Jeff Salway: Financial advice rule changes set to boost investment trusts

Sales of investment trusts are a fraction of those enjoyed by unit trusts and open-ended investment companies (OEICs), despite evidence suggesting they fare better in terms of the long-term returns they deliver to investors.

That may finally be set to to change, however, when new financial advice rules come into force next year.

As it stands, while unit trusts pay commission to advisers for selling them, investment trusts do not.

That goes a long way to explaining why investment trusts account for just 0.5 per cent of the client money placed by independent financial advisers (IFAs), according to the Association of Investment Companies (AIC).

But commission payments from providers to the advisers selling their products will be outlawed from January, under the retail distribution review (RDR) – and investment trusts are expected to benefit.

Richard Wadsworth, financial planner at Carbon Financial in Edinburgh, said: “One of the main reasons investment trusts have not been more widely used by investors is that most advisers still sell products that pay commission, and commission paying unit trusts dominate  client portfolios.

“Once the RDR is implemented on 1 January, 2013, investment trusts will have a more level playing field due to the  removal of commission from unit trusts.”

In other words, if you have a financial adviser who is paid by commission, there’s a good chance they have never recommended investment trusts. Investment trusts and unit trusts are both forms of collective investments (see box for main differences), but the bulk of your money is likely to be in the latter.

Does that mean you’re missing out? It depends who you ask, of course, but fans of investment trusts will point to performance figures showing that the average investment trust often outperforms the typical unit trust.

That was the conclusion of recent  research by Money Management, a specialist magazine aimed at financial advisers.

It found that over the long term, investment trusts have the edge in terms of performance, producing superior returns to their open-ended counterparts in all but one fund sector (UK smaller companies).

Money Management is not alone in reaching this conclusion. Canaccord Genuity, a broker, last month published figures showing that over the past decade, investment trusts have outperformed unit trusts by at least 2 percentage points across a range of sectors.

It’s not all one-way. Money Management found that unit trusts tend to be more effective at minimising losses when markets are sliding. While UK smaller companies investment trusts were down 26.2 per cent in 2008/09, for example, their unit trust counterparts lost 19.6 per cent.

But it’s over the long term that the comparison between unit trusts and investment trusts really favours the latter.

One reason is the lower fees charged by investment trusts, reducing their drag on performance. Wadsworth said: “The comparisons are normally made with unit trusts, which have much higher charges, due in part to the fact that the charges contain an allowance for commission to be paid to an adviser, something that investment trusts do not do. Post-RDR, this comparison should be much easier to make once commission is removed from the mix.”

But charges within the investment trusts universe can vary widely from sector to sector, and even within specific sectors, he added.

“Even within a sector such as ‘global growth’ there are large differences. Global growth trusts have low charges but the further you go from plain vanilla global growth, the more expensive they are, and in a lot of cases I don’t think investment trusts would be cheaper.”

He also recommends checking if you have to pay performance fees.

“The practice of charging performance fees is also more common in the investment trust world, so any potential investor should understand how much is payable and under what circumstances.”

The gap between the charges on investment trusts and unit trust is beginning to narrow. Not only are fund groups increasingly aware of the focus on costs during times of low growth, but the higher fees levied by unit trusts reflect the commission paid to advisers – a cost that will be vastly reduced next year. Some unit trust managers have already launched commission-free versions of their funds in preparation for next year.

There are other advantages to investment trusts when it comes to delivering returns, however. Brian Steeples, chartered financial planner at The Turris Partnership in Glasgow, picked out one of them: “Investment trusts can retain up to 15 per cent of earned dividends each year whilst distributing a minimum of 85 per cent each year,” he said. “Over many years this has allowed them to build up a reserve pot from which they can ‘top-up’ dividend distributions. This creates a smoothing of the income stream for investors and can be very useful.”

That’s especially useful for equity income trusts, from which investors look for a regular and increasing income stream.

“Our top picks for UK equity income are currently paying income of around 4 per cent a year,” said Steeples. “They include the Edinburgh Investment Trust, City of London trust, Temple Bar and, with a slightly lower income but with very good capital growth, Finsbury Growth and Income.”

Investment trusts have their pitfalls, however, and some investors and advisers will continue to steer clear. One feature that can make investors wary of trusts is their ability to borrow, known as gearing. It’s advisable when researching trusts to check the extent of their borrowing and the effect that this has on performance.

Also look at the extent of any price premium or discount and be aware of the size of the trust, Steeples added.

“A very small fund is a small fund for a reason. Be clear on what that reason is,” he said. “And if your adviser doesn’t know much about investment trusts or is not prepared to recommend them, find another adviser.”