TONY YOUSEFIAN, investment trust research analyst at FundCalibre, explains what he and his colleagues are looking for when assigning a rating to an investment trust.
Investment companies have been around for 150 years. Having survived a number of world wars and stock market crashes, the longevity of many surviving trusts is impressive. A key advantage is that the closed-ended structure of investment trusts lends itself to taking a long-term view on investment opportunities.
According to the Association of Investment Companies (AIC), more than half of investment companies have had the same fund manager at their helm for more than a decade.* Almost a quarter (23%) have had at least one of their managers in charge for 20 years or more. Considering how many of us in other roles change jobs far more regularly, this is a surprisingly large percentage.
Another important factor is that investment companies have a board of independent directors who oversee the management of the investment company and provide continuity. With 400 trusts from which to choose, selecting the right one for your portfolio can be daunting, especially if you are also looking at the 3,000 rival open-ended funds on offer. But there is help at hand. Fund researchers have the job of narrowing down the choices on offer to a more manageable number of funds they think are the best. It is notable, however, that only a few conduct research into investment trusts. FundCalibre is one.
The Way We Analyse Investment Trusts
For us the longevity of the manager is vitally important. This is because we like fund managers, whether they run open-ended or closed-ended vehicles, with longterm track records. It means they have experience of investing through all the different stages of a stock market and economic cycle, not just the good times. You should never confuse a bull market with investment genius, as the old saying goes.
The longer the track record, the more effectively we can analyse the value they add. To do this we use a proprietary screening tool, AlphaQuest, that we have developed ourselves. AlphaQuest is the first stage in our fund-rating process. It is a quantitative screening system that analyses the past performance of a trust. We do this by stripping out the impact of market movements to identify the returns which can be directly attributable to its fund manager. It then measures the consistency of the returns that the fund manager produces, to help us determine whether they are genuinely skilled or merely have been lucky.
While many screening systems that analyse past performance exist, we think ours is unique because we attempt to calculate the probability of future performance as well. Our process is designed to produce an estimate of how likely a manager is to continue to deliver superior returns over the next 12 months. Managers must have a track record of at least three years to be considered and a trust must pass this screen before we will proceed further with our research. The best trusts on our analysis are then eligible to be given an ‘Elite Rating’.
Our process has three steps:
- We start by running the AlphaQuest screen, as outlined previously. Only trusts that pass this screen and whose managers we think show a high probability of continuing to deliver over the next 12 months will proceed to the next step of our process.
- Those fund managers who pass the AlphaQuest test are then subjected to further detailed qualitative analysis. Our experienced research team will interview the fund manager face-to-face, on at least one occasion, to better understand and assess how their investment process and style gives them an edge over other managers.
- Once this analysis has been completed, the research will be subject to peer group review within our team. Only then will those trusts, whose managers we believe to be the most skilful, be awarded our Elite Rating.
Only a minority of trusts – about 30% of the total – survive the initial screening. To qualify we need to be able to assign at least a 60% probability to a trust’s next-year outperformance. Those trusts which qualify typically register between a 60% and 90% probability of achieving that; we have never found a fund that has more than a 90% probability of success, underlining that there are no sure things in investment. Since we launched the process three years ago, the open-ended funds we have given a top rating to have subsequently outperformed. We don’t yet have similar figures for the investment trust process, so it is too early to demonstrate a similar result.
We do want the Elite Rating to be a badge you can believe in. Unlike some agencies, we don’t run a tiered system of funds rated 1 to 5, or gold, silver and bronze. Our philosophy is simple: a fund is either good enough to qualify for a rating or it’s not. This means that we rate far fewer funds than our competitors (around 150 compared with more than 400), leaving investors with a much more manageable number from which to choose.
Other Factors To Consider
While the aim of an investment trust is the same as an open-ended fund, they do have other elements which we also need to analyse when considering them for a rating. From the perspective of a buy-and-hold investor, perhaps the biggest difference is that inflows and outflows of money do not affect the investment strategy of a trust. If a lot of investors all want to redeem their money from an open-ended fund all at once, it can result in the manager being forced to sell positions he still likes purely in order to meet those redemptions. This is not the case for investment trusts. That is what makes the closed-ended structure particularly suitable for specialist trusts holding assets that cannot be easily or swiftly bought and sold (such as property, private equity or very small companies). Trust managers don’t have to sell their holdings in order to release money back to investors looking to liquidate their investments.
(a) Discounts and premiums
Because an investment trust has a limited number of shares, the price of its shares is affected not only by the performance of the underlying investments, but by investor sentiment towards the trust itself. Sometimes in life, the more popular something is, the more expensive it is, and vice versa. The same is true for investment trusts. The price you pay for a share is based on the value of the investments held in the trust, but also on how popular the shares are.
If the shares are seen as desirable, their price may rise to a premium to its net asset value (NAV). If they are not so appealing, their price may fall to a discount. This means you are sometimes paying a bit more for a share in a trust or could be getting a ‘bargain’.
In theory, a discount allows you to buy into a trust for less than the value of the assets, but it is important to think about why it is trading at a discount. Is it a function of short-term negative sentiment or has the market identified a fundamental flaw with the investment strategy or fund manager? It isn’t a given that the discount will narrow or become a premium. Some trusts trade perpetually below NAV. You have to look at the history of the premium and discount.
Likewise, while you need to be wary of paying more for the value of the assets than you need to, some sectors have a long history of trading at a premium. Infrastructure trusts are a good example. This sector has traded on a premium, as high as 20% on occasion, for the best part of a decade or more. You need to look at a trust’s historic pricing to understand whether or not it is offering good value or not.
Another key element of an investment trust is gearing. This is the mechanism by which an investment trust borrows money in order to make extra investments, with the aim of achieving a return greater than the cost of the borrowing. For example, take an investment trust with a value of £100m. If the stock market is rising, the fund manager may see lots of potential opportunities. But to take maximum advantage, he or she might want to invest an extra £20m. Having borrowed the money to do this, the investment trust is now ‘20% geared’.
In the right hands and benign market conditions, having the flexibility to allocate more capital to favoured assets can pay off. When the market gathers momentum, an investment trust with gearing gets an extra boost. In 2012, for example, when Shinzo Abe became prime minister of Japan promising wholesale reform, the Japanese stock market was seen as attractive by many investors. Abe’s reforms (later coined ‘Abenomics’) held out the promise that he could finally lift the Japanese economy out of its longstanding deflation. Investors who were convinced that, after many years of false dawns, the reforms would have the desired effect were highly rewarded if they invested in a geared Japanese equity trust, such as the BAILLIE GIFFORD JAPAN TRUST. While the average open-ended Japanese equity fund returned 130.23% from 5 December 2012 to 1 October 2018, and the average Japanese equity investment trust returned 233%, Baillie Gifford Japan Trust (which is Elite Rated by FundCalibre) returned 332%.* On the flip side, of course, gearing can also exacerbate losses and volatility during times of market stress.
So investors need to look closely at how much gearing is permitted in an individual trust (a matter for the board to approve), how much gearing the manager tends to use and how and when they use it. This will differ from trust to trust. Investors need to be comfortable with the level of gearing, as it can increase the risk significantly.
(c) Dividend capacity
Saving for a rainy day is an idiom we all know well. Investment trusts can do this too, via a ‘revenue reserve’. When an economy is strong, dividend payments from companies can be a great source of regular income for investors, but how reliable they are can be anyone’s guess. As we have seen in the past, companies can cut their dividend payments or stop them altogether if times are bad and they don’t have the spare cash to return to their shareholders.
During the good times, investment trusts can retain up to 15% of the dividends they receive in a pot called the revenue reserve. The more dividends the fund manager generates from a trust’s investments, the more money can be put aside for the future. During the bad times, when dividends become scarce, the fund manager can tap into the reserve and boost what might otherwise be a lacklustre dividend to produce a more steady return for the trust’s shareholders.
This stability of income can be especially attractive to investors who need a consistent income, such as those who need the income from their investments to help pay monthly bills. The AIC has a list of investment company ‘dividend heroes’ – trusts that have increased their dividends for at least 20 consecutive years. The dividend hero with the longest history, CITY OF LONDON INVESTMENT TRUST, managed by Job Curtis from Janus Henderson for the past 26 years, is one of our Elite Rated trusts. It has increased its dividend in each of the past 52 years. During that time Job has dipped into his revenue reserve on seven occasions to maintain its income-paying track record.
(d) The independence of the board
Last, but by no means least, accountability is becoming increasingly important to investors. Having an independent board is one way of ensuring this accountability. An independent board will be made up of a group of experienced professionals whose job is to support the fund manager, but also have a responsibility to identify if the fund manager is going o ff track and the authority to question how performance may be improved. They also act as a fair and objective earpiece for investors.
The quality of the board will depend on the quality of its members. We would also suggest that investors carefully examine the qualifications and track record of an investment trust’s board. How active have they been in looking after shareholders’ interests? Is there a discount control mechanism in place? Are they willing to issue shares when demand is high to avoid the investment trust moving to a high premium and to buy shares when demand is low and a discount has got too wide?
There is a lot to consider when choosing an investment trust but, with the right guidance, it is possible to make more reasoned choices and the outcome can be rewarding. We currently have assigned an Elite Rating to just 12 trusts. You can find more details of the trusts which have qualified from our website. The regulators rightly require us to say that past performance is not a reliable guide to future returns. When you buy shares in an investment trust you may not get back the amount originally invested and tax rules can change over time. However the knowledge that professional analysts have analysed a trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to have more confidence in making their own decisions.
12 Elite-Rated funds:
Baillie Gifford Japan
Baillie Gifford Shin Nippon
F&C Global Smaller Companies
Fidelity China Special Situations
Fidelity Special Values
Jupiter European Opportunities
Lowland Investment Company
Schroder Oriental Income
The City of London
* The Association of Investment Companies, 19 June 2018.
* Source: FE Analytics, total returns in sterling, for the IA Japan sector, IT Japan sector and
Baillie Gifford Japan Trust, 5 December 2012 to 1 October 2018.
TONY YOUSEFIAN has been involved in discretionary investment management for both
private client portfolios and funds, as an analyst and fund manager, since 1987. He
joined FundCalibre as a research analyst in 2016. Tony’s views are his own and
should not be regarded as constituting financial advice.