wealth managers don’t know how this concept works and fear that if they invest large amounts of money it will make the trust trade at a premium while if others take large amounts of cash out, the result is trading at a discount (there is some truth to this and is why trusts seeking to close the discount engage in share buybacks).
Ms Suter added: “Investors also need to understand how the gearing is arranged. Some trusts shun bank lending or other corporate borrowing in favour of issuing new ‘preference’ shares in the trusts in order to borrow.
“These zero-dividend preference shares have a fixed rate of return, much like bank interest, but usually will get their capital returned before other shareholders. Acorn Income, which has the highest level of gearing of the trusts, uses this funding method, as does Aberforth Split Level Income and Chelverton UK Dividend, among others."
