Investing Basics: Investing in the UK with investment trusts

The UK has not had the best reputation as a destination for investors since the Great Financial Crisis. Perceived as offering sluggish growth and beset by political strife surrounding Brexit after the 2016 referendum, some investors have chosen to stay away as a result.

 
As you can imagine, this isn’t a particularly nuanced view and it doesn’t capture the opportunities the UK market has to offer. Although it’s true London’s large cap index has not performed amazingly well as a whole since the financial crisis, there are still plenty of companies, both in that index and further down the size scale, that have.

Identifying these companies does require a level of expertise though. It also means taking an active approach to the market that can potentially be more advantageous than simply tracking an index of the UK’s largest companies.
 

UK investment trusts

 
It’s for this reason that many people prefer to invest in the UK using investment trusts, instead of going it alone and picking stocks themselves.

Free to try and find the best companies, as opposed to just tracking a benchmark index, investment trust managers can focus on the firms which are more likely to outperform. This is particularly beneficial in a market that may be experiencing a cycle of poor performance.

Aside from this, trusts can also use gearing – borrowed money – to enhance returns. It’s worth noting this can also have the opposite effect and increase losses if the trust managers make poor investment decisions.
 

UK investment trusts vs UK open-ended funds

 
Gearing is something that open-ended funds cannot use, for regulatory reasons. This is not necessarily a bad thing but it does mean closed-ended funds have the potential to enhance returns in a way that open-ended funds do not.

Other factors that may make investment trusts more appealing are closed-ended funds typically have to hold a larger amount of cash or other liquid assets in order to meet the need to offer redemptions to shareholders who want to ‘cash in’ their holdings. These assets tend to yield lower returns and stymie the fund’s performance over time.

Trusts’ closed-ended structure means they do not have to deal with redemptions – shareholders of a trust must find buyers for their shares on the stock market, where these shares are traded just like any other – and are thus freer to devote more funds to their underlying investments. Assuming they make the right calls, they’ll see enhanced returns compared to their open-ended counterparts as a result.

Redemptions also have a negative effect on open-ended funds during periods of underperformance. Investors are more likely to remove their holdings from open-ended funds when this happens, forcing the managers to sell their most liquid holdings, which can compound the effects of a bad performance.

Trusts have no such problem which means they’re better able to ride out periods of poor performance and don’t have to worry about redemptions making a bad situation worse.
 

 

Different types of UK investment trusts

 
Focusing on high-level performance metrics does mean we can miss the fact that UK investment trusts take a range of approaches to the market, mainly in terms of the goals they want to achieve for shareholders and the sorts of companies they invest in.

The AIC separates UK-focused investment trusts into four different categories and it’s worth going through these to understand what’s available to you as an investor.
 

UK All Companies

 
As its name suggests, trusts in the AIC’s UK All Companies sector are free to invest in any London-listed company. That means they can mix up large companies, like HSBC or Shell, with others that are further down the market cap spectrum, like Future or Sumo Group.

Trusts in this sector may take divergent styles too. For instance, Baillie Gifford UK Growth (BGUK) invests predominantly in growth stocks. Fidelity Special Values (FSV) does the opposite and focuses instead on finding the best UK value stocks.
 

UK Equity and Bond Income

 
Equity and Bond Income trusts hold a mix of UK bonds and stocks. The ultimate goal is to try and generate capital gains and dividends for shareholders.

Ultra-low interest rates for over a decade meant that bonds became much less popular with investors, who have mainly gone deeper into the stock market to try and find higher returns.

The result of that is there is now only one Equity and Bond Income trust on the market. Henderson High Income (HHI) has some exposure to fixed income securities but, unsurprisingly given the dynamic described above, it has a much higher proportion of its holdings in equities.

However, it’s plausible this will change moving forward due to the interest rate hikes that we’ve seen from central banks across the world since the end of 2021.
 

UK Equity Income

 
Large cap dividend payers are a prominent feature of the top end of the London equities market and many investors looking for income are happy to buy into them.

Trusts are also a useful vehicle by which to access this part of the market. That’s because they’re able to hold on to 15% of all dividend payments they receive each year and keep them in reserve. If there is a dip in income as a result of a drawdown in the market, a trust can use these reserves to pay out dividends to shareholders.

This ability to smooth out dividend payments during any down periods in the market arguably makes trusts a more reliable source of dividends for UK income investors than shares held directly in individual companies.
 

UK Smaller Companies

 
Arguably the most exciting area of the UK market is its small cap sector and it’s here that trusts in the AIC’s UK Smaller Companies sector focus their efforts.

Investors have tended to be sceptical of UK firms’ ability to deliver growth, which is understandable if you focused solely on the larger companies in the market over the past decade.

But UK small caps have historically provided strong growth to shareholders and have also outperformed the wider market by some margin. A £1,000 investment in the Numis Smaller Companies (NSC) index back in 1955 would have produced returns of £8.3m at the end of 2022. Over the same period an investment in the HSBC FTSE All-Share Index ETF would have returned approximately £1.3m.

This is another area where trusts’ benefits come into play. The UK small cap market is vast and, depending on how you define ‘small’, comprised of about 1,000 companies. Sifting through these to sort the good from the bad is a difficult task and one that a dedicated team of analysts is extremely useful for.

You can see the value these analyst teams create as trusts in the sector averaged share price total returns of 167.7% for the ten years up until 21/12/2022, compared to total returns of 100.4% for the NSC index over the same period.