Investment trusts are back in the limelight

Previously overshadowed by unit trusts, they are now flourishing and advisers are more likely to recommend them

Investment trusts tend to perform well when markets are risin (Getty Images)

Investment trusts have had to exist in the shadows of the more heavily sold unit trusts for the past few decades. They were castigated as an investment that was antiquated and prone to sharp moves in performance.

But as markets have enjoyed a bumper 2012 and early 2013, many reckon investment trusts are on the way back. Indeed, JPMorgan recently announced of its 10 biggest fund purchases this month an unprecedented six are investment trusts.

Not only do they generally outperform funds when markets are on the rise, but investment trusts can deliver more stable, growing income streams, say their supporters.

And new regulations that have just kicked in mean independent financial advisers will be more likely to recommend them to their clients. In the past, advisers have pocketed commission for selling unit trust funds, but not investment trusts. The Retail Distribution Review, which came into force at the turn of the year, puts an end to commission in most cases, meaning a whole raft of products, including investment trusts, are coming your way.

"Investment trusts are in a renaissance period and are coming up on the radar of more people, far more than five to 10 years ago," says Simon Elliott at broker firm Winterflood Securities. "There is a lot more attention on the superior performance records of these trusts versus their equivalent open-ended funds."

But it wasn't that long ago that investment trusts were easily shunned for being "too complicated" or risky because of their "gearing" or "discounts". Although these terms may seem alien aspects that you don't have to bother with when buying the more prolific open-ended fund, it's certainly worth taking a little time to understand the pros and cons of trusts, as they can play a useful role in your investment line-up.

Investment trusts, which were born in 1868, are closed-end products listed on the London Stock Exchange. Unlike their more popular rival unit trusts, they have a fixed number of shares in circulation.

You can buy these shares when the trust is first launched in the offer period, or you can trade them on the stock market. Although a trust's share price generally moves in line with the value of its investments, the price can be affected by a range of factors, such as demand from investors and the situation in the broader economic market.

Buying or selling shares when the price is below the value of the trust's assets is at a "discount", while the opposite scenario of the shares being higher than the asset value means you're trading them at a premium. In contrast to other types of fund, investment trusts can borrow money to boost investment. This is known as gearing. Although gearing can turbo-charge your returns when markets are on the up, it can exacerbate your losses if markets are falling. The more gearing the trust has, the more likely your gains, or losses, will be magnified.

Gearing is one of the ways investment trusts have managed to beat their unit trust peers. "Investment trusts tend to outperform when markets rise," says Mr Elliott. "They're a good bull market product. And gearing is one aspect of that."

Over a three-year period, the average investment trust turned a £100 lump sum into £123, while an unit trust fund would have delivered £115. Over a 10-year period, an investment trust would have returned £288 while an unit trust fund would only return £213, according to the Association of Investment Companies.

Aside from higher returns over the long term, investment trusts can provide a more stable, growing income. Some trusts have been able to increase their dividend payments for almost 50 consecutive years, which is impressive given a number of companies slashed payments a few years ago. The City of London Investment Trust, for example, has increased its dividend for 46 years in a row. Whereas unit trusts tend to invest in equities or bonds, investment trusts have the ability to tap harder-to-access areas such as private equity.

"The case for investment trusts is strong in more niche areas like infrastructure or physical property," says Jason Hollands at Bestinvest. "Investment trusts make sense in these cases, where unit trusts can't really hold these asset classes." While more obscure areas like infrastructure are arguably riskier than stocks or bonds, holding a portion can help diversify your investment portfolio.

Mr Hollands tips the John Laing Infrastructure trust for income, which has a dividend of around 5.5 per cent, higher than many bonds. "Investment trusts can be a one-stop shop for children's savings schemes," he added.

The opportunity to buy a trust at discount is akin to shopping and finding a bargain you know is worth more than the price. But if you're worried about the price fluctuating or the discount widening even further, trusts tend to have "control mechanisms" in place. "Historically most investment trusts have traded at a discount and often traded at high discounts. Now, many have a discount control mechanism where the board can buy back the shares," says Mr Hollands. "It's a good thing, to ensure there are not discounts of 40-50 per cent. But it's nice to buy on a discount, if there's belief that it could narrow."

On the other side of the coin, if a trust is trading at a premium, it does not mean it's worth writing off. "I think there's more to a premium. You have to ask why is this the case," says Mick Gilligan at stockbroker Killik & Co. "What are the chances this will be maintained? And you also need to look at your time horizon. It's less of an issue if you're invested for 10 years with a quality manager."

Investment trusts have tended to have lower charges, which can help to boost your gains over the long term. "A major benefit of investment trusts is that they are usually cheaper than open-ended funds," says Patrick Connolly of AWD Chase de Vere. "This should help to increase their popularity as financial advisers and investors should be focusing more on overall investment charges."

Emma Dunkley is a reporter for citywire.co.uk