The Retail Distribution Review, due to be implemented at the end of 2012, gives us all every incentive to take greater control of our financial destiny. Given the breadth and scope of the different options on offer it would be easy to feel intimidated but there are tools out there which are tailor-made for you, the investor, and which will help you construct a well-balanced portfolio designed to both create and preserve wealth.

Investment trusts are one such option. As RDR obliges independent financial advisers (IFAs) to tell their clients about all of the available opportunities, and not just mutual funds and unit trusts, it is likely they will gain a much higher profile in the months and years ahead.

In three simple parts, this handy guide will explain what the brave new world of RDR means for you, how investment trusts fit in to the wider universe of fund investment options and how you can best use them.

1. Seize the day

The framework for the Retail Distribution Review (RDR) was first announced by the Financial Services Authority (FSA) in June 2006. After several rounds of consultation it is set to be introduced on 31 December 2012.

The RDR’s objective is to deliver a better deal for investors through greater transparency and fairer charges. One of the review’s central aims is to address the potential for adviser remuneration to distort consumer outcomes. A large number of IFAs - for the time being - still work on a commission basis. This can result in them promoting products which include either upfront fees or redemption charges.

RDR aims to improve the quality of financial advice given to investors by removing commission bias from the decision-making process. Its proposed changes should make charges clearer for investors, increase competition in the market and diminish the potential for platforms to favour certain products over others.

Under the auspices of RDR, IFAs will also need to hold at least QCF Level Four qualifications, broadly equivalent to the first year of a degree course, if they wish to continue offering financial advice beyond 31 December 2012.

In addition, IFAs will not be able to take commission as a form of remuneration but instead will have to quote a fee for the advice they give to you. RDR also outlaws the payment of trail commission to IFAs by the fund manager whose funds they recommend. Since the new rules will see IFAs move to a fee-based set up, they should be incentivised to sell clients the most efficient products, a change that may well stimulate growing demand for investment trusts and also exchange-traded funds.

Get an edge

While in a post RDR world, advisers are unlikely to flock to investment companies overnight, it should pay for investors to get ahead of the game and study this often neglected option in greater detail.

The regulations offer a clear opportunity. In the brave new world of RDR, you could well benefit from taking control of your own finances and destiny through the construction of your own investment portfolio.

But if you do not feel that confident, at least your adviser will now be outlining all of the available options in the context of your appetite for risk and desired returns. Any investment involves a certain degree of risk and the trick is to manage those challenges and target portfolio picks where the potential for profit more than compensate you for any dangers that lurk. Asset prices will ebb and flow in line with the fortunes of the wider economy so you should therefore not invest more than you can afford to lose and never do so with borrowed money.

The amount of time you have to devote to investments and your level of confidence will vary but taking a more active role in managing your cash does not mean you have to spend hours every day reviewing individual stock selections. Collective investments, including unit trusts, Open-ended investment companies (Oeics), exchange-traded funds (ETFs) and investment trusts can all be a valuable part of your portfolio and sit happily alongside direct investments in equities, bonds and even commodities, property and foreign exchange.

2. The funds landscape

While some investors will feel comfortable choosing their own investments , not everyone will have the time or confidence to do so.

One of the key advantages of collective investment is it enables you to create a diversified portfolio even if you do not have huge amounts of capital at your disposal. By investing even £1,000 in a fund with 100 holdings in its portfolio, you obtain exposure to far more stocks or bonds than you could if investing directly in the market yourself. Exposure to far-flung markets such as Brazil, Russia, India or China is another key investment plus that can come from a professionally-managed portfolio, as these arenas are difficult if not impossible for private investors to access on their own.

Take your pick

If you decide that even a portion of your cash should be professionally managed, then the first choice you must make is between two distinct styles of investment:

• Passive. This approach encompasses so-called tracker funds and also exchange-traded funds (ETFs), which seek to replicate the performance of an underlying stock market index or basket of quoted firms. Several fund management houses run so-called ‘tracker’ funds, including Vanguard, BlackRock, M&G, Ignis, HSBC and Legal & General, while on the London Stock Exchange it is possible to buy and sell over 1,000 ETFs, exchange-traded commodities (ETCs) and exchange-traded notes (ETNs). Some investors prefer this route as they know exactly what they are getting in terms of performance - the result offered by the underlying asset. Since a tracker fund does not need teams of analysts or fund managers, costs are also lower.

• Active. Investors will seek the active option in the view the fund manager can not only match their benchmark index but beat it, either by means of superior asset allocation, shrewd stock picking or both. Active funds really should generate these premium returns to justify the additional costs involved, which include the salaries of the money managers and also the frictional fees involved as they buy and sell assets within the portfolio to which you are entrusting your cash.

If you decide the active route is for you, then there are four key choices available when it comes to selecting a fund that will hopefully protect and grow your wealth.

• Unit trusts and Open-ended investment companies (Oeics). These pooled funds are often grouped together as they operate in similar ways and generally invest in one or more of the main asset classes - shares, bonds, property and cash. Both kinds are classed as 'open-ended' investments, meaning their size is not limited and varies according to supply and demand. Open-ended funds have no maturity date and can grow larger or smaller depending on the number of investors wishing to buy or sell shares or 'units'. Unit trusts and Oiecs can be held in Individual Savings Accounts (Isas) and Self-invested personal pensions (Sipps), tax-efficient structures which shelter capital gains and dividend income from the attentions of the tax man.

• Investment trusts. Investment trusts are a form of closed-ended investment company traded on the stock market, in which shares can be bought and sold on the London Stock Exchange. They represent a cornerstone of an investment industry consisting of 410 companies with total assets of £92.8 billion as at 30 June 2012, according to data from The Association of Investment Companies (AIC). Apart from the manner in which they can be bought and sold, just like any other listed businesses, investment trusts are in many respects similar to pooled funds, although they have a slightly different structure. Whereas units of open-ended funds fluctuate with buying and selling volumes, investment trusts are referred to as 'closed-ended'. This means the number of shares within the fund is fixed, so rather than being inextricably linked to the value of the underlying portfolio, investment trusts’ share prices are driven by the market. As a result, the total value of the shares can be worth more or less than the assets held, so investment trusts tend to trade at a discount to or even a premium to net asset value (NAV).

As is the case with unit trusts and Oiecs, investment trusts can be held in Individual Savings Accounts (Isas) and Self-invested personal pensions (Sipps).

• Venture Capital Trusts (VCTs). VCTs are fully-listed companies whose principle mission is to invest in unquoted developing companies seeking capital. Firms listed on the junior Aim market and the ICAP Sharedealing Exchange (ISDX), formerly PLUS, are regarded as unquoted under VCT rules. VCTs also purchase new shares in privately-owned companies too.

In order to compensate investors for the risks involved with backing higher-risk businesses, VCTs come with tax benefits. These include income tax relief of up to 30% on new shares, dividend payments free of income tax, as well as exemption from Capital Gains Tax (CGT) on profits made on VCT share disposals. Existing shares offer tax-free yields and tax-free disposals, while on subscription for new shares, an investor is entitled to income tax relief of up to 30% to a maximum level of £200,000 in the tax year. In order for the initial tax relief to be retained, the shareholder must hold the shares for at least five years and the VCT must have invested at least 70% of the funds it has raised in qualifying holdings.

• Hedge funds. Hedge funds are aggressively managed portfolios that have historically been the preserve of institutional investors and high net worth individuals, but changes are afoot. Some hedge funds now offer a chance to get involved through funds listed on the London Stock Exchange. Two such examples are BH Global (BHGG), which is a feeder fund to the Brevan Howard Global Opportunities Master Fund and BlueCrest AllBlue GBP (BABS) which accesses all of BlueCrest's funds, both discretionary and systematic.

You can find out more on the website of the Alternative Investment Management Association (AIMA) at www.aima.org.

The case for investment trusts

Each of this quartet has its merits but investment trusts may be the area about which most retail investors know the least. But
these collectives, which also encompass split-capital trusts, real estate investment trusts (Reits) and venture capital trusts, do have several distinctive features which speak for their inclusion in a balanced portfolio.

• Tax angles. Investment trusts' satisfaction of the requirements of Section 1158 of the Corporation Taxes Act 2010 exempts them from paying tax on capital gains realised from portfolio investments and ensures shareholders are not taxed twice - once at the fund level, then when they actually sell shares in their investment trust in the market. In addition, it bears repetition that investment trusts are eligible for inclusion in both Isas and Sipps.

• Liquidity. The ease with which investment trusts can be bought or sold should not be underestimated. In the case of most unit trusts or Oeics, it is only possible to trade once or twice a day and there is no real guarantee of what price you will get.

Investment trusts have a fixed number of shares - they are ‘closed’ after the initial fund raising - although they can increase or reduce the number of shares in issue through open offers and share buybacks.

• Fund flows. A key plus is that during bull runs, investment trust managers do not have to deal with unwelcome flows of money to invest, possibly at a time when equity prices are too high. During a bear market, they are not forced to sell assets to meet redemptions as investors turn fearful and withdraw cash from equity-based funds. This gives the investment manager more flexibility and can help boost long-term performance, thus explaining the old market adage 'unit trusts are sold, but investment trusts are bought.' Templeton Emerging Markets Investment Trust (TEM), a fund steered by Mark Mobius since 1989, has established an impressive ten-year track record of share price, NAV and dividend growth.

• Aligned interests. Investment trusts have independent boards, which means they effectively work for the shareholders rather than the management company, so money managers’ interests are aligned with those of their investors. Retention of the fund manager must also be ratified by shareholders each year at the investment trust’s Annual General Meeting.

• Dividend record. Unlike unit trusts, investment trusts can build up revenue reserves. This means investment trusts can retain income in good years to ensure they can maintain dividend payments in the bad ones. Such a facet makes for a compelling investment case, since academic research shows nearly two-thirds of total shareholder return (TSR) from investing in the stock market comes from dividends and their reinvestment. The Witan Investment Trust (WTAN) has increased its dividend each year since 1974 - or 37 years in succession.

• Gearing. Providing the long-term returns on equity exceed the cost of borrowing, investment trust managers can employ strategic gearing to boost net asset value (NAV) returns, although the benefits of increases in fund assets and NAV can of course work in reverse. Unit trusts and Open-ended investment companies are able to borrow no more than 10% of the fund value. Moreover, these collectives can only use this to manage cash flow rather than boost their exposure to any particular investment.

• Costs. Investment trust bulls also argue their cost benefits will come to the fore following the implementation of RDR. Investment trusts commonly operate on a fee rather than a commission structure and tend to have lower Total Expense Ratios (TERs) than their open-ended rivals.

TER is the fund management industry’s benchmark for cost efficiency. Calculated by dividing the total annual cost by the fund's total assets averaged over a year and denoted by a percentage, it takes into account dealing costs, stamp duty, auditors' fees and the annual management charge (AMC) levied by fund groups. Typically, the TER on an actively managed fund is pitched somewhere between 1% and 2%, whereas tracker funds charge 0.5% or less. Investment funds tend to run toward the lower end of the 1.0% to 2.0% range. Annual research published last year (31 May) by the Association of Investment Companies (AIC) - using data from Lipper - revealed 31% of investment companies had Total Expense Ratios (TERs) of less than 1%, while 62% had a TER of less than 1.5%.

This compares very favourably with most Oeics and unit trusts. Here, an initial 5% commission can be incurred if you go directly to the fund manager, although accessing a collective via one of the big fund platforms, such as FundsNetwork, run by wealth management giant Fidelity, Hargeaves Lansdown's Vantage Service and also Cofunds, an independent platform only dealing with intermediaries, can see this initial fee reduced or even waived. The TER of 1.0% to 2.0% then comes on top.

Discount debate

The one point that is usually held against investment trusts is their share prices can trade at a discount to net asset value (NAV). The reason for this is a closed-ended fund's share price is determined by supply and demand factors. For every buyer, there must be a seller and if you sell, you can argue you are being short-changed as you are liquidating your ownership at the underlying assets at a level that is below their effective market worth.

Yet if a money manager has a particularly good track record, then there is nothing to stop an investment trust trading at a premium, although in this case it is the buyer who needs to be wary, as he is technically overpaying for access to the assets which form the portfolio. At the time of writing one example of an investment trust which trades at a premium is Standard Life UK Smaller Companies (SLS). This reflects the excellent long-term performance record of its star portfolio picker Harry Nimmo.

Nor are investment trust boards unaware of the negative impression big discounts can create. They frequently implement share buybacks in order to maintain or narrow discounts to NAV.

Finally, the canny investment trust punter could argue the discount is a plus, not a minus. During bull runs, discounts tend to close as markets rise and animal spirits surge, and this can add welcome leverage to increases in the value of the underlying assets and share price performance.

3. How investment trusts work

In a report published in the spring entitled A golden opportunity, Collins Stewart's Alan Brierley made a compelling case for investment trusts. He argued 'proven track records, lower total expense ratios, the ability to focus on managing money rather than be distracted by managing inflows/redemptions, the ability of income funds to use revenue reserves to smooth dividend payouts, the potential for NAV enhancements through gearing, buybacks and share issuance give the sector strong competitive advantages.' Moreover, his analysis showed 'over the past ten years, investment trusts have outperformed open-ended funds by a healthy margin in eight out of nine regional sectors, and relevant benchmarks in seven.'

The trick now is to select the right fund for your portfolio’s goals, time horizon, appetite for risk and desired return.

Online data sources enabling you to check out costs and performance include www.trustnet.com, www.morningstar.co.uk and www.citywire.co.uk, while investors can screen funds by TER via the web site of the Investment Management Association by visiting www.investmentfunds.org.uk/fund-sectors/fund-search/. The AIC’s website provides clear information on just investment trusts and all of the sites provide links through to the fund managers’ own data, including fact sheets on the portfolios and the individuals who run them.

These websites enable you to freely assess the key factors which will determine whether an investment trust is suitable for you or not:

• Investment style and underlying focus

• Performance record and individual
fund manager’s history

• Discount to net asset value

• Costs

Investment style

To help investors and advisers compare like-with-like, the AIC also runs a classification system which breaks down all of the available investment trusts based on their style and geographic focus. This will enable you to decide whether a portfolio is suitable for your investment aims and philosophy. More aggressive investors may seek to focus on growth, emerging markets or small caps, while more risk-averse savers may prefer to select income options or more staid, developed markets, and the range of options is plentiful.

• Asset class . Investors can glean exposure to bonds, equities, commodities and property via investment trusts but more esoteric areas are also available for the more risk-tolerant and adventurous portfolio builder. Hedge funds, funds of funds and private equity can all be accessed, while there are 110 portfolios which hail from the world of venture capital, including those run by Octopus, Hargreave Hale and Unicorn. Nine options target commodity picks, including City Natural Resources High Yield (CYN), seven address debt, six target infrastructure, including HICL Infrastructure (HICL) and three even specialise in forestry assets, including Phaunos Timber (PTF).

• Large or small caps . Twenty-nine investment trusts offer small-cap focused books of holdings, often with a geographic twist, such as Aberdeen Asian Smaller Companies (AAS), Baillie Gifford Shin Nippon (BGS) and JPMorgan US Smaller Companies (JUSC).

• Growth, income or a mixture of both . The North American Income Trust (NAIT) is well positioned to profit from the cash-rich balance sheets of US corporates whose investors are increasingly keen to see surplus funds deployed to drive dividend growth rather than share buy backs. Managed by Philadelphia-based Paul Atkinson, the £216 million cap seeks out quality and above-average dividend income among the ranks of the S&P 500.

Another closed-ended vehicle offering an attractive aggregate yield through exposure to differing global dividend cultures is the Henderson International Income Trust (HINT) run by enthusiastic income-hunter Ben Lofthouse. This £47 million cap company's underlying holdings range from American healthcare behemoth Abbott Labs (ABT:NYSE) to French media and telecoms play Vivendi (VIV:PA).

• The UK, Europe, the USA, Japan, Asia or emerging markets. One of the most high-profile portfolios offering exposure to the China story is Fidelity China Special Situations (FCSS), the London-listed investment trust run by legendary stock picker Anthony Bolton with a brief to play China's long-term growth potential.

At the time of writing, 41 portfolios target specific equity sectors such as biotechnology or technology, such as Polar Capital Technology (PCT) and Herald Investment Trust (HRI), managed by Ben Rogoff and Katie Potts respectively.

Performance record.

Past results are no guarantee of future returns but a good track record is undeniably a plus. The AIC's website provides performance data over one, three, five and even ten years, where available, and each vehicle is benchmarked against the relevant industry average.

Book value

Regardless of how good the money manager's record is, we are always reluctant to pay a premium, especially a big one, to access their expertise. Harry Nimmo's Standard Life UK Smaller Companies trust is not the only one to enjoy such exalted status. The global scramble for yield in a low interest rate environment leaves BlackRock North America Income (BRNA) and New City High Yield Resources at a premium to NAV, too.

A big discount is tempting but needs to be approached with just as much care. This could be the result of poor performance, high gearing or the showing and liquidity of the underlying assets. JPMorgan Russian Securities (JRS) and FPP's Ukraine Opportunities (UKRO) trade at discounts of 12.3% and 62.1% at the time of writing. If you believe an asset class, market or sector is about to fire the market's enthusiasm then buying at a big discount could help gear up returns as the value of the assets should rise and the gap close.

Costs

Under European Union (EU) proposals, investment companies will eventually have to publish an 'ongoing charges' figure as part of a Key Investor Information Document (KIID). The new rules, drafted in as part of the EU's Undertakings for Collective Investment in Transferable Securities (Ucits) directive, applies to unit trusts and Open-ended investment companies. Governed by the Financial Services Authority's Listing Rules, investment trusts do not have to produce
a KIID.

The AIC already publishes a very similar ongoing charges figure, calculated by Morningstar. The recommended AIC methodology for assessing an ongoing charges percentage figure is:

Annualised ongoing charges

Average undiluted NAV

Conclusion

As with any portfolio pick, it is imperative you do your research before you commit any of your precious capital to an investment trust. As well as examining a fund’s track record, costs and asset value, it should pay to look under the bonnet to check that they are comfortable with the underlying assets in which the fund is invested. Information on a fund's investment objectives and core holdings can be found on the websites offered by the AIC and the fund management groups themselves. As a final point, please bear in mind that any fund sold to the public has to be authorised by a regulator, generally the Financial Services Authority, although some are cleared elsewhere by the EU. S

The analyst's view

First and foremost, Read is keen to stress closed-ended investment companies lend themselves to more illiquid assets than their open-ended brethren, and are also traditionally lower cost. An added plus is 'an investment trust can gear up in a way that open-ended funds don't have the capability to do', he explains.

When choosing between the many listed investment trusts, Read believes you first need to decide what your investment objectives are in terms of capital growth, income, a combination of the two styles, or your desire to glean exposure to a particular theme or sub-sector. 'Your objectives will guide the evolution of your choice of what to buy,' explains the investment trusts expert. 'Review the literature', he continues. 'Is the manager constructing the portfolio consistent with how he says he is going to do it? Make sure the manager isn't going off-piste. If the manager is doing things that aren't consistent with the investment trust's objectives, it could lead to surprises. And they could be good surprises, or they could be bad surprises.'

Investor check list

Read highlights the importance of track record when choosing between investment trusts, although there are nuances. 'I would actually look at their performance and look at it over a range of time periods,' he explains. 'It is worth having a look relative to a number of benchmarks as well as the peer group,' he explains, adding 'there are some timeframes that are more relevant than others.' Read also points out the communication of the factors that are driving performance
is important.

Moreover, 'always have a look at the performance in total return terms', urges Edison's analyst. Be wary of investment trusts that do not include dividends in performance statistics, since dividends have an impact on net asset value (NAV), or of investment trust boards that demonstrate an 'unwillingness to return capital to shareholders. How are your interests aligned with the board and manager?' Read continues: 'I always find it comforting if these guys have put some of their money into it.' Good corporate governance is a useful screen, urges the expert, as 'you don't want to see a really close-knit board that has been going on forever.' Read also advises prospective investment trust investors to 'look at the capital structure' in terms of the equity, level of gearing and gearing policy and to 'ask yourself, are you comfortable with it?'

Be aware of the nature of excessively wide discounts or premiums too. You need to question whether a high discount or premium 'is reasonable in terms of performance, because performance tends to drive these things.' One red flag is a persistently high discount which an investment trust board is not doing anything to address, something Read describes as 'poor stewardship of shareholder capital. There is an onus on boards to do something about it.' On the other hand, frothy premiums can have a downside. 'The danger is if something moves to a premium and then there is a setback, that could really hurt people who've bought at a premium and damage the reputation of the vehicle.

Crucially, in any assessment of the merits of an investment trust, investors need to 'look at what they are charging, because there are variances. You just need to understand why. If they are more expensive, is it because they are good value for money?' (JC)