SANDY CROSS, of Edinburgh discretionary investment management firm Rossie House Investment Management, explains the central role that Scotland has played in the development of the investment trust sector and the key role that active investment management plays in constructing client portfolios.
I am happy to nail my colours to the mast as a firm believer in the benefits of active management. Passive investing has its place – if you want a low-risk way to have your savings return slightly less than a market index over time it works brilliantly (or at least has done up to now). However, my colleagues and I are pretty sure that if you want your assets to be not just managed, but stewarded for the long term, you will find that a skilled and thoughtful human will do you rather better than a robot. Our aim, then, is to identify talented managers who can produce very good returns over long periods without exposing our clients’ assets to excessive risks. There is a view that these managers do not exist. We disagree. They do exist. They just aren’t easy to find. On the plus side we find there is one part of the asset management market where they are easier to spot than usual – and that is in the investment trust sector.
A Constantly Innovative Structure
The concept of a listed company, the purpose of which is to invest in other companies, was pioneered by London lawyer, Philip Rose, creator of the FOREIGN & COLONIAL INVESTMENT TRUST in 1868. His intention was to allow those with ‘moderate means’ the opportunity to access types of investment (for example, overseas bonds and shares) and a level of diversification that was out of reach to all but the wealthy. This was an enormously creative (and egalitarian!) thing to do at the time. But the really interesting thing is the way in which the sector has hung on to that sense of striving for innovation. Rossie House has its head office in Edinburgh, a city that is also home to a disproportionate number of well-known investment trusts. On the face of it they are leftovers from the huge fortunes made in Dundee in the jute industry (the material was much in demand for sacking material as international trade expanded and – famously – to make sandbags in the American Civil War).
This money needed to be invested somewhere, and investment trusts provided a very neat vehicle for securing and growing the wealth generated in the jute industry. Robert Fleming, who founded the eponymous bank and was grandfather to the James Bond author Ian Fleming, launched the first Scottish investment trust in 1873 and it is still active today. But these funds are more than leftovers. They are hugely modern wealth-creating machines.
Take the largest investment trust in the UK (at the time of writing), the FTSE 100 member SCOTTISH MORTGAGE INVESTMENT TRUST, which is managed by Edinburgh-based Baillie Gifford. It launched in 1909 with a plan to provide loans to fund the rubber plantations that supplied the emerging automotive industry with the raw material for tyres. That was exciting stuff at the time. But look at the Scottish Mortgage portfolios now and you will see that, while it isn’t for everyone, the trust is as brave and exciting (adventurous?) today as it was 100 years ago. That, we think, tells you a lot about the adaptive and long-term nature of the investment trust structure.
Evolve, Adapt, Endure
So what has made the trust industry so successful? Where has this remarkable ability not just to hang on but to thrive through centuries of war, crisis and financial upheaval come from? A key part of the answer lies in the fact that the pool of capital inside a trust is fixed, something that encourages a patient, longterm approach from those who are managing it. Sure, investors can sell their shares – but, however much they might want to, they can’t pull their capital out of the fund itself. Top investment managers love this. It means they can invest for the long term without the constant admin distraction of inflows and outflows of capital. Better still, they can also hold small company positions or unusual specialist assets, which, while they may be less liquid than large equities or bonds, can still offer excellent long-term opportunities. The result? A really skilled and properly interested manager will naturally gravitate towards investment trusts, where we will hope to find and support them!
When Philip Rose set up his investment trust he opened a whole new world of investment to ordinary people. Today’s trusts are doing the same thing – just with different assets. Twenty years ago it was, thanks in part to Rose, perfectly simple for anyone who wanted a standard equity or bond portfolio to get into one. But a variety of other assets – private equity, commercial property and unlisted companies, for example – remained the preserve of the rich.
No more. The ability of trusts to invest in the less liquid assets that mainstream open-ended funds find too risky has led to the most significant recent development for investment trusts – the large-scale growth in alternative asset trusts. Think about property. Hold it in an open-ended fund and you may find that come a crisis you get a wave of redemptions; have to sell it in a hurry; and have to take a crisis price. Hold it in a closed-ended fund and that will never happen. The trust might move to a nasty-looking discount but the assets can stay intact. That’s a hugely valuable feature – and the reason why there are now funds investing in areas ranging from aircraft leasing, healthcare facilities and social housing to litigation finance.
Harnessing That Innovation For Clients
We aren’t militant about out what vehicle we use for investing our clients’ money. We will take the best wherever we find it. However, we do find that many of the managers we consider to be superior are drawn to managing equity investment trusts and may also include some of their best, but liquidity constrained, ideas in their investment trust portfolios rather than similar open-ended funds they manage.
We are particularly keen on using trusts in specialist areas. We hold a number of high-quality Asian investment trusts for regional exposure and also like to buy alternative asset funds for diversification purposes. Listed private equity is one area we have been invested, for example – although, as with all investments, we like to keep a firm eye on costs. At the other end of the trust spectrum, we like a number of the big global funds. Investment trusts started out with global mandates and it remains an area in which they excel. Very often, too, you can buy in at a highly competitive price. The MID WYND INTERNATIONAL INVESTMENT TRUST, for example, has a management fee of 0.5% per annum. In the world of asset management that represents genuine value.
Keeping a Critical Eye
Nothing is ever settled. The past is no guide to the future. And we are not set in our ways. Reasonable fees, the appeal of the structure to able managers with a long-term perspective and – in some cases – effective use of borrowing have meant investment trust returns have fared well compared to open-ended returns in many studies. But we should never forget that a trust is just a structure and, as with all funds, it will only ever be as good as its managers and the assets they choose. So we keep as close an eye on the negative trends in the sector as the positive.
We are watching the fairly high fees in alternative asset funds and also noting the practice, in certain cases, of constantly issuing new equity, which arguably undermines the fixed-pool-of-capital argument in favour of trusts. Among more conventional equity trusts we are watching the way boards manage discounts and premiums. We love the idea that when you buy a trust you get an independent board to steward your interests. But we won’t invest in trusts where the board isn’t doing that well.
Four Things To Think About When You Choose An Investment Trust
1. Find managers who focus on companies rather than macro stories
Macroeconomic forecasting is hard to get right, as the fact the US Federal Reserve did not forecast any of the last eight recessions would testify. It therefore follows that investment stories based too emphatically on exciting-sounding macro themes have a tendency to disappoint, as many a macro hedge fund return would suggest. Fortunately, investing isn’t really about macro trends. It is primarily about companies – their products, their cash flows, their profits, their management’s expertise and their cultures. And while identifying the trends in these isn’t easy, it comes with many fewer variables than forecasting the direction of global interest rates. Better, we think, to work with people who focus on what is useful and possible than what is usually impossible and not necessarily useful.
2. Find managers with some sense of stock market history
We cannot predict the future using the past, but we can learn useful lessons and minimise the future mistakes. A visit to Edinburgh’s Library of Mistakes, a splendid financial history resource, can be most instructive on this front. There, and in numerous business school libraries, shelves groan with research that comes to one key conclusion: about three quarters of M&A is a complete failure for shareholders. I can therefore tell you with some certainty that shares in companies engaged in M&A, other than small infill acquisitions, are less likely to be good investments than those that stick to organic growth. If your manager loves an acquisitive company, acquire holdings in someone else’s fund.
History teaches us similar lessons about leverage. We always want to be ready for a crisis (there is almost always one on the way). We know that it is the companies with the most debt that come a cropper the fastest in a crisis. Having debt to pay back and banks to keep happy reduces flexibility and autonomy, which are both things that managers need most when the chips are down. Long-term investors are far better off accepting lower annual returns in return for a greater degree of financial resilience and a greater chance of long-term survival. So check your managers’ top ten holdings list. If there are too many highly leveraged firms you may be better off avoiding the fund.
3. Find managers who back themselves
You want to see a manager investing in their own fund. If it isn’t good enough for his own money, why should it be good enough for yours? There are all sorts of definitions of risk around in the financial world. The only one that should matter to most investors is the risk of permanent loss of capital. If a manager isn’t investing in his own fund you might wonder why he reckons his own capital isn’t safe there and take yours elsewhere.
4. Find managers who think more than they trade
Very often the biggest difference between a successful asset manager and an unsuccessful one is turnover. Low turnover means lower costs (which are a helpful predictor of long-term performance). But it also suggests a higher level of conviction. You want a manager who has a clear strategy which brings him good ideas and who then gives those ideas time to play out. All too many managers get swayed by the short-term direction of the market: it takes only the smallest of worries that their own strategy might mean they underperform the market in the short term for them to adopt someone else’s. We’re looking for the small number of managers in the market who can demonstrate more stamina than most. The ones who have a (good) plan and stick to it regardless of what everyone else is up to.
SANDY CROSS is an investment director at Rossie House Investment Management.