How to invest in investment trusts for income
Ever heard of the trust 15% rule?
Published
September 4, 2024
London, 1868.
The very first traffic lights were erected outside the Houses of Parliament. The famous Smithfield market opened its doors for the first time and the stapler was being patented.
What a time to be alive.
Lightbulbs and zip-fasteners didn’t exist yet but investment trusts did. Just.
The F&C Investment Trust was launched in 1868 with the aim of “bringing stock market investing to those of moderate means.”
And, 153 years later, that purpose hasn’t really changed.
There are a lot more of them now but trusts are still essentially baskets of stocks, managed by a human. Everyday investors can buy and sell that basket on the stock market, just like a company share.
If that sounds a bit like share-ception, you’ve got it. The human trust manager and their analyst team research and buy stocks for the trust, and we get to look at that collection every day and decide whether we want to buy into it.
Take F&C for example. It holds over 450 stocks at the moment, with Amazon, Microsoft, Goldman Sachs and PayPal among its top names. The trust itself is listed on the stock market and has its own share price so you can see what you’d be buying into if you snapped it up.
Those investments might change over time and it’s up to us if we like the way manager Paul Niven invests, as well as the specific blend of stocks he chooses.
When trusts are set up, they gather cash from investors first (normally in the hundreds of millions) and then close the door to new money. That’s when they get on with selecting stocks for the portfolio and holding for the long term.
As we’ve mentioned, it’s useful to think about trusts as companies in themselves, as once they’ve raised money the only way you can buy into them is by buying their shares, just like you’d buy a share in a regular company.
The goal here is for the trust manager to invest wisely on your behalf and steadily grow the fund’s value.
But couldn’t you just look at what the trust is holding and go off and recreate it yourself? In a lot of cases, yes. And you wouldn’t have to pay the management charges, or dreaded performance fees (more on these later), that come with a lot of trusts.
But trusts have a few more quirks that might make them attractive for the everyday investor.
One advantage trusts have is that they are allowed to invest in private companies.
That gives them the ability to buy into early stage pre-IPO opportunities.
If we take a look at Scottish Mortgage, the biggest trust in the world (and a relative spring chicken, having only been launched in 1909) we can see how useful that allowance can be.
Its private company investments include TikTok-owner ByteDance, Fortnite-maker Epic Games, payments firm Stripe and remittance company Wise (formerly Transferwise).
It’s rare for everyday investors to have access to these private companies, outside of crowdfunding. And even then private firms often mean staying invested with no solid timeline to going public in sight.
Using a trust to invest in them can be a more useful way of matching your investments to your life goals like buying a house. You get the access and you can still buy and sell when you need to.
Another plus for trusts is their ability to squirrel away 15% of their income each year so that, when dividends are hard to find, they can dip into their reserves and prop up payments to investors relying on them for income.
That was of huge benefit to investors in 2020 as the dividend environment suddenly dried up.
And then there are the advantages that you get with any company, like a board of directors keeping the manager in check. They also have the power to bring in a new head investor if they feel the current one isn’t cutting the mustard.
Trusts can also borrow money to invest too, in a process called gearing. This can amplify returns if those investments go well but there is the possibility of losses ballooning too if it all goes south.
There are a few other less savoury things to keep in mind.
Trusts charge a management fee, normally monthly, that you pay whether performance is positive or not. Some even go as far as to charge a performance fee if the trust does particularly well in a certain year.
You have to ask though, why should everyday investors be penalised if the trust does well? It certainly takes the shine off the message that they’re all about the customer.
It’s important to say that a lot of trusts are lowering their charges across the board as investors demand more transparency and, ultimately, proof of value for money.
It’s something to keep an eye on though. Especially as trusts are positioned as the most long-term of long-term investment vehicles. If managers are truly focused on buying and holding quality stocks (as they should be) what do all those fees go towards?
It used to be that you had to go directly to the trust provider if you wanted to buy its shares. Now, you can use any investment platform like the Freetrade app.
The good thing is that, because trusts are listed, you can buy them at any point during the market’s opening hours. That might seem pretty obvious but it’s not the case for open-ended investment companies (OEICs) or unit trusts.
That’s because, although they invest in companies on the stock exchange, the funds themselves aren’t listed. This often means they only have one daily dealing point instead.
If you’ve decided the long-term aspect of trusts is appealing, have a think about what your life goals need from your investments. Are you focused on growth? Do you need an income? Maybe you need a bit of both.
Then you might decide there’s a ‘UK smaller companies’ or ‘global healthcare’ shaped hole in your portfolio that a trust could help with.
It could well be that you’re looking at a few to meet a couple of personal requirements.
A good place to get to know what’s on offer is the Association of Investment Companies (AIC) site. You’ll be able to see every trust in the UK and find out what they’re all about. You can see the full range we hold on Freetrade on our investment trust page.
Just make sure you actually look at what these trusts hold. If you end up investing in a few, you don’t want to realise they have the same holdings and you’re doubling up when you thought you were diversifying.
Fees can end up eating your soul. I don’t care if that’s dramatic, I’m sticking to it.
They get a lot of scrutiny, and rightly so, as they can be such a hindrance to the performance of your assets over the long term.
But focusing purely on what you’re paying misses the bigger picture. What we really need to be asking is if we’re getting value for money.
There are trusts out there holding a simple mix of UK companies that you could absolutely replicate yourself. It’s hard to see how they’d be adding value there.
But, as we’ve seen, there are trusts doing something a bit different to what we can do as retail investors. As long as that strategy works and provides a noticeable uplift in value over and above its charges, a trust may merit its fees.
There’s also the issue of not having to do it yourself. That’s not to say that trusts should be measured on how active they are in trading short-term positions (quite the opposite) but there’s something to be said for not having to look at your portfolio constantly or scan the market daily for investment ideas.
Sometimes the joy of going to a restaurant is simply in not having to do the washing up yourself. But that value fades quickly if it’s a terrible meal and you feel like you should have just stayed home. ‘I could have done that’ isn’t what you want to be saying in either case.
Investment companies/trusts are listed companies with boards of directors and their own share price. They’re similar to unit trusts, which also invest in baskets of stocks on behalf of lots of other investors and have a manager at the helm.
But unit trusts and OEICs aren’t listed on the stock exchange. They are normally run by big fund houses and have a single daily dealing point, usually around lunchtime. They also don’t tend to go too far into the private space and most often stick to public markets.
They also can’t do all the fancy stuff like keeping income to one side or gearing. And it’s extremely rare for them to charge a performance fee too.
When you buy a unit trust, it simply creates more units and sells them to you so you can be part of the gang. Then, if you sell it will simply delete those units. This means you’re always dealing directly with the fund rather than on the secondary market as you would do with investment trusts.
A big reason long-term investors tend to gravitate towards investment trusts as opposed to their open-ended cousins is that, because trusts are closed to new money, they can get on with investing in the knowledge that they don’t have to keep some money to one side in case a big investor suddenly wants out.
Open-ended funds like unit trusts and OEICs do have to be that paranoid though. They’ll often have to keep a part of the fund in cash to be able to deal with daily in and outflows which, importantly, it isn’t being invested.
And because there is the possibility that investors might suddenly want their money back, they are often less willing to invest in less liquid shares or assets like property which are difficult to sell in a pinch.
Most things you buy in life have one price. Trusts are lucky enough to have two.
The first one shows you what everything in the trust is worth and the second shows what people are prepared to pay to own a slice of the portfolio.
That first one, the NAV (net asset value), is the value of the fund’s assets (e.g. stocks) minus its liabilities (i.e. costs that need to be paid from the value of the fund).
It’s important to have that, as a lot of trusts with private holdings don’t get a regular view of what those firms are worth. So the NAV is calculated every so often to give an overall view of the worth of both listed and non-listed securities in the trust.
If that particular blend looks attractive, investors might be willing to pay up to own part of it. That would put the share price above the NAV, which we normally describe as ‘trading at a premium to NAV’. If they aren’t that bothered, the share price might ‘trade at a discount to NAV’.
A lot of investors like to buy at a discount as they’re effectively getting a bunch of more valuable assets for a cheaper price than they’re worth.
When it comes to buying investment trust shares at a premium, investors often find it a trickier trade.
Buying at a premium can feel like a silly thing to do because it’s plainly telling you the price is above the value of the assets it represents.
But sometimes the manager or strategy is so popular that the demand persists. For example, there have only been a handful of times in the past 10 years when you could have bought the Lindsell Train Investment Trust at a discount. With popular fund manager Nick Train at the helm, it has commanded a pretty hefty premium at times.
There are some sectors where trusts rarely trade at a discount, like infrastructure. And some have such wide diversification into areas like private hedge funds and weird asset classes that the premium reflects their unique portfolio offering. RIT Capital Partners has fallen into this bucket a lot over the past decade.
Let’s have a go at running our own investment trust.
We buy 500,000 shares in Company X at £10 per share, 100,000 shares in Firm Y at £7.50 per share and 900,000 shares in Business Z at £1 per share.
We have no debt in the trust and there are 1m shares in issue.
The NAV would be:
(500,000 x £10) + (100,000 x £7.50) + (900,000 x £1), all divided by the 1m shares in issue.
NAV = £6.65.
If the share price of our trust is £6, we can work out the discount like this:
((6.65-6)/6.65)*100.
That would give us a 9.8% discount.
Anyone who’s read any of the stuff we’ve written on dividend income will know exactly what is coming next.
A company’s ability to pay out a dividend consistently trumps any of the rockstar dividend yields out there.
It just does. One big payout might feel great but if there is a profit warning next quarter or the dividend is chopped in half, where does that leave your income stream?
Because of trusts’ ability to preserve income in the good years and top up payouts in the leaner times, a lot of retirees choose them to help with their retirement living costs.
And that means making sure you’ve set up your portfolio with regular dividend payers, and a clear aim to keep up with income payments.
As consistency is key, the AIC keeps tabs on the trusts which have consistently increased their dividends for 20 or more years in a row. Here are the current members of the Dividend Hero club (that header image just made sense):
Setting up your portfolio with a group of trusts to pay out regularly doesn’t necessarily mean getting dividends every month.
Most trusts are more likely to pay out quarterly so it’s worth seeing when their quarter begins and ends if you want to keep getting a steady stream of income.
In fact, in the current dividend environment of sheepish returns to payouts, the Ediston Property (LSE:EPIC) real estate investment trust is one of the only (if not the only) trusts paying a monthly dividend.
It has the bulk of its money in retail warehousing, with its fund manager Calum Bruce confident we’ll see a change in retail shopping, and the retail parks and warehouses firms will need in the future.
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