Investment Trusts - An investment option for Irish investors

In the late nineteenth century, several financial entities were established in Dundee to meet the demand from Scottish farmers emigrating to western US states including Oregon, Washington and Idaho. These entities were established to provide mortgages to settlers who used the proceeds to buy land and establish new lives for themselves in the US frontier states.

The three Dundee-based mortgage and land companies – the Dundee Investment Company, the Dundee Mortgage and Trust Investment Company and the Oregon and Washington Trust, merged in 1888 and renamed their investment vehicle the Alliance Trust. The capital in the Alliance Trust was sourced from British investors who were increasingly seeking investment opportunities abroad as the yield on UK government bonds declined in the latter half of the nineteenth century.

Over time the Alliance Trust broadened their investments away from mortgages for agricultural land. The “Dust Bowl” period of the 1930s had a devastating impact in many drought- stricken US states when severe dust storms led to farmers simply deserting their land leading to one of the largest internal migrations in US history. This led to the Alliance Trust owning large tracts of US land, however shareholders subsequently benefited as it retained mineral rights to these lands whenever possible. Royalties on mineral discoveries amounting to tens of millions have benefited Alliance Trust shareholders in the intervening decades. The Alliance Trust continues to be managed to this day growing over time to become a constituent of the FTSE 250 index.

History of Investment Trusts and why Irish investors might consider investing

This episode demonstrates the longevity and interesting backstories of many of the investment trusts that remain in existence today. Investment trusts originated in the UK in 1868 and represented the first vehicle to allow investors to pool their savings and invest in diversified opportunities outside the UK. The diversified pooled fund structure did not broaden beyond the UK until the rise of the mutual fund in the United States during the 1920s. 

While investment trusts have long been used by UK investors, their use among Irish investors has been more limited. However, we believe that investment trusts offer Irish investors the opportunity to access differentiated strategies from skilled investment managers that are frequently not accessible through other structures.  While each trust needs to be assessed individually, Irish individual investors that hold shares in certain Investment Trusts may be taxed in accordance with normal Irish tax rules rather than fund exit tax.  This means that income derived from the Investment Trust would be subject to income tax, USC and PRSI (up to 55%) and chargeable gains would be subject to Capital Gains Tax (CGT) at 33%. The rate of Fund exit tax is 41%.

In addition, where the disposal of the shares in such an Investment Trust gives rise to a loss, this should be considered a capital loss for Irish CGT purposes.

What are Investment Trusts? 

Investment Trusts are products that pool capital from investors to provide exposure to a particular asset class, sector or region. A single unit in an investment trust represents ownership in that trust’s entire investment portfolio.

Investment trusts differ from other investment fund structures in a couple of ways. In most fund structures (referred to as “open-ended” funds), investors acquire or sell units in the fund at the current unit value, i.e. the price of the unit directly reflects the value of the fund’s holdings. As a result, in a fund structure, the manager needs to invest or liquidate holdings to match investor inflows or outflows.

However, investment trusts are set up as publicly traded companies that trade like a stock throughout the trading day (referred to as a “closed-ended” structure). This means that investors buy and sell units in the trust at the prevailing market price, rather than a specified unit value. The manager of the trust manages a fixed amount of assets and does not need to reposition the portfolio in response to investor demand.  

Features of Investment Trusts

A notable advantage of investment trusts is that the trust’s managers can adopt a long investment time horizon in the knowledge that they do not need to manage client contributions/redemptions. This gives fund managers the ability to build portfolios through a combination of liquid and less liquid holdings. As an example, the Scottish Mortgage Investment Trust holds c. 25% of its portfolio in privately held companies. Baillie Gifford as manager has a very successful track record of investing in private companies and first invested in names such Alibaba, Spotify and Airbnb when these companies were private.

This differentiated mix of public and private equity cannot be accessed through open-ended equivalent funds which need to remain liquid to meet client redemptions. These exposures available through investment trusts can often be accessed at a competitive fee and without any minimum allocation requirement often needed to access private investments.

Investment trusts have historically been used by investors as a means of income generation. Unlike open-ended funds which must pass through dividend income to the fund holder, trusts can retain 15% of their income each year and draw on this reserve to pay dividends in leaner times. This represents an attractive feature for many investors that have a need for regular income. There are seventeen investment trusts that have consistently increased their dividend for 20 years or more, with seven of these increasing dividend payments for over 50 consecutive years.

Discount/Premium to Net Asset Value and use of Debt

Another feature of investment trusts is that the closed-ended structure may cause them to trade at a discount or premium to the Net Asset Value (NAV) of the positions held. A scenario where there are more sellers than buyers will result in the investment trust trading at a discount to the NAV, but critically will not require the fund manager to redeem assets.

Other differentiators of investment trusts include the ability to use debt within the structure while having fewer constraints compared with open ended funds in building the portfolio. As an example, open-ended UCITS (Undertakings for the Collective Investment in Transferable Securities) fund must adhere to certain rules around diversification and ensure that no stock makes up more than 10% of the total.

Risks of Investment Trusts

Some of the features that are specific to investment trusts such as the use of debt can present additional risks to investors. The closed-end structure highlighted above can mean that an investment trust will trade at a discount to the underlying NAV of the portfolio held within the investment trust. This can create additional volatility as the price return will be dependent not only on changes in the NAV but also on changes in the premium or discount to this NAV.

The use of debt can amplify returns  on the upside but also on the downside. Excessive use of debt can create additional volatility and lead to returns that are lower than if no debt had been applied. On balance however, we believe that when applied prudently by skilled investment managers with good risk management practices, the ability to apply gearing can lead to better returns over time.

Davy Investment Trust portfolio

At Davy, we have reviewed a very broad range of investment trusts on the market and currently recommend a portfolio of seven investment trusts. We have met with the portfolio managers for each and rate these investment trusts highly on their own merits. In addition, when building the portfolio our intention was to provide a mix of complementary strategies to result in a recommended portfolio that is well balanced across different geographic, sector and stock exposures.

We review the investment trusts on an ongoing basis to ensure that the fund managers continue to manage these strategies in a manner consistent with their stated investment process. We evaluate each investment trust across a range of criteria including, for example, the strength of the organisation, the calibre and depth of the investment team, amongst other factors; this structured evaluation process allows us to conclude that a particular strategy could potentially outperform into the future.

To summarise we believe that Irish investors could look more closely at investment trusts given the attributes highlighted and the ability to access differentiated portfolios from skilled investment managers.

If you would like to discuss investment trusts in more detail to work out whether they may be a fit for your portfolio, and/or to discuss our evaluation process in more detail please contact your Davy Adviser.

Market data: Calendar year returns