Investment trusts, like funds, invest in a 'basket' of underlying assets such as equities, bonds or property. But unlike funds, they are structured as companies listed on the London Stock Exchange. Investors in a trust share in the capital gains (or losses) and in any income payments made.

A fixed number of shares is issued, which raises a fixed amount of money for the manager to invest in a portfolio of assets. The shares are then traded on the stock market. The share price goes up and down according to investor demand and supply, but (unlike open-ended funds) the trust manager's investment plans are not affected by these fluctuations.

Trusts have two values: the amount the investments themselves are worth in total (the net asset value or NAV), and the trust’s share price on the stock market. When the share price is lower than the NAV per share, this is known as a 'discount' to NAV. When the share price rises above NAV, the trust is trading at a 'premium', meaning investors who buy are paying more than the assets are worth.

If you buy at a discount and that discount reduces or narrows (due to increased shareholder demand, say), your holding could gain in value, even if there's no movement in the underlying NAV. Conversely, the discount could widen if shareholders started selling in numbers, so your holding could lose more value than the underlying assets. 

There are various types, but the majority invest in equities. The main regions being UK, US, Europe, Asia Pacific and emerging markets. 

A number of trusts simply adopt a global approach, in which the fund manager invests wherever he or she sees fit. Some investment trusts invest for growth, others focus on income, while some mix and match between the two. Others invest in a certain sector, such as biotech. 

The other main type, which over the past couple of years has been gaining in prominence, is investment trusts that focus on alternative assets. In 2019 sectors that proved popular included renewable energy, infrastructure, commercial property and private equity. 

There are other investment trusts available, including venture capital trusts that invest in small unlisted companies and come with certain extra tax breaks [link], and split capital trusts that issue a number of different types of share.  

Investment trusts are allowed to gear, or borrow to invest. This can improve their performance, but it means they tend to be more volatile than their open-ended peers. 

Gearing in a rising market magnifies gains for each shareholder; but if the market falls, investors in a geared trust will suffer greater losses per share.

Simply put, if the manager borrows X to invest and the trust grows, the manager has to repay X plus interest but retains the investment growth as part of the trust's NAV. So if you have £1,000 invested (let's assume a constant share price for now) and the manager gears by 10%, then there is effectively £1,100 working for you.

Now, if that doubles in value to £2,200, the manager pays back the £100 plus, let's say, 1% interest. That leaves you - the investor - with £2,099. If the manager had not geared, you'd only have £2,000.

Conversely, if the same investment halves in value to £550, the manager still has to pay back £101. This magnifies the losses, leaving you with only £449 instead of the £500 you'd have without gearing.

Pros 

• Over the long term, investment trusts tend to outperform funds due to their various structural advantages.  
• Much more consistent at raising or maintaining dividend payments compared to funds, due to their ability to hold back up to 15% of income generated every year. 
• Fixed pool of assets – means fund manager is not distracted by investor money flowing in or out in the short term
• Opportunity to buy a bargain when a trust trades on a wider than usual discount. 
• Investment trusts are allowed to gear, or borrow to invest. In a rising market, gearing magnifies gains.  
• Overseen by an independent board of directors, who ensure the investment trust is being managed in line with shareholders’ interests. 

Cons

• Generally, more volatile than open-ended funds due to the ability to gear and the potential for discounts to widen beyond NAV movements, so expect a bumpier ride. 
• In a falling market gearing works in reverse - investors in a geared trust will suffer greater losses per share.
• Investment trusts can trade on a premium – so investors who buy end up paying more than the underlying assets are worth. 
• Two layers often considered to make them more complex to understand 
• Can be difficult to get information about less commercially focused trusts 

Internationally diversified global investment trusts with a broad range of underlying investments can form an ideal portfolio core and are perfect for regular monthly investments. Many global and UK trusts are also ideal for income-seekers, because of their ability to smooth dividend payouts over the years. 

Also consider investment trusts that adopt a ‘multi-manager’ approach. This means the portfolio is parcelled up, with different segments of the portfolio outsourced to carefully selected external fund managers. One respected trust that invest in this way is F&C Investment Trust, which is one of our Super 60 fund choices.  

Income-paying investment trusts have a particular attraction for investors because investment trusts don't have to distribute all the income generated every year. Up to 15% can be held back each year, which means they can build up a ‘rainy day’ fund to bolster dividend payouts in leaner years. During the financial crisis, the majority of UK equity income investment trusts were able to either maintain or increase their dividends, as they dipped into their reserves. 

Some income-paying investment trusts are labelled ‘enhanced income’ and generally offer higher dividend yields than other income trusts. To achieve a higher dividend yield, enhanced income trusts finance their dividends from capital as well as income.