How to build a diversified portfolio with investment trusts

Share prices can rise and fall quickly from day to day. Over longer periods, they tend to reflect how well individual companies are doing or not doing, but in the short term they can be impacted by events such as geopolitical tensions, changes in government policy and shifts in the wider economy. One of the best defences investors have against this kind of volatility is diversification.

Diversification is about spreading your investments across a variety of sectors, regions and asset classes. This might be making sure that you balance areas that tend to be sensitive to economic growth, such as luxury goods, with areas where demand is less variable, such as utilities or consumer staples companies. People tend to pay their utilities bills or buy basic groceries in all economic conditions.

Across regions, investors may look for balanced exposure to developed economies such as the US, Europe or the UK, with higher growth emerging economies such as China or India. Diversification may also mean blending stock market investments with some bonds (fixed income). While stock markets may do well when economic growth is buoyant, fixed income can help to stabilise portfolios in more difficult periods. This is not universally true, but has been used as a basic principle in investing.

Should you invest in an index fund or investment trust?

You can invest in the stock market through index-focused products, such as an ETF or other passive funds. These products aim to replicate an index such as the FTSE 100 index or S&P 500 index, rather than having a fund manager pick individual shares. This has its place in a portfolio, but you may find that investing in an index can leave you with higher or lower exposure in certain areas. For example, more than a third of the value of the S&P 500 index is from just 10 companies, almost all of them technology-focused^[1]. It is a similar picture with the MSCI World index^[2], with over 70% of the index invested in the US. It can be worth introducing some balance in a portfolio.

Investment trusts are complimentary to index investing. Investment trusts are actively invested, meaning fund managers use their skill and judgment to back those companies that they believe will perform better than the market over the long-term. This means that the investments held within the trust will often look very different to those held in an ETF or passive fund based on the FTSE 100, S&P 500 or MSCI World indices. The ‘closed-ended’ structure of an investment trust means it does not have to buy and sell its underlying investments when investors buy or sell shares in the trust, which can give managers more flexibility to stick with their long-term decisions.

Investment trusts can broaden your portfolio beyond the largest domestic markets, with specialist regional trusts run by experienced managers. They can also provide access to different asset types, including bonds and other fixed income strategies. Used alongside other holdings, they can help you build a more resilient portfolio that is diversified across sectors, regions and asset classes.