Over their 150 years of history investment trusts have proved themselves to be one of the great innovations in the financial world and rightly command loyalty and admiration among those who have taken the trouble to understand how and why they operate.
They remain, however, if not the best kept secret in the City, as was once said about them, still relatively little known and used by far fewer investors than they deserve to be. In an age when increasing numbers of individuals have shown themselves able and willing to take more responsibility for their own investment decisions, and the internet makes researching and monitoring investments greatly easier than in the past, anything that can shed a brighter light on the potential of the investment trust business is, I trust, to be welcomed.
The Investment Trusts Handbook you are looking at now is the first edition of a new publication. The idea behind the Handbook is to combine a detailed data-driven snapshot of the sector as it is today with a range of features, analysis and useful information that illuminates the opportunities trusts create for new and experienced investors alike. It is a reference work to keep and consult throughout the coming 12 months. The next edition will be published in November 2018.
As a longstanding investor in trusts, as well as a non-executive director, I am conscious that boards of directors need to keep pressing for improvement – keeping costs down, performance under review and portfolio managers on their toes. A flourishing trust sector is a force for good and it is important that more investors are kept aware of its potential to provide – as, in the right hands, a great number of trusts already do – a rewarding investment experience. We hope that this Handbook will contribute to that process.
Of course, some readers may say, what is the point of producing an annual handbook when so much information can be readily found in real-time on the internet? It is a fair question, but I don’t think it is that hard to answer. One reason is that while basic information about investment trusts is indeed widely available on a range of websites, and many accessible for free, the context and analytical approach you need to take full advantage of that information is not. Interpretation of data is just as important as content.
A second reason is that some of the best research on investment trusts has long come from broker analysts, but it is becoming ever more difficult for individual investors to access; indeed, from 1 January 2018, thanks to a complex piece of European legislation known as MiFID II, it will become even harder than before. With the best analysts having already effectively been prevented from distributing research directly to anybody other than professional clients, the new legislation requires that all broker research be paid for directly for by those who use it.
One consequence of these new arrangements, almost certainly, is that the number of analysts following investment trusts in the City, and with it the amount of published research, will contract. At the last count there were 14 broking firms working in the sector, and not enough fee-paying business in the coming environment to justify the cost of the research that they collectively produce. As the number covering trusts declines, it creates a gap that other publishers and research providers such as ours will seek to fill.
A third reason is that not everyone wants to spend their time using the web to do research – in my experience, even as a professional investor, it can be tedious and time-consuming to collect all the relevant information you want in one place, even when you know where to go to find it. Not every website is able to provide all the information you need – numbers, charts, links – in the form that you want it.
One particular thing that I know would help me is a convenient calendar that gives me notice well in advance of when the investment trusts that I follow are likely to produce their interim and annual results. I also appreciate having advance warning of when annual general meetings are coming up. A calendar of just that sort is one of the features you will find in this Handbook, along with a directory of all the largest trusts currently listed in the London market.
Another important function that handbooks can play is to provide understanding and perspective. There was a time when cricket fans simply had to buy Wisden if they wanted to study and compare scorecards and averages across a whole season. Today online cricket databases, like those for many other sports, are wondrous things full of arcane facts and the most extraordinary minutiae.
The scores and averages, however, were never the sole, or even the primary reason, to rush out and buy the latest Wisden, as many used to do. It also included some excellent features by and about the best cricket writers and players. The handbook format similarly lends itself to picking and reproducing interesting commentary on the investment trust sector.
This inaugural edition includes contributions from some of the most highly-experienced and well-qualified investment trust professionals around, including Peter Spiller, Robin Angus, John Baron and James Burns. Mark Dampier, the head of research at the UK’s largest retail broking firm, Hargreaves Lansdown (which is doing an increasing amount of business in investment trusts), also chips in with his observations about the sector. We also have three in-depth interviews with prominent fund managers from different sectors, some additional insights on venture capital trusts, and a section that offers broad guidance on how to analyse trusts. We are looking forward to coming up with more features for next year’s edition. All suggestions for improvements will be gratefully received. The problem, I suspect, will be to decide what to leave out as much as it is what to include.
How stands the investment trust business as we head into 2018?
At the time of writing these notes the short answer, I would say, is: in a pretty good place. Global equity markets are buoyant, which always helps, interest rates are still very low and the bond market has yet to reverse course decisively enough for us to be able to call the final turning point in the 35-year-old cycle of falling bond yields.
As a result of these positive market tailwinds and the broader use of discount controls by trust boards, the average discount across the sector – always a good indicator of its health – continues to narrow. At the end of the third quarter of 2017, the average discount on mainstream trusts was around its lowest level since the great financial crisis, while the average alternative asset trust, the fastest growing part of the IT universe, was trading at a premium to net asset value.
The emergence of a flourishing sector of alternative asset trusts, a broad grouping that extends from private equity to renewable energy, and from warehouses to mortgages and aircraft leasing, has been the most striking feature of the last few years in trust-land. The common feature that binds most of these disparate types of trust together – private equity being the major exception – is their ability to generate income for shareholders.
This in turn has spawned a steady stream of new trusts coming to the market and finding ready buyers, particularly among the wealth management and financial advisor communities, which are now the largest institutional buyers of investment trusts. Although it is not strictly true, it feels as if almost any new entity that can offer a headline yield of more than 5% will find a buyer, so great is the demand for anything with an income attached.
Trusts with what can broadly be described as an alternative asset mandate now account for around a third of the trusts in the Association of Investment Companies classification. Headline yields are not always what they appear to be, however. Trusts have a range of ways to enhance or pad out their income-generating capacity, now including the ability to draw on capital as well as revenue reserves, and you would do well to heed the advice from our contributors that it pays to look very carefully under the bonnet at how real and sustainable those yields may be.
How long the fashion for income and the persistence of premiums for these newcomers continues is one of the things that observers will be watching closely as we move into 2018. The greater diversity that you can now find in the trust universe as it has evolved today is, however, undoubtedly a source of strength. The ability of the investment trust sector to regenerate itself at periodic intervals has always been one of its defining characteristics.
History tells us, of course, that it is exactly at times like this, when all seems set fair, that a crisis may be just around the corner. The only predictable thing about stock markets, as J. P. Morgan observed many years ago, is that they will fluctuate. The cycle of boom and bust will persist as long as markets exist. Financial markets generally, however, are notable at the moment for their placidity. Volatility is at its lowest level for many years.
Experienced investors have noticed this and the prudent ones are making preparations for at least a temporary interruption in this benign picture – not because they necessarily can see the causes of the next downturn, merely that they know one will come eventually, as it always has done. Anyone who doubts as much would be well advised to study the history of the first and oldest investment trust of them all, Foreign & Colonial (F&C), which in 2018 marks the 150th anniversary of its formation.
As historian John Newlands reminds us in his essay on the subject, F&C was set up by three enterprising Victorian professionals to offer those with means the opportunity to invest in a well-diversified portfolio of high-yield bonds issued by what were then the emerging markets of their day. (A good quiz question, the answer to which you can find in John’s piece, is to ask which government amongst the 19 original issuers in its initial portfolio was the first to default?)
While F&C was the pioneer in creating a listed investment vehicle of this kind, and rightly deserves the celebrations which are to be held to commemorate the fact over the course of 2018, it has had to endure many turbulent moments in its history since. So too has the whole investment trust sector, which over the years been buffeted by two world wars and market collapses, as well as occasional scandals.
F&C owes its continued survival and prosperity in part to its willingness to take big contrarian bets at times of market weakness, as it did in 1974 and 1987. An opportunity to do so again will undoubtedly emerge in due course. Whatever the trigger, the next bear market is sure to test the resolve of existing shareholders, but it will also – just as certainly – provide an opportunity for savvy trust connoisseurs to pick up bargains as discounts widen once more. For the forearmed investor, a crisis is an opportunity, not just a threat.
In the 1930s, just as investment trusts were starting to recover from the trauma of the 1929 market crash, a new and potent competitor to the investment trust appeared in the shape of the first open-ended fund. The unit trust, as it was known, being easier to run and market, and with the huge advantage of being able to offer sales incentives to financial advisors, has continued to outsell its older closed-end counterpart more or less ever since. The investment trust has survived that threat only by its ability – admittedly sometimes only under duress – to generate superior performance and higher standards of governance.
Scroll forward 80 years and it is possible to see new – and not dissimilar – threats emerging in the competitive landscape. One is the relentless rise of passive investment, which has seen ultra-cheap index funds and more recently exchange-traded funds (ETFs) challenge the traditional dominance of actively managed funds, into which category effectively all investment trusts fall. Tracker funds and ETFs offer a direct challenge to two of the investment trust’s fundamental competitive advantages – low running costs and a commitment to effective active management.
The second threat comes from the ever-increasing burden of compliance with regulation. Ironically the Financial Conduct Authority, the financial services regulator, shows little sign of either understanding or caring much about investment trusts – in its recent Asset Management Review, it only mentioned the trust sector once by name (and that was in a footnote on p.94!). Some of the regulator’s policies, such as the banning of sales commission to financial advisors for recommending funds and the drive for greater transparency on fees, have been positive for investors. Nevertheless the overall impact of a heavier-handed and more intrusive regime is clearly bearing down in a number of ways on the ability of the investment trust sector to operate profitably and grow.
Aside from the loss of competitive advantage of lower costs, one particularly important side effect of the new regulatory regime is that it has led to considerable consolidation in firms that traditionally have managed private client portfolios and remain the trust sector’s biggest source of institutional support. That in turn has made it much harder for new trusts in the conventional equity fund mould to come to the market. Some private client firms now say they will only support the launch of a new trust if it is capable and likely of reaching at least £200m in assets.
Unless you are a particularly highly regarded star fund manager, such as Neil Woodford or Terry Smith, that is a disincentive and a tough hurdle for firms contemplating a trust launch to overcome. Only trusts with a clearly differentiated active management strategy and investment team are able to make it to the IPO stage. Were it not for the popularity of the all-conquering high-yielding newcomers in the alternative asset space, and the resilience and longevity of the bull market, you might perhaps be hearing questions raised about investment trusts’ continuing relevance and survival.
Such questions are nothing new. Investment trusts have regularly had to demonstrate the ability to adapt or shrink and will doubtless do so again. It helps that the quality of board director, it seems to be widely accepted, has improved, as has their willingness to take a more active role in obtaining terms from their investment managers. The last couple of years have seen more trusts negotiating lower annual management charges and/or reviewing – and often eliminating altogether – the use of performance fees.
Trusts such as Scottish Mortgage have shown it is possible to use economies of scale to bring down their fees without apparent difficulty; its ongoing charge ratio of 44 basis points (0.44% per annum) for an actively managed global equity fund is certainly competitive with the cheapest index fund alternative. The most successful trusts remain profitable for fund management firms, so I suspect there is room for margins to be squeezed further. For many smaller trusts, however, given the cost of their legal and reporting requirements as listed companies, and the competitive and regulatory challenges now emerging, it is going to remain an uphill struggle to keep costs down and some will probably fall by the wayside.
A somewhat different challenge faces those whose job is to analyse and value trusts. Putting a value on a trust that invests in renewable energy, or in infrastructure projects, or peer-to-peer lending, requires a different set of skills and techniques. Trusts in a new specialist sector such as renewable energy all use different discount rates and inflation assumptions, making valid comparisons more difficult. When index-linked gilts first appeared in the 1980s, it took a few years for the market to work out how to price them correctly. Something similar may be happening now in these new sectors. Analysts too, therefore, are also having to raise their game.
Such issues aside, investment trusts are in good order. They remain the investment vehicle of choice for many of the smartest investors I know. Performance of the best ones has been good and their traditional strengths – high-quality active management, effective use of gearing, the ability to follow a conviction approach – continue to stand them in good stead. They offer investors plenty of choice and diversification potential. That is why we look forward to continuing the task of chronicling their progress in the interesting times that undoubtedly lie ahead.
JONATHAN DAVIS MA, MSc, MCSI is one of the UK’s leading stock market authors and commentators. A qualified professional investor and member of the Chartered Institute for Securities and Investment, he is a senior advisor to Sanderson House and a non-executive director of the Jupiter UK Growth Trust. His books include Money Makers, Investing With Anthony Bolton and Templeton’s Way With Money. After writing columns for The Independent and Financial Times for many years, he now contributes regularly to The Spectator and records a weekly interview with leading professional investors for the Money Makers podcast channel.