Industry expert ALEX DENNY explains how using investment trust with different styles and objectives can reduce the risk of investing in financial markets.
When it comes to investing, the benefits of diversification are clearly significant. Most investors will be familiar with how spreading your investments across a range of areas can reduce your exposure to single-asset risk. Putting all your investment eggs in one basket can offer extraordinary returns (think Apple in 2003 or Tencent in 2017), but it can also lead to catastrophic losses (Northern Rock in 2008 or Volkswagen in 2015).
Indeed, some investment fads can be so volatile that they can produce incredible returns and losses in quick succession. Bitcoin returned over 1,000% in 2017 and peaked at around $19,000 in December that year but is down more than 50% since then at the time of writing.
Everyone likes to see their money grow, but there is no risk-free way of guaranteeing these enormous returns. Turning £20 into £10,000 is the kind of gamble you might be willing to take. Turning £10,000 at the time of investment into just £5,000 at the time of redemption is exactly the kind of mistake we all like to avoid.
As a general rule, the majority of investors will therefore look to build a core portfolio of diversified mainstream investments and savings, split across the three broad areas: cash, bonds and equities. This core portfolio will be held through bank accounts and, probably, funds.
Source: Fidelity International, August – indicative chart only.
The allocation or balance between these different assets will vary between different people and are clearly dependent on individual objectives and circumstances – what you are saving for, your age, appetite for risk and capacity for loss.
These core asset classes are exactly that – core. They form a central component of how our financial systems and markets work, but as such they may all suffer from related setbacks. For example, an equity investor may feel confident that holding a range of index trackers provides sufficient diversification. However, in today’s global economy, major inflexion points can occur simultaneously across all markets – just see returns over the second half of 2008 or mid-2015 for a painful reminder.
￼“SOME INVESTMENT FADS CAN BE SO VOLATILE THAT THEY PRODUCE INCREDIBLE RETURNS AND LOSSES IN QUICK SUCCESSION.”
￼Source: Datasteam, August . Index performance based on total return in GBP. Past performance is not a guide to the future.
INVESTMENT TRUSTS AND AVOIDING SYSTEMATIC RISK
There are lots of reasons why global equity markets can follow each other; markets are not rational in the short term. Driven by sentiment, a sell-off in one market can often trigger a downturn in another. The trick to avoiding this sort of risk – and achieve genuine diversification – is to access parts of the market which are not well-covered or represented in an existing core portfolio.
Investment trusts are nearly all actively managed and have structural advantages which allow them to avoid these systemic risk pitfalls. Their capital structure – with a fixed number of shares and no flows of cash in or out from investors – allows them to invest in much smaller, illiquid companies which fall outside of mainstream indices (or have negligible correlation to them).
They also have the ability to invest in companies before they are even listed, as well as alternative areas like real estate or long-term infrastructure projects which aren’t well represented in mainstream funds due to liquidity issues.
There are investment trusts which specialise and focus on investing in these kinds of areas – smaller companies trusts, private equity and venture capital trusts, real estate investment trusts – as well as trusts which follow relatively mainstream markets from the core of your portfolio while adding these non-core elements as well.
Take FIDELITY ASIAN VALUES PLC as an example. It is an actively managed investment trust whose manager, Nitin Bajaj, focuses on buying good, well-run businesses, which are undervalued by much of the market. This often entails buying companies that operate in sectors which are very unfashionable – but can still be very profitable and therefore create good investment returns. This contrarian investment style, by its nature, leads the manager towards industries and companies that do not make up a significant proportion of the regional market index.
In fact, at the time of writing, the company has 99.5% its portfolio held in stocks and assets which do not form part of the MSCI AC Asia ex Japan Index, which is most commonly used as a comparator for funds investing in the region. This figure is called ‘active money’ and gives an indication of how much, or how little, a fund or company’s portfolio differs from a typical benchmark tracker.
￼￼￼Source: Datasteam, September . Index performance based on total return in GBP. Past performance is not a guide to the future.
With a near total lack of stock overlap, it stands to reason that a holding in the company is not closely correlated with the index over the shorter term – though it still benefits from the long-term structural tailwinds which support the region’s growth. It is therefore possible to complement a mainstream equity portfolio with this type of investment to take out the impacts of short-term trends, smoothing returns and improving risk-adjusted returns at a portfolio level (although diluting out some of the additional absolute returns that may be added by active management).
Another example, in developed markets, is the recent launch of BAILLIE GIFFORD US GROWTH TRUST which eschews simple index returns by having authority to invest up to 50% of its portfolio in companies which are not listed at all. Whether you’re looking to gain exposure to specific alternative asset classes or you are attracted to the ability to invest in small or unlisted companies, these examples highlight to good effect the benefits that investment trusts can offer when held as part of a well-diversified portfolio.
ALEX DENNY is the head of investment trusts at Fidelity International. This article does not constitute investment advice and should not be used as the basis of any investment decision. Past performance is not a reliable indicator of future results.