Investment trusts offer genuine structural advantages — the ability to gear, to hold illiquid assets without forced selling, and to smooth dividends through revenue reserves. These same structural features, however, come paired with a distinct set of risks that do not apply, or apply differently, to open-ended funds. Understanding liquidity risk, gearing risk, and governance considerations is essential before treating an investment trust as a straightforward substitute for an open-ended fund tracking similar assets.
Liquidity risk: trading a fixed pool of shares
Because an investment trust has a fixed number of shares in issue, an investor wanting to sell relies entirely on finding another investor willing to buy at an acceptable price, rather than the fund itself creating or cancelling shares to meet demand as an open-ended fund does. For large, well-known trusts with substantial daily trading volumes, this is rarely a significant practical issue. For smaller trusts, however, share trading can be thin, meaning:
- Bid-offer spreads can be wider than for larger, more liquid trusts.
- Attempting to buy or sell a large number of shares relative to typical daily trading volume can move the price against the investor.
- Selling during periods of broad market stress, when many investors may be trying to sell simultaneously, can be particularly difficult for less liquid trusts, sometimes coinciding with a widening discount to net asset value.
Checking a trust's liquidity before investing
Average daily trading volume, the trust's total market capitalisation, and typical bid-offer spread are all disclosed via stock exchange data and many platform research tools, and are worth reviewing, particularly for smaller or more specialist trusts.
Gearing risk: amplified losses in a downturn
As covered in more detail elsewhere on this site, gearing — an investment trust's ability to borrow money to invest alongside shareholder capital — amplifies both gains and losses relative to the underlying portfolio. A geared trust falling in a weak market will typically fall by more than its underlying assets, and rising interest rates increase the ongoing cost of maintaining that gearing, which can further reduce shareholder returns during periods when borrowing costs are elevated.
What to check
- The trust's current gearing level and its stated maximum permitted level.
- Whether the trust's borrowing is at a fixed or variable interest rate, and when any fixed-rate debt is due to be refinanced.
- How gearing levels have varied historically, indicating whether the manager tends to increase gearing tactically or maintain a more stable structural level.
Board governance: a safeguard, but not infallible
An investment trust's independent board of directors is intended to act in shareholders' interests, including overseeing manager performance, approving the trust's gearing and dividend policy, and, in some cases, taking action against a persistently wide discount or a manager underperforming over a sustained period. This governance structure is a genuine safeguard not present in the same form for open-ended funds, but it is not infallible.
Considerations around board effectiveness
- Boards vary in how proactively they hold managers accountable, and in how decisively they act on issues such as a persistently wide discount.
- Board members, while independent of the manager in principle, may have long tenures or close working relationships with the manager that could, in some cases, affect the vigour of independent oversight.
- Shareholders can vote on board appointments and certain major decisions at annual general meetings, providing a mechanism for accountability, though most individual retail shareholders hold a very small proportion of votes.
Discount volatility as its own risk category
Beyond the risk of the underlying portfolio falling in value, investment trust shareholders face the additional risk that the discount to net asset value can widen — sometimes sharply and for extended periods — independent of the portfolio's actual performance, reducing the share price further, or delaying or reducing the benefit of any subsequent portfolio recovery.
Comparing risk categories for investment trusts
| Risk type | Description | Particularly relevant to |
|---|---|---|
| Liquidity risk | Difficulty trading shares at a fair price, especially in size | Smaller, less-traded trusts |
| Gearing risk | Amplified losses and increased borrowing costs in downturns or rising rate environments | Trusts using meaningful levels of gearing |
| Governance risk | Board oversight may vary in effectiveness | All trusts, to varying degrees |
| Discount volatility | Share price can move independently of underlying NAV performance | All investment trusts, structurally |
Practical due diligence steps
- Review the trust's average daily trading volume and typical bid-offer spread relative to the amount being invested.
- Check current and historical gearing levels, and the structure and maturity of any borrowing.
- Read recent annual general meeting outcomes and board composition, available in the trust's annual report.
- Review the trust's discount/premium history over several years, alongside its stated discount control policy, if any.
- Consider trust size — very small trusts may carry additional liquidity and governance-scale considerations compared with larger, longer-established trusts.
A worked example: liquidity risk in practice
Suppose a hypothetical investor wants to sell £25,000 worth of shares in a small specialist trust with an average daily trading value of only £40,000 across all market participants combined. Attempting to sell such a large proportion of a single day's typical trading volume in one transaction could push the price down meaningfully before the full amount is sold, compared with a scenario where the same investor held a large, liquid trust with several million pounds of daily trading volume, where a £25,000 sale would likely have negligible price impact. This example illustrates why checking typical trading volume relative to intended trade size is a useful practical step, particularly for smaller or more specialist trusts. Figures are illustrative only.
Concentration risk in smaller or specialist trusts
Beyond general liquidity concerns, smaller or more specialist investment trusts can also carry concentration risk in their underlying portfolios, holding a smaller number of individual positions, or focusing on a narrower geography or sector, than a large diversified generalist trust or a broad index fund. This is a separate consideration from the trust's own share liquidity, relating instead to the diversification of what the trust actually invests in, and both dimensions are worth reviewing together.
Manager and strategy risk
As with any actively managed investment, an investment trust's performance depends significantly on its manager's decisions and the soundness of its stated strategy. A change in lead manager, a shift in investment approach, or a period of manager underperformance relative to the trust's stated objective are all risks that exist independently of the structural factors (liquidity, gearing, discount) discussed elsewhere in this article, and are worth monitoring through the trust's regular reporting and manager commentary.
Regulatory protections that do apply
Despite these risks, UK-listed investment trusts operate within a robust regulatory framework, including main market listing requirements, the FCA's oversight of listed companies, and the AIC's own code of good governance practice, which many (though not all) trusts choose to adopt. These protections do not eliminate the risks described above, but they do provide a baseline of disclosure, governance standards, and market oversight that investors can reasonably expect from any FCA-regulated main market listing.
Building awareness of these risks into a broader plan
None of the risks discussed here are reasons to avoid investment trusts altogether — they are widely used by both retail and institutional investors and offer genuine structural benefits, as covered elsewhere on this site. Rather, they are factors worth weighing specifically because they differ from the risks of an equivalent open-ended fund, and understanding them supports a more informed comparison when choosing between the two structures for a given strategy.
How risk factors can combine
It is worth recognising that these risk categories do not operate in isolation — a smaller trust with meaningful gearing, holding a concentrated portfolio of less liquid assets, combines several risk factors simultaneously, and the effect of a downturn can be more pronounced than considering any single factor alone would suggest. Larger, more diversified, ungeared or lightly geared trusts holding liquid listed equities generally represent a more moderate combination of these same risk factors, illustrating why trust-by-trust assessment matters more than broad generalisations about investment trusts as a category.
Where to find ongoing risk disclosures
A trust's annual report typically includes a dedicated principal risks section, required under UK corporate governance and listing rules, setting out the board's own assessment of the key risks facing the trust and how they are being managed or mitigated. Reviewing this section periodically, alongside the more general considerations discussed in this article, provides an ongoing, trust-specific view of risk that supplements the general framework covered here.
Comparing risk disclosure standards across trusts
Not all trusts disclose risk information with the same level of detail or clarity, and comparing the depth and specificity of risk disclosures between similar trusts (rather than assuming a brief, generic risk statement is equivalent to a thorough one) can itself be a useful, if informal, indicator of the overall quality of a trust's governance and investor communication more broadly.
A final summary of the risk-reward trade-off
The structural risks explored in this article are, in many cases, the flip side of the very features that make investment trusts attractive — gearing that amplifies losses is the same mechanism that can amplify gains, and a discount that can widen unpredictably is inseparable from the exchange-traded flexibility that allows trusts to hold illiquid assets without forced selling. Understanding this trade-off, rather than viewing the risks in isolation from the benefits, gives a more balanced basis for deciding whether a specific investment trust suits an individual investor's own circumstances and risk tolerance.
Key takeaways
- Investment trusts carry liquidity risk tied to their fixed share structure, particularly relevant for smaller, less-traded trusts.
- Gearing amplifies both gains and losses, and rising interest rates increase the ongoing cost of maintaining borrowing.
- Independent board governance is a genuine safeguard but varies in effectiveness and is not a guarantee against poor outcomes.
- Discount volatility is a risk category unique to closed-ended structures, capable of moving the share price independently of underlying portfolio performance.
- Checking trading volume, gearing levels, board composition, and discount history are practical due diligence steps before investing in any investment trust.