Investment trusts – a vehicle fit for volatile times
This article explains the key benefits of investment trusts and why they could provide a safer haven for investors during periods of market volatility.
30 March 2016
Stockmarket volatility is deemed as a constant threat to the value of investors’ savings. Those investors can get too involved with day-to-day movements and how funds are performing, worrying over the latest share price shift or market panic. While it is important to monitor how your portfolio is performing, the point of buying funds - instead of individual stocks - is to let the professionals worry about market movements.
While the long-term direction of the stockmarket is generally up, it doesn't rise in a straight line. The rule of thumb is that the more risk you take, the greater the potential return, but also the greater the potential loss. You will need to construct a portfolio with a risk profile that suits you.
So why choose an investment trust?
The key structural characteristic of investment trusts which sets them apart is their closed-ended structure, which offers an element of stability. As such, they have a fixed number of shares in issue, which is a great advantage to the investment trust portfolio manager as they do not have to deal with daily inflows and outflows of capital. This thereby limits dealing costs, while the portfolio retains the potential to capture any future upside of a stock in the future. It also allows them to take a long-term view, as the sale in the market of existing shares of an investment trust does not change the underlying amount of money within the portfolio, and therefore the manager’s long-term strategy remains unaffected.
Open-ended fund managers have to carefully manage flows as shareholders trade in and out of a fund. This is often magnified during periods of market weakness, when uncertainty and speculation can lead to heightened volatility.
In such markets, many investors might decide to sell their holdings, presenting a problem for the manager of an open-ended fund, who might find their chosen investment strategy compromised by the need to sell holdings – perhaps at unreasonably cheap prices – in order to accommodate redemptions.
Selling stock when markets are falling goes against the ideal scenario of buying low - and selling high. It crystallises losses that were previously only on paper.
Seasoned long term investors are urged to take market falls and panic in their stride. While the volatility of investment trust share prices may mean they are not always suitable for investors with a lower risk appetite or a shorter investment horizon, on the flip side, they can provide excellent value over the longer-term– even in volatile markets.
Key benefits of investment trusts
The unique features of how investment trusts are structured can make them attractive to investors, even in volatile markets. Investment trusts can hold back up to 15% of income generated by underlying assets each year to build up a reserve to be used to smooth dividend payments in tougher times. This means investors can enjoy a steady income, however markets are performing.
Investment trusts are allowed to borrow money to invest, which means that if managers think there is value in a particular market, they can use this for further investments. This is known as “gearing”. This offers the fund manager greater opportunity to invest as they can react to opportunities that arise without having to sell out of their existing holdings.
In a rising market, returns from an investment trust can be magnified because gearing means managers are better able to take advantage of rising share prices.
However, when share prices fall, the losses of geared funds can be exaggerated. It’s also worth noting that there could be greater swings -and therefore volatility - as the widening of premiums and discounts could move the share price more than the value of the underlying investments.
Opportunities for new investors
A depressed share price when market shocks hit can be an attractive entry point for new investors. Investment trusts can therefore be an attractive new investment when the stock market is depressed because of how their pricing works. When the price is greater than the value of the assets held in the company, this is known as a premium. At a time it is less, it is known as a discount.
Although there is no guarantee how quickly, or if at all, the discount will narrow, there could be well priced funds available. This is also true for investors making regular monthly contributions or reinvesting dividends will actually end up being able to buy a larger number of shares as a result of the price weakness.
However, timing the market is one of the hardest parts of a professional fund manager’s job, so for private investors to attempt this is an even taller order.
The time an investment is made – that is, when investors “buy” into the market is important. Investing right before a certain area takes a hit could result in the value of savings drop overnight. It all depends on the share price of all the different stocks involved. A much favoured trick by experts is drip-feeding money into the market, which removes the need to get the timing right. By saving a monthly amount into an investment portfolio it is possible to cash in regardless of how the market is performing. It helps to smooth out the highs and lows in share prices. When they go up, the value of stocks rise, and when they go down the next contribution buys more. This is known as “pound-cost averaging”. Plus, buying stocks at a lower price means a higher return when the market swings back up.
Whatever the condition of the market, it’s important to choose the right investment tailored to individual circumstances. If you are thinking about making a new investment or changing your investment strategy, speak to your Financial Adviser. If you do not currently have a Financial Adviser, you can find one near you at www.unbiased.co.uk
Please remember that the value of investments and the income from them may go down as well as up and you may not get back the amounts originally invested.
Schroders launched its first investment trust in 1924 and our range provides investors with access to a range of nine distinctive investment opportunities including: UK and Japanese equities, Pan-Asian equities and real estate.
To find out more, please visit www.schroders.co.uk/its
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