MARK DAMPIER, research director at Hargreaves Lansdown, the UK’s largest and most influential online platform, says that investment trusts can make good choices for self-directed private investors.
Although I only own shares in a handful of investment trusts myself, I do sit on the boards of two trusts and have had the chance to observe them from both sides of the fence. In some respects, trusts are an ideal
investment vehicle for the DIY investor. Many of the principles of investing in unit trusts and OEICs apply equally to investment trusts, but it is undeniable that they are slightly more complicated and harder to explain, which can be a deterrent.
Not that it seems to be deterring an increasing number of private investors from taking an interest, if our experience at Hargreaves Lansdown is any indication. Of the one million plus clients who now use our platform, around 150,000 hold at least one investment trust. In many cases these may be holdings that they held before they transferred their assets to us, but we are also seeing an increase in transactions as well. As you might expect, the wealthier and more sophisticated the client, the more likely they are to hold an investment trust.
How investment trusts differ from unit trusts is that they are (a) closed-ended and (b) trade on the stock exchange. This means that to start life they need to raise money through a public offering of shares (an IPO, in technical jargon) and this gives them a fixed amount of starting capital. Unlike unit trusts, which create or cancel units at will, they can’t grow or reduce their capital anything like as easily as a unit trust can, although it has become easier to do so in recent years.(1)
The net asset value of an investment trust generally rises and falls in line with the market and the expertise of the fund manager. Consequently, whereas the price of a unit in an open-ended fund should nearly always track its net asset value very closely, this is not so with investment trusts, whose share price is influenced by supply and demand.
If the trust is in fashion, or performance is stonkingly good, the shares may stand at a premium to net asset value. If you buy shares in the trust in these circumstances, you will be paying more than its current assets are worth. If on the other hand demand is poor or non-existent, and performance has been indifferent or worse, the trust’s shares may well slip to a discount. The share price will then stand below the net asset value of the trust; now when you buy the shares, you will be paying less than the underlying value of its assets.
Got that? I can assure you that it isn’t as complicated as it sounds. In simple terms, buying shares in an investment trust when they are at a discount is broadly a good idea – akin to something being in the January sales. Buying at a premium, however – certainly if it is more than say 3% to 5% – is usually a poor idea in the long run. There are some nuances behind this simple formula, however!
It depends a lot on why the discount has come about. If it is because the fund manager is no good and the trust’s performance reflects that, the case for buying is weak, even if the price is a bargain-basement one. But if it is because the whole sector is unfashionable and unloved, it can often be an indication of genuine value and you should investigate it as a potentially contrarian buying opportunity. Even in the first case, it may be worth keeping an eye on the trust as the board of directors always has the power to change the fund manager for someone better. If this happens, you will tend to see the discount start to narrow, though rarely immediately, which may still give you time to get on board.
When a trust is trading at a very large premium, it may be because the fund manager is exceptionally good, or more often it is an indication that the sector the trust invests in has become highly fashionable and therefore at risk of a sudden or dramatic change in sentiment. When a trust is trading at a premium of over 10%, it strongly suggests to me that you should not be buying it. It really has to go some in order to justify that kind of fancy rating. Even top-quality fund managers can see shares in their trust go from a premium to a discount. In those cases, however, they can often go back to a premium again, so keeping a watching brief on the share price and discount can be worthwhile, since from time to time it can throw up attractive opportunities.
One of the best examples of that phenomenon over the last decade has to be the case of FIDELITY CHINA SPECIAL SITUATIONS. The story includes one of the UK’s best fund managers, a sector that has drifted dramatically in and out of favour, and the impact of huge media exposure. The trust was born when Anthony Bolton, who had successfully run unit and investment trusts for Fidelity for more than 25 years, decided after a brief retirement that he wanted to move to Hong Kong in order to run a China fund for his old firm.
Given his track record and high profile in the industry, coupled with the popularity of China as an investment theme, the launch of his new investment trust attracted a record amount of money, more than £500m. Initially the shares, issued at £1 each, performed well, and before long were trading at a premium of more than 15% to net asset value – a classic example of a warning bell sounding. What happened next was that the Chinese stock market started to perform less well, and a couple of Mr Bolton’s core stock selections turned out badly (one of his companies being accused of fraudulent accounting practices). Given his high profile, these problems inevitably hit the headlines in a big way.
The fund slipped from a premium to a discount and, worse still, the share price fell as far as 70p, well below the issue price of 100p. The media was full of stories that Mr Bolton was unable to transfer his skills from the UK to China. Some gave the impression that he was over the hill and had lost his way. Many private investors expressed their disappointment by selling their holdings at between 70p and 90p a share.
By the time Mr Bolton retired from running the fund three years later, the media was still largely hostile, some going so far as to imply that his time at the helm had been a failure. At that point the shares were still trading on a discount of 14% to net asset value. Yet the net asset value itself had risen 90%, and the trust had handsomely beaten the fund’s Chinese benchmark while he was in charge. That hardly justifies being called a failure.
More to the point, he had already laid the seeds of a high-return stock portfolio. Since his retirement the portfolio has continued to blossom under Dale Nicholls, its new manager. Eight years after launch the net asset value had risen to a peak of 300p and the shares, while still trading at a discount, were nearly four times higher than they had been at the earlier low point. Since then, not unsurprisingly, they have fallen back again; any investment in a developing economy such as China will always be more volatile than most.
The point is that those who sold out after the initial disappointing performance missed out on a chance to make a superb gain. This neatly illustrates the fact that you shouldn’t believe everything you read in the media. A little time spent in research would have suggested that the move to a big discount was actually a classic buying opportunity, not a sell signal. Given that any equity investment should be seen as a long-term project, it was a mistake for investors to sell after just two years of experience, however disappointing the ride had been.
The other point is that the Fidelity China Special Situations story illustrates how investing in investment trusts can be both more hazardous and more rewarding than investing in an equivalent unit trust, precisely because of the discount/premium cycle. It takes more work and more courage to invest this way – whether that is for you is a matter only you can decide.
Another important difference between investment trusts and unit trusts is that investment trusts can ‘gear’ their returns in a way that unit trusts cannot. What this means is that, if the board of directors agree, the trust can borrow money in order to boost the amount of capital that they have to invest. If the fund manager can make a greater return with this extra capital than it costs to borrow the money, the trust and its shareholders will be better off. (To continue the driving analogy, they have moved up a gear or two.) The scope for gearing is another factor that makes analysing investment trusts more complicated as the decision to gear or not can make a significant difference to investment performance. It also adds to the risk of share price volatility.
Each trust makes its own decision, adding to the diversity of returns. Some investment trusts never gear, believing that their portfolio is already risky enough. Gearing can work both ways. When interest rates were much higher than they are today, many trusts mistakenly geared up by borrowing at a fixed rate, in some cases locking into permanently high borrowing costs. With the march of time this problem has gradually unwound. In a world of very low interest rates, as we have today, gearing does appear to make more sense. The effect of gearing means that investment trusts in general outperform their unit trust equivalents when prices are rising in a bull market, but are certain to suffer disproportionately the next time the stock market takes a tumble. Care therefore needs to be taken when comparing unit trusts and investment trusts. In the main, the last few years have been good to investment trusts, as they have had the double benefit of narrowing discounts and gearing. It will not always be so.
Should you be put off by the greater complexity of investment trusts? I don’t think so, although it does obviously depend on how much time for research you have at your disposal. Potentially investment trusts are a rich feeding ground for the self-directed investor. There are plenty of pricing anomalies you may be able to exploit. One reason is that professional investment institutions, which once were big buyers of investment trusts, have steadily divested their holdings over the years in favour of managing their investments directly. In a market dominated by individual investors, pricing anomalies do not always disappear as quickly as they would do in the professional institutional market.
“INVESTMENT TRUSTS ARE A RICH FEEDING GROUND FOR THE SELF DIRECTED INVESTOR. THERE ARE POTENTIALLY PLENTY OF PRICING ANOMALIES YOU MAY BE ABLE TO EXPLOIT.”
In my view their complexity means that investment trusts will never be mass market investment vehicles in the same way as unit trusts were designed to be. That is actually a good thing. If they were to become more broadly owned, it would remove most of the advantages that private investors enjoy with them today. The very first investment trust, FOREIGN & COLONIAL, despite its long illustrious history, after more than 150 years is still only capitalised at £3.9bn. By contrast, in the few months after Neil Woodford launched his CF Woodford Equity Income unit trust in 2015, it had attracted more than £6bn of investors’ money. The Fundsmith Equity fund, launched in 2010, now has nearly £14bn. Now that is what I call a mass-market product – simple, easy-to-own and simple to monitor. Investment trusts will never be that, but they do have other advantages instead.
You will see in the media that financial firms such as ours are often criticised for not recommending investment trusts more frequently. There is a simple reason for this. Many investment trusts are quite small and that makes it difficult for firms with large numbers of execution-only clients to suggest them. The reason is that buying and selling shares in many investment trusts in size is difficult. The top 20 largest trusts rarely trade more than £2m in a day. This won’t matter to a DIY investor who is looking to buy or sell between £1,000 and £10,000 of trust shares, or to advisors who can spread client orders over a period of time. But for a firm like ours with more than a million clients, recommending an investment trust could suddenly swamp the market with buy orders, something that could never happen with a unit trust.
Just suppose we recommended an investment trust through our newsletter. What might happen? The market makers, the professional firms that take and implement buy and sell orders, would see the recommendation and mark up the price of the trust well before the orders came through. Buy orders on any significant scale could not all be fulfilled, leaving clients frustrated. Worse still, the clients might want compensation for failing to have their orders fulfilled, particularly if that price continues to move up. If our advice was to sell, then the problem would be even more acute.(2) This is why platforms offering execution- only services are wary of investment trusts and is why I also think they are generally unsuitable for the broadest mass market.
That does not mean they might not be right for you. If you can get to grips with understanding how investment trusts work, they can be an attractive way to invest. They can still help you even if most of your money is going into open- ended funds. I own shares in RIT CAPITAL, for example, in part because there is no open-ended alternative. The premium or discount at which investment trusts trade can also be extremely useful in seeing how investor sentiment is moving. It can be a good indicator of whether a particular sector or market is on the cheap or expensive side. If many more trusts are trading at premiums, it may be flagging up that we are near to a market top, while large discounts across a number of sectors suggest the opposite.
Having recently been appointed a non-executive director of two trusts, INVESCO INCOME GROWTH and JUPITER EMERGING AND FRONTIER INCOME, it has given me an opportunity to invest some more money in the trust sector. As a shareholder it is generally a good sign if directors of a trust have a significant personal holding in the shares. It means that their interests will be closely aligned with yours. If the investment manager is doing a poor job, the board has every incentive to try and improve the situation. Now that I am approaching retirement, I have a particular interest in generating income and I am keen to ensure that the trusts where I am on the board are making sufficiently good returns to sustain and ideally grow their dividend-generating capacity into the future.
Thirty years ago it was often said that the boards of many investment trusts were ineffectual – I recall that my boss, Peter Hargreaves, was fairly outspoken on that subject (as well as on many others). As a generalisation it had some merit. It is no accident that some of the oldest surviving trusts started life as investment vehicles for the wealth of successful merchants. They and their successors had every incentive to keep the management of their trusts on their toes, but that was far from being a universal situation, especially once the big investment management firms moved in on the action. Too often it was the external managers rather than the directors who called the shots.
Since then the quality and calibre of non-executive directors has improved by leaps and bounds. Of course, as one of the new breed of directors myself, you may be thinking: ‘He would say that, wouldn’t he?’ and you would be right.
(1) What they can do is issue more shares from time to time, either by buying them in and reissuing them, or making what is called a C-share issue. It is still a more cumbersome process.
(2) See Peter Spiller’s observation in The Investment Trust Handbook 2019
But I genuinely believe that it is nevertheless true. I would not have dreamt of agreeing to do the job unless I thought that I could make a difference. Whether or not you agree, it can only be good that more private investors are now making the effort to understand how trusts operate and to understand which boards and managers are really doing their best for shareholders.
MARK DAMPIER has been head of research at Hargreaves Lansdown, the UK’s largest independent stockbroking firm, since 1998. He has been in the financial services industry for more than 30 years, initially working as an advisor helping individual clients to invest their money. He has become one of the best-known and most widely quoted figures in the fund management industry. He wrote a regular column in the Independent on funds and markets for many years, and regularly comments in the national press and on broadcast media. Effective Investing (Harriman House, 2015) was his first book (and, he swears, definitely his last!).