Why I love investment trusts for early retirement
Investment trusts are often referred to as the City of London’s ‘best kept secret’. This is because they are often overlooked in favour of their open-ended (mutual fund) counterparts, despite the fact that they mostly have a superior performance track record.
Their unique characteristics make them an ideal option for someone looking to reach financial independence through investing in the stock market, but by taking a hands-off approach.
What are investment trusts?
Investment trusts are a collective investment vehicle that’s listed on the stock market. Their shares can be bought or sold on the stock market like those of any other company. This means that the price of their shares can move independently to the value of the underlying securities in the portfolio, leading to them trading at a premium or discount to net asset value (NAV).
Investment trusts have several advantages over open-ended funds.
Firstly, the fact that they are closed-ended means they don’t have to worry about redemptions (i.e. people selling shares). An investor who wants to sell simply sells his shares on the open market, and this has no impact on the activities of the fund manager.
This stands in contrast to open-ended funds, which have to meet redemptions from their own financial resources. In the case of the latter, a large amount of selling can lead to the fund manager having to offload shares from the underlying portfolio in order to meet redemptions, which can have an adverse effect on long-term performance. The fact that an investment trust manager doesn’t have to worry about meeting redemptions means they can simply get on with running the portfolio without the added distractions.
Investment trusts also have an independent board of directors who monitor the performance of the fund manager and act in the best interests of investors. For example, they might switch fund managers if performance is consistently weak, or they might negotiate lower fees. This is an added layer of oversight which can be a major benefit over the long term.
Investment trusts can also borrow money in order to invest. Whilst it is true that this can create an added layer of risk – especially if a trust is heavily geared going into a bear market – when used wisely it can enhance returns. The board is also there to monitor the level of gearing and to make sure that the fund manager is not taking too much risk.
The final feature of investment trusts that I’d like to highlight is the fact that they can retain up to 15% of their revenues each year in their ‘reserves’. This is particularly important for income investors, as it enables a trust to build up a buffer from which it can continue to pay dividends in the event of a market downturn. This explains why some investment trusts have very long track records of paying – and increasing – dividends year after year.
The Association of Investment Companies (AIC) keeps a record of the investment trusts that have increased their dividends for 20 consecutive years or more. These ‘dividend heroes’ include the likes of City of London Investment Trust (LON:CTY), which has increased its dividend each and every year for more than half a century! To me, that seems like and income stream that I can rely on. A list of the top 15 AIC dividend heroes can be seen below: