How they work

Investment companies share some common features with other collective investment funds such as unit trusts. But investment companies also have several special features that also make them unique. This section will tell you about more about investment companies and their unique features.

• Closed-ended structure
• Listed on a stock exchange
• Boards of directors
• Shareholder democracy
• Buying at a discount
• Gearing
• Different share classes
• Specialisation in particular sectors
• Fund management

Closed-ended structure

Investment companies raise money for investing by issuing shares to prospective investors. This means that by issuing a set number of shares to investing shareholders the amount of money which the company raises to invest is fixed at the start. Generally, this happens once – when the company is created. This makes investment companies closed-ended.

An advantage of the closed-ended structure is that investors trading in the company’s shares have no effect on the underlying investment portfolio. The fund manager will invest and managed a fixed pool of money which enables the fund manager to plan ahead. This is especially useful for those investment companies with investment objectives which specialise in more illiquid assets such as smaller companies, emerging and developing markets and unlisted investments.

Unit trusts, on the other hand, are open-ended. This means the fund expands by issuing additional units on demand as people invest in the fund and contracts by the redemption of units on demand when investors wish to sell their units in the fund.

Listed on a stock exchange

Investment companies are listed on the stock market, which means that the shares of the company are traded on a stock exchange, just like the shares of other companies. However, unlike other public companies, investment companies are not trading companies with factories or shops; they exist to invest in a portfolio of investments.

Investment companies may be listed on the Official List of the London Stock Exchange (LSE) or any other exchange such as the Channel Island Stock Exchange or on the LSE Alternative Investment Market (AIM). The most common UK listing for investment companies is on the LSE's Main Market. Each exchange will have different rules and regulations which the company must adhere to. For example companies which list on the LSE's Main Market need to be admitted to the Official List by the UK Listing Authority (UKLA), a division of the Financial Services Authority, whereas to list on AIM or on another stock exchange different rules will apply.

Boards of directors

Investment companies have boards of directors whose duty it is to govern the company to secure the best possible returns for shareholders within the framework set out in the company's Articles of Association – in other words, to look after the interests of you the investor. The directors meet several times a year and monitor the company’s performance. The directors are directly answerable to the shareholders.

Shareholder democracy

When you buy a share in an investment company you become a shareholder in that company. Shareholders in investment companies have the same rights as other shareholders in other companies. This means shareholders can participate in the company in a number of ways. They can vote at the company's AGM on issues; they can table motions; they can requisition EGMs, or they can even vote in a new board if they are not happy with the current one.

This level of shareholder participation is not available to other types of collective investment funds for example a unit trust is not a company – you do not become a shareholder when you buy units in a fund.

Buying at a discount

As explained above, a stock exchange provides a mechanism for the sale and purchase of shares. The price of a share in an investment company or other listed companies is established by the stock market. The "agreed" price between a willing buyer and a willing seller is likely to reflect the market's perception of what that share is worth, this is known as the market value. The market value of the share may be different to the net value of all the underlying investments held by the company, this value is known as the net asset value. The difference between the market price and the net asset value is known as a discount or premium to net asset value (NAV).

There are various reasons why a company's shares trade at a premium or discount to NAV, these include; market sentiment towards a particular type of investment or market the company invests in, past performance under a particular manager or board; the market's belief that the NAV of the company is not reflecting a fair value or in some cases this may be due to the market not understanding the true value of the company.

More often than not, an investment company's shares tend to trade at a 'discount' i.e. when a share price is lower than the value of the underlying asset value of the share.

The prices of unit trusts are calculated depending on the value of their assets, so you cannot buy them at a discount.

Gearing

Investment companies, being companies, can borrow to purchase additional investments. This is called "gearing". It allows the company to take advantage of a long term view or favourable situation or a particularly attractive stock without having to sell existing investments.

The idea is to make a high enough return on the investments to be able to pay the costs of the loan, repay it and then make a profit on top of that. Obviously, the more a company borrows ('gears up'), the higher the risk it is taking. Gearing works by magnifying shareholder performance. If a company "gears up" and markets then rise and the returns in the portfolio outstrip the costs of the borrowing, the return to the shareholder will be even greater. But there is a downside to gearing too. If markets fall and the performance of the assets in the portfolio is poor, then losses suffered by the investor will be magnified due to both the costs and constant value of the borrowing.

When investment companies gear up, they can usually borrow at lower rates of interest than individuals. Investment companies have great flexibility in the ways that they can implement gearing, ranging from issuing long term debentures, preference stock, or prior ranking shares, to arranging bank loans at various interest rates for various time periods. What is important to remember is the use of gearing by investment companies affects both the capital value and the company’s revenue and dividend potential.

Not all investment companies use gearing and many of those that do, use it to very modest levels. Whether or not to use gearing is a decision taken by the fund manager and the board of directors. The gearing policy of the company may change from time to time and will be regularly reviewed by the board and manager.

Other kinds of collective investment vehicles are unable to borrow to the same extent as investment companies. In particular retail authorised unit trusts and OEICs are only able to borrow to invest albeit in a limited extent (10% of the fund’s value on any day) for up to three months in normal circumstances.

Different share classes

Investment companies which issue only one class of ordinary share are commonly known as "conventional" investment companies. Depending on the company's objectives, this usually gives shareholders a right to dividends and the opportunity to increase the capital value of their investment.

Certain investment companies issue different classes of shares which have rights and entitlements within the company. The different classes of share are designed to meet different investors' needs. These are known as split capital investment companies ('splits'). Some split shares aim to pay regular dividends for investors who want an income. Others aim to pay out only a capital amount at the end of the company’s life. The different share class priorities and entitlements can provide a type of gearing with varying risk levels called "structural gearing".

Other kinds of collective investment vehicles cannot offer this split structure within one fund.

Specialisation in particular sectors

Investment companies may specialise in a particular region or type of company or more generally in mainstream global companies. Some specialise in companies from different parts of the world whilst others specialise in particular business sectors.

Companies also specialise in what they aim to return to their shareholders. Some try to maximise income. Others aim exclusively for capital growth over the long term. Some companies aim to provide a combination of income and capital growth.

The types of investments the company invests in are in accordance with the stated objective of the company. Investment companies are able to invest in an almost unlimited range of investments, any investment restrictions will be subject to a company’s Articles of Association and approval of the board.

There are various specialist investment companies including Venture Capital Trusts (VCTs), funds of hedge funds, property investment companies and private equity investment trusts.

Some investment companies are what is called a "fund of funds": their objective is to invest in other investment companies, which means they take advantage of another layer of investing expertise (the fund managers in those investment companies). This can give good results, but the disadvantage is that you may be exposed to additional layers of operating costs and gearing.

The various investment companies can be suited to different investment purposes. For example, a large globally invested company could be used as a core holding, whereas a smaller specialist company might add spice to an established investment portfolio.

Fund management

Each company has a fund manager who makes the day to day decisions about what stocks and other investments to buy and sell. Most investment companies are managed by an external fund management group which may provide fund management services to a number of companies. The fund management group and the board of directors select the fund manager (or fund managers).

Companies that have no fund management group involvement are called "self-managed" or "independently" managed. This means the board of directors selects and employs a salaried fund manager (or managers) directly.

Split capital structures