Using Investment Trusts to Diversify

June 20, 2013

Diversification is often quoted as one of the key principles of successful investing, and ranked alongside the importance of time in the market to maximising returns. It is impossible to say which asset will perform best over the next 12 months, 5 years, or 20 years. But by comparison to history and considering the effects of the economy, geopolitics, and other issues on asset prices it is possible to say that assets tend to move differently at different times.

Diversify across assets

When seeking to diversify, the first rule of thumb is to spread investments across different assets. By doing so, an investor will negate the downside of an underperforming asset because other assets will be rising. One way to do this is to invest in each asset in turn, perhaps buying a property for investment purposes, government and corporate bonds, and shares in a stock market bell weather company, as well as holding cash in a deposit account.

Diversify across different industries

Just as assets move at different paces at different times, so do different industries. Investors should spread their money across the whole range of the economy, and not focus in one area. When the oil sector is strong, and the distributive trades weak, an investment across both will mean the better performer making up for the bad performance.

Diversify across individual investments

However, diversification across assets and industries is unlikely to be enough on its own to ensure that risk is kept to a minimum. When investing in equities, for example, the purchase of shares in a single company leaves the investor with specific risk: the risk that the company will fail or underperform the market. The same can be said of bonds, particularly corporate bonds, and property.

For diversification to realistically cut risk, investment needs to be spread across not just assets but also individual securities within each asset class.

Where investment trusts come in

For most investors, employing such a high level of sophistication in investment methodology is not only beyond their experience and ability but also beyond their pocket. To diversify across an investment in the stock market, for example, it is estimated that holdings in at least 30 different companies should be made. That is a lot of investment research to be conducted, and unless tens of thousands of pounds can be committed to the investment the costs of dealing will be punitive to investment return.

Investment trusts offer investors a way to invest in diversified portfolios in a single investment. With hundreds of investment trusts available to investors, they range from investment trusts that focus on the broad market – called generalist trusts – to ones that specifically target a single sector of the economy.

Their investments are managed by professional managers on a day to day basis, and these managers have expertise in specific economic areas.

There are also investments trusts designed for investing in different types of company to meet different investment objectives, whether they are capital growth or income related. Split capital investment trusts have a share structure that allows investors to accommodate different needs through the investment in a single investment trust.

Invest in different geographies

In exactly the same way that assets move in different directions and speeds so too different countries. His has been particularly evident over the last few years, as Europe has struggled with second and third level recessions while the United States has been recovering from the financial crisis of 2008/ 9 and the economies in countries like China have grown at a pace the western world can only dream about.

Geographically targeted investment trusts allow the investor to target specific continents or regions, even individual countries. There are trusts that invest in continents, countries, and specific industries.

Diversification across investment trusts

The costs of buying investment trusts are a lot lower than those of buying unit trusts, and generally speaking the annual charges are lower, too. This makes them attractive to investors who want to use collective investment schemes to accommodate their investment strategies. But just as using the principles of diversification holds for investing across assets, industries, individual instruments, and geographies, so it holds true for investment in the investment trusts themselves.

An investment trust investor should always consider investing in a number of likeminded investment trusts with different companies. While the possibility of the failure of an investment trust company may be slim, it is, nonetheless, there. By investing in a range of different investment trusts, targeted at different assets, geographies, and industries, through several different investment trust companies, an investor will achieve the ultimate in investment diversification.

In summary

An investor who wants a diversified portfolio has a range of options open to him. Using investment trusts to meet his needs is one of the easiest and most cost efficient ways of these, though care should be taken when assessing whether the discount or premium to net asset value that an investment trust is trading at is justified before committing funds.

The Association of Investment Companies have a fully comprehensive and searchable database of all UK investment trusts.