Why investment trusts can anchor long-term wealth building

Long-term investors need to understand how investment trusts work before relying on them to grow their money.

Investment trusts are one of the three main kinds of funds. The others are exchange-traded funds (ETFs) and open-ended investment companies (OEICs), also known as unit trusts, depending on their structure. Each works differently, with its own strengths and drawbacks. Here's how investment trusts operate and where they have an edge.

Investment trusts issue a set number of shares and trade on the stock market. Through your broker, you buy shares from an existing investor; when you cash out, another investor buys them from you. The trust's own pool of money is unaffected by either transaction.

OEICs are open-ended funds, so their shares do not trade on a stock exchange. To invest, you pay the fund manager through your broker, who then creates new shares for you. When you redeem them, the manager cancels those shares and returns your money. Every purchase or redemption changes the amount held by the fund.

Investment trusts have a permanent capital structure

An investment trust can trade shares without forcing its manager to buy or sell anything in the portfolio. Cash does not have to be raised when investors redeem their holdings, so the trust retains permanent capital - useful for investments that may take time to sell, such as infrastructure, private equity, real estate, or small-cap companies, as well as some long-term strategies. The trade-off is that investors buy and sell at the prevailing market price, which may sit above or below the trust's net asset value (NAV) - the value of its assets less its liabilities. Nothing automatically keeps the share price aligned with NAV.

An OEIC trades at its NAV. An ETF's price should stay close to NAV too, since authorised participants can quickly trade away any discount or premium. That makes ETFs suitable for tracking an index or holding liquid assets, and you should be able to sell your investment at its full market value whenever you choose.

Investment trusts can build long-term value

ETFs and OEICs may be easier to use, but investment trusts give investors other ways to increase returns. Buying shares at a discount to NAV can magnify gains: investors benefit from the underlying investments, then gain again if that discount narrows. A particularly large discount may shrink when the trust performs well, though there is no guarantee it will do so. The trust might buy back shares or make a tender offer to push the share price higher, but neither approach always succeeds. Discounts can persist for years when investors lose interest in a particular sector, investment style, or investment trusts generally. Even so, buying back shares for less than their underlying value should add value for the investors who remain.

The long term is where trusts earn their keep. Each trust is a listed investment company: shareholders provide the capital, a board represents them, and an outside manager runs the portfolio. That structure gives trusts choices open-ended funds do not have. Subject to a limit set by the board - often 20% - they can borrow to buy more assets. Gearing may lift returns, but it magnifies losses too. Trusts can also retain part of their income, helping keep dividends steady when returns weaken. If the manager performs badly, shareholders can replace them. Persistent underperformance or a large discount gives shareholders another route: they can vote to sell assets and return some capital, or close the trust entirely. Compared with OEICs, it is a different relationship with investors and, in BFIA's view, a sound way to build wealth.