Reflecting popularity in the market
An investment trust is a company with a set number of shares. Unlike an open-ended investment fund, an investment trust is closed ended. This means there are a set number of shares available, which will remain the same no matter how many investors there are. This can have an impact on the price of the shares and the level of risk of the investment trust. Open-ended investment funds create and cancel units depending on the number of investors.
The price of the investment trust shares depends on two main factors:
• The value of the underlying investments (which works in the same way as open- ended investment funds)
• The popularity of the investment trust shares in the market
This second point applies to investment trusts but not to open-ended investment funds or life assurance investments. The reason is because they are closed-ended funds. The laws of economics say that if there is a high demand for something but limited supply, then the price goes up. So, if you own some investment trust shares and there are lots of people queuing up to buy them, then you can sell them for more money. On the other hand, if nobody seems to want them, then you will have to drop the price until someone is prepared to buy.
The result is that investment trust shares do not simply reflect the value of the underlying investments: they also reflect their popularity in the market. The value of the investment trust’s underlying investments is called the ‘net asset value’ (NAV). If the share price is exactly in line with the underlying investments, then it is called ‘trading at par’. If the price is higher because the shares are popular, then it is called ‘trading at a premium’, and if lower, ‘trading at a discount’. This feature may make them more volatile than other pooled investments (assuming the same underlying investments).
There is another difference that applies to investment trusts: they can borrow money to invest. This is called ‘gearing’. Gearing improves an investment trust’s performance when its investments are doing well. On the other hand, if its investments do not do as well as expected, gearing lowers performance.
Not all investment trusts are geared, and deciding whether to borrow and when to borrow is a judgement the investment manager makes. An investment trust that is geared is a higher-risk investment than one that is not geared (assuming the same underlying investments).
Split-capital investment trusts
A split-capital investment trust (split) is a type of investment trust that sells different sorts of shares to investors depending on whether they are looking for capital growth or income. Splits run for a fixed term. The shares will have varying levels of risk, as some investors will be ahead of others in the queue for money when the trust comes to the end of its term.
The tax position is largely the same as for open-ended investment funds. You should be aware that tax legislation changes constantly, and you should find out the most current position.