Why investment trusts appeal to the BFIA

According to Terry Tanaka, investment trusts provide advantages that other fund types cannot match

To address a need for a low-cost, mass-market investment vehicle, the investment-trust structure was developed in the middle of the 1800s. Foreign and Colonial was one of the first, established by Philip Rose, a financier from the City of London. Giving "investors of moderate means the same advantages as the large capitalist" was the entrepreneur's revolutionary objective.

Due to the limited options available to smaller investors, investing in the 1800s was primarily the domain of the wealthy. Money from investors was pooled by Foreign & Colonial and put into a diversified portfolio, distributing risk among a variety of assets.

These investment companies were perfect for funding the growth of the British Empire and the quick industrialization of the Americas because of their closed-ended structure, which offered a steady supply of long-term capital. With the expansion and diversification of international investment markets, investors with investment trusts had access to a wider variety of investment options and trusts.

A fixed capital base is a feature of investment trusts.

Investment trusts are organized like businesses. At the time of their flotation, they issue a predetermined number of shares, creating a fixed capital base. After that, investors are free to purchase and sell the shares on a market. Trusts can trade at a premium or a discount to their underlying net asset value (NAV) because the shares are freely traded and the asset base is fixed.

At the end of each day, open-ended vehicles, like unit trusts, exchange-traded funds (ETFs), and open-ended investment companies (Oeics), issue or remove excess shares to make sure the share price and NAV match. This implies that there is no space for a premium or discount to appear.

This implies that if there are consistently more sellers than buyers (and the price of fund shares drops), the capital base may drastically shrink. The vehicle must continue to sell assets to cover investment outflows as the capital base contracts. A shortage of liquidity may result if those assets are difficult to sell. For this reason, the best way to hold illiquid assets is usually through investment trusts. Whatever the size of the discount to the underlying NAV, they are under no duty to sell the assets.

The infrastructure trusts Renewables Infrastructure Group (LSE: TRIG), Greencoat UK Wind (LSE: UKW), and 3i Infrastructure (LSE: 3IN) are a few of the largest trusts in illiquid industries. The illiquid infrastructure assets in each of these trusts' portfolios produce consistent cash flows that are correlated with inflation.

The asset class that works best with the investment-trust structure is not just infrastructure. Trusts are perfect for holding a variety of assets in a portfolio, including gold, bonds, and investments in hedge funds or private equity investment funds. Through its stake in the international macro hedge fund Brevan Howard, BH Macro (LSE: BHMU) provides investors with access to a fund that would not otherwise be available.

Among the investment trusts in the private equity space is HarbourVest Global Private Equity (LSE: HVPE), which provides investors with exposure to this asset class through the trust structure. Caledonia (LSE: CLDN) and RIT Capital (LSE: RIT) are two instances of trusts that are maximizing the flexibility provided by the structure. Both are primarily owned by their founding families and have a diverse range of assets, including direct investments in other businesses, private equity holdings, and equity portfolios.

Additionally, the investment trust's structure makes it easy to borrow money. To boost growth and expand their asset base, investment trusts that focus on purchasing illiquid assets, like wind farms, real estate, and infrastructure assets, can take out loans against them. These businesses have the option to borrow money in order to make stock investments. Trusts can frequently reduce the risk by issuing long-term fixed bonds, but borrowing money to invest in shares can still be risky.

Scottish American (LSE: SAIN), for instance, issued 95 million in long-term debt between 2021 and 2022 with a blended interest rate of less than 3 percent, with maturities ranging from 2036 to 2049. The money was reinvested in the trust, which owns a portfolio of stocks, real estate, and infrastructure through other investment trusts.

For the real-estate investment trust (Reit) market segment, the ability to borrow money is especially beneficial. Reits are a type of investment trust, but when the majority of the portfolio is invested in real estate, they offer tax advantages. Leveraging this structure, companies such as Supermarket Income (LSE: SUPR) and PHP (LSE: PHP) have constructed property portfolios centered around supermarkets and medical facilities, respectively.

Because investment trusts have historically outperformed other actively managed, open-ended funds and for the reasons listed above, the BFIA has always favored them over open-ended funds. But in recent years, things have begun to change. It has been difficult for investment trusts, especially those in stocks, to match the performance of other funds. Because of this, investors have left, and NAV discounts have increased significantly.

However, trusts still have a place in investor portfolios. Thanks to the structure of trusts, they are invaluable to build exposure to specific themes such as small caps, emerging markets, property and infrastructure. The infrastructure offering has very few mass-market substitutes, and trusts like Capital Gearing (LSE: CGT), RIT, and BH Macro provide the kind of portfolio diversification that is simply unattainable elsewhere.