PETER SPILLER, founder and guiding light of Capital Gearing Trust, has been analyzing and managing investment trusts for nearly four decades. He offers some guidance on what he has learnt over the years.
1. Funds are a tax haven.
A long-term portfolio in a tax-paying account should invest in a fund if possible. The reason is that any capital gains tax is deferred until the investment is realised, or extinguished if held to death, rather than charged each year on realised gains. The difference over long periods can be startling.
I have been running Capital Gearing Trust for 35 years. Assuming an average 25% capital gains tax rate, an annual turnover of 20% (probably conservative) and an annual return of 15% (the actual rate achieved by the trust over the period), an investment of £1,000 in a discrete portfolio would have produced, after tax, cash proceeds of £51,298.
Inside the fund, the actual return, even after paying a terminal capital gains tax of 25% to make the comparison fair, would be just over £100,000, and that is after all fees, which were ignored for the direct portfolio. That leads to the final advantage of a fund over a direct portfolio: namely that the fees are deducted before distributions, so that they are in effect tax-deductible. Of course, these advantages are less the lower the tax rate, the fees and the return, but they are always positive.
2. Asset allocation should respond to values.
It is well-established that asset allocation should reflect the time frame of the investor. Those close to retirement cannot afford the risk of having to sell assets at the bottom of a bear market, whereas a young worker can tolerate much greater volatility and illiquidity in her pension fund. Academic institutions have an even longer, essentially unlimited time frame.
But that does not mean that those with a long horizon would always hold only equities, the asset class that has the best record of long-term returns and the highest volatility. That is because the balance of risk against returns is determined by the price of the asset.
Far better for long-term investors is to shift the duration of their portfolio to reflect the prospective returns of each asset class.
Fundamentally, the valuation of most assets reflects the long-term real risk-free interest rate. When real interest rates are high, valuations will be low and prospective returns good. The key point is that attractive prospective returns should be locked in for as long as possible; since equities are broadly speaking the longest duration asset, the asset allocation should heavily overweight them.
Similarly, bond portfolios should have long duration. By contrast, when risk-free returns are low, duration on the portfolio should be as short as possible. That means short-dated bonds and low allocation to equities and probably property. Of course, relative values play a large role in all asset allocation. But the main point is that markets can be timed if the horizon is far enough away. It is only the short term that is random.
3. Beware of ETFs.
Exchange-traded funds (ETFs) are growing in popularity and often with very good reason. Few looking at the track record of active fund management in the S&P 500 in the US would conclude that the extra costs of an active fund are money well spent. Unfortunately, the great insight of index-tracking – that in well-researched liquid markets, prices are sufficiently efficient that the winners will be those with the lowest cost rather than the brightest mind – is not applicable to all markets.
The less efficient and the less liquid a market, the less appropriate it is to invest through ETFs. That is true even of quite large asset classes like corporate bonds and smaller company equities. In both cases, ETFs purport to offer daily liquidity in an asset class that is of limited liquidity. In ordinary times, sales of underlying stock either by the ETF or the Authorised Participant (AP), with whom investors actually trade, are easily absorbed. But in the event of sustained redemptions, those APs will not be willing to finance large inventories, not least because regulatory charge has raised their cost of capital. They will simply lower their bid for the shares in the ETF, perhaps to a significant discount to the NAV or enough at least to show a profit after accepting discounted prices themselves to place the above normal market size of the individual assets.
Effectively, investors will be unable to realise their assets at close to their ‘real value’. If investors hold on until markets have stabilised, they should not suffer too much harm – but it is easy to see how downward momentum could gather in difficult markets. Given the size of ETFs, their problems could powerfully effect the valuation of the asset class. Put another way, the change in nature of the ownership of illiquid assets could make the dynamics of the next bear market in various assets quite different from those of the past. And the consequences for the real world are important. If the primary market for junk bonds, for instance, dries up, then companies may have difficulty in refinancing maturing debt.
4. Corporate governance matters.
In the world of investment trusts, the board of directors is critical to the long-term success of an investment. The two critical variables are the total investment return, which is down to the manager, and the relationship of the share price to the net assets. Where those assets are liquid, there is no real excuse for a large discount; all discounts are voluntary. Unfortunately, not all directors understand that.
Often they are appointed with little experience of investment trusts, though usually a record of success in something else. So that if, for instance, a trust is controlled by a manager who is indifferent to the interests of shareholders, it should be the job of the directors to make sure that the other shareholders, whom one might call the oppressed minority, do not have to accept a large discount if they wish to sell their shares. Sadly, on occasion, directors fail to exercise that responsibility, whether through inertia, ignorance or lack of gumption.
Less extremely, powerful management houses sometimes give the impression of putting the size of their own funds under management ahead of the interests of shareholders. Once again, it is the role of directors to assert the interest of the latter, particularly where commitments made by the board are broken, e.g. the discount will never exceed x%. The lesson for investors is to avoid such trusts. The apparent attraction of a significant discount now can turn into the nightmare of a much wider discount in a bear market. Far better to buy on little or no discount where corporate governance is good and particularly where a zero discount mechanism is in place.
5. Don’t trust votes in investment trusts.
Wind-up votes were introduced by imaginative investment bankers so that they could launch new trusts in a world where discounts were widespread. The concept was that new investors could relax about discounts in the short term because the vote, typically five or seven years later, would ensure a tight discount, or none at the point of the vote. A wide discount would always lead to a vote to liquidate the trust. Turkeys don’t vote for Christmas and shareholders would always vote in their own interest.
In practice, that did not turn out to be true. Trusts on large discounts and sometimes dreadful performance have sailed through wind-up votes. The reasons are too numerous and on occasion ignoble to go into here, but the lesson is clear. Investors should buy such trusts only with deep knowledge both of the board and their fellow shareholders.
6. Turnover is the enemy of performance.
It has become fashionable to note the importance of fees as a determinant of future returns. But fees are merely a subset of total costs and the impact of turnover can be substantial; think of commissions, dealing spreads and, for UK equities, stamp duty.
Furthermore, since the short-term direction of markets is more or less random, with a slight bias to momentum, there is usually little advantage to high turnover. Much better to buy good value for the long term and simply ride out short-term fluctuations. That helps to avoid the final trap: trying to be too clever.
PETER SPILLER founded CG Asset Management (cgasset.com) in 2000 and has been the lead manager of Capital Gearing Trust since 1982. He was previously a partner at Cazenove & Co Capital Management.