7 Factors to Consider Before Investing in an Investment Trust
7 Factors to Consider Before Investing in an Investment Trust
Investment trusts are easily traded on stock exchanges, and can be used to meet a variety of investment objectives and time frames. Some investment trusts are targeted toward growth while others can produce valuable income streams, and investors are not only able to buy shares of investment trusts accordingly, but some investment trusts – known as split capital investment trusts – will have different classes of shares to satisfy different investor needs.
When an investor buys shares in an investment trust, their returns will be dependent upon the performance of the investments made by the investment trust. As with any investment, past performance is no guarantee of future performance: but there are seven factors that an investor should consider before buying shares in an investment trust.
1) Examine the investment trusts charges
Investment trusts with higher costs and fees will have to see their funds perform more strongly than lower charging investment trusts. Investing £10,000 in an investment trust with charges of 1.5%, where the annual return is 10% will produce a final investment value of around £50,000 after 20 years. But if the charges within the investment trust are just 0.5%, then the value of the investment after 20 years will be nearly £61,000.
2) Look at the size of the fund, and its history
Investment trusts with a short term history often show strong returns. But consistent returns become harder over the longer term. Managers will likely add to the original portfolio of stocks in which money has been invested, and as they do so the impact of a small number of winning stocks decreases. Reference to how long strong annual performances have been repeated, and measurement of consistent outperformance of benchmarks, will help select the best investment trust to suit purpose.
3) Think about turnover rates
The turnover rate of a portfolio is the amount of times a manager buys and sells underlying investments. The more often shares are sold and bought will impact the total trading costs and taxes incurred within the investment trust.
4) What is the volatility of the investment trust?
By examining the investment trust’s past performance and share price history, an investor will be able to make a judgement about the risk associated with an investment. Investment trusts that have large swings between positive and negative annual performance will not be suitable for an investor who needs his investment to meet certain goals by a certain date.
By examining year by year performance an investor will also be able to establish if long term gains were made consistently or by one off-good years.
5) Consider the risk the investment trust takes to make its profits
Investment trusts are able to borrow money to invest, an operation known as gearing. Any profits made with borrowed money will magnify the return made by the investment trust. However, gearing also magnifies any losses in a down trending stock market.
It should also be remembered that investment companies that concentrate much of their investments in volatile stocks – the shares of smaller companies, or IPO’s for example – will themselves carry greater risk.
6) Examine longevity of management and fund management
Investment trusts operate as companies, and the stability of management and consistency of investment approach will have an effect on how the market views the investment trust itself. Where investment managers’ change regularly or bad or good management has been replaced, investment performance may be impacted either negatively or positively. This can produce a short term effect to share price as well as long term investment returns.
7) Look at the effect on your overall portfolio
Long term investment success depends upon a number of factors. One of the key elements in achieving investment objectives is portfolio diversification. Investing in an investment trust that replicates an existing portfolio will concentrate investment focus and not diversify it.
In summary
Just as when investing in shares, bonds, or property directly, an investor needs to conduct proper due diligence and research the investment trusts in which he is considering an investment.
Buying shares in investment trusts is easily done through stockbrokers, and does not suffer the same costs of investing in OEICs or unit trusts, but a bad investment is a bad investment, regardless of dealing charges or the costs to set up. Even though investment trusts offer diversified funds for investment, an investor should be prepared to spend time investigating company fundamentals and the market in which the investment trust invests.
The investment should be commensurate with maintaining a diversified and balanced portfolio, which is a key to developing an acceptable risk over the medium to long term. When thinking about how an investment in any particular investment trust will fit in with overall investment strategy, the investor should also consider the long term strategy and inherent risk of the investment trust.
By following the seven points above, an investor will increase the probability of making the best possible choice of investment trust.