Should the Neil Woodford saga make us afraid of investment trusts?

    3 October 2019

    Like crochet bikinis and tie-dye dresses, things that were trendy decades ago can become popular again. That seems to be the case with investment trusts, which are enjoying a rebound following the problems with Neil Woodford’s investment funds.

    No one who invested with these funds in recent times has done well, but the experience has emphasised the difference between investment trusts and open-ended funds such as unit trusts or Ucits funds. The two Woodford funds structured as Ucits funds have suspended dealings and trapped investors’ money. Meanwhile, investors in the Woodford Patient Capital Trust (structured as a more old-fashioned investment trust) have made large losses, but at least they have been allowed to sell their investments.

    Should the Woodford saga cause me to reassess my dislike of investment trusts? An investment trust is a closed fund. A certain amount of money is raised from investors and then given to a fund manager to look after. The trust is listed as a company quoted on the Stock Exchange, allowing investors to buy and sell their investments just as they trade shares in individual companies. A unit trust or Ucits fund (the former is a long-standing British institution and the latter an EU invention, its acronym standing for the mouthful Undertakings for the Collective Investment in Transferable Securities) is very different. The fund expands and contracts according to how many people are buying and selling ‘units’.

    In theory, the share price of an investment trust should reflect the underlying value of the assets invested. But it doesn’t always. If the fund is well managed and makes good returns, investors can drive the share price of the trust higher than the underlying investments are worth. So you have to pay a ‘premium’ in order to invest — effectively paying over the odds for a basket of shares.

    If, on the other hand, the performance has been dire, many investors may want their money back and so the share price of the investor can trade at a discount to what the underlying investments are worth. If an investment trust’s underlying assets perform badly and the discount widens, investors get penalised twice over when they come to sell.

    This is the reason I hate investment trusts and why I prefer to invest in either unit trusts or Ucits. As an investor I buy units of a fund. And when I sell or buy, I do so at a price more or less equivalent to the value of the underlying assets. The buying price is always a little higher than the selling price, so I am effectively paying a fee when I trade. But it is transparent and simple.

    I was pleased to discover that the Ucits fund in which I invest most of my money cannot be closed in the way the Woodford funds have been. But Russ Mould, Investment Director at A.J. Bell, believes I am missing out by shunning investment trusts: ‘There is a real income advantage to investment trusts as they can use reserves to smooth out dividend payments, continuing to pay out money even when companies are cutting their dividends, for example, in recession.’ Investment trusts, he adds, can also use gearing (i.e. borrow money to invest), which can amplify returns (as well as losses).

    There is some evidence that investment trusts benefit from something called ‘permanent capital’. They have a fixed amount of money to invest, allowing the fund manager to concentrate on long-term performance. Managers of unit trusts, on other hand, can be forced to buy and sell shares even when they don’t really want to, as the size of their fund expands and contracts. According to Professor Andrew Clare of Cass Business School: ‘Our results suggest that the structure of an investment trust, where the manager does not have to contend with constant inflows and outflows, may have led to better or more efficient investment decisions.’

    And as Mould points out: ‘The world’s most successful fund manager, the legendary Warren Buffett, runs what is effectively an investment trust. His investors buy shares in Berkshire Hathaway — a company quoted on the New York Stock Exchange.’

    Ummm. But this ‘permanent capital’ argument is most relevant to active fund managers, whose stars shine brightly when they are performing well, but burn out quickly as investors flee when the performance turns down. I only invest passively in tracker funds, and so my funds are far less susceptible to such inflows and outflows.

    However it does seem the Woodford experience has persuaded some back to investment trusts, with A.J. Bell seeing a small increase in the amount invested in them. But as far as I am concerned, investment trusts are like a corset — too damaging to my (financial) health to ever become fashionable again.