Investment trust expert MAX KING offers advice to private investors on how to benefit from closed-end funds. This article was first published in the 2018 edition of the Investment Trusts Handbook and has not been updated.
A significant proportion of the financial service sector operates on the assumption that savers are neither capable nor willing of looking after their own investments and so need help from the ‘experts’. Inevitably this help and all the regulatory encumbrances that accompany it are costly, eating into investment returns. There is often a strong bias towards sacrificing returns for what the professionals regard as lower risk, but which is, in reality, only a reduction in short-term price volatility.
People are accustomed to taking significant financial decisions such as buying a property or a car without paying for advice so why do they not take the same view of their investments? Taking the DIY plunge requires confidence and nerve, but it soon becomes much easier. The greatest dangers lie in getting carried away by success or despondent about disappointment, in letting personal emotions get in the way of sensible decisions and in being influenced by people whose job it is to entertain, scare or impress you, but not to make you money.
The best advice for all would-be investors was carved on the lintel of the doorway to the temple of the Delphic oracle thousands of years ago: “Know yourself ”. What works in investment varies from person to person. It takes time, experience and some uncomfortable mistakes to learn the rules which you are best suited to follow. Long ago I realised that I was happier investing my own money in funds rather than directly in stocks, bonds or private companies, despite the tax advantages of the latter. Many investors successfully combine all three, but investment funds have some distinct advantages so should form at least a significant part of most portfolios.
Firstly, they encompass a broad spread of underlying investments making them less vulnerable to individual stock disasters. Secondly, they are managed by professionals who are better able to keep abreast of corporate developments, their markets and the broader economy. Finally, with the professional manager taking the individual stock decisions, the investor in the fund can leave well alone, just monitoring its performance and keeping an eye out for signs of trouble.
Inevitably, there are costs attached to this, which means that if you pay a wealth manager to invest in funds for you, you are paying twice over. There is little more satisfying than picking a stock market winner based on an insight the professionals have missed – and few more salutary lessons, on the other hand, than seeing the value of an investment wiped out. Investing in funds reduces the incidence of either extreme.
Having decided to invest in funds, your decision to go for investment trusts or other closed-end investment companies rather than unit trusts (now called open- ended investment companies or OEICs) is an easy one. Numerous studies have shown that over all time periods, closed-end funds nearly always outperform comparable open-ended funds in each sub-sector of the market, even when the funds are run side by side by the same manager. There are several reasons for this: firstly, closed-end funds tend to have lower costs. Secondly, their managers can take advantage of gearing, borrowing for investment when opportunities are attractive and raising cash when they are not. Thirdly, fund managers find it easier to manage a fixed pool of money than a variable one. When an open-ended fund is doing well, new money floods in, forcing the manager to invest even though prices may be unsustainably high. When the market drops, money floods out and managers have to sell into falling prices. The risk of this also constrains the manager’s ability to invest in less liquid but perhaps highly attractive opportunities.
Another major advantage is that closed-end funds are governed by a board of non-executive directors who are independent of the management company. The management company may be more interested in growing funds under management and in keeping fees high than in performance, but the directors won’t be. If the performance is poor, they can negotiate a fee reduction, a change of manager or a move to another investment company. They will issue new shares only if it is to the advantage of all investors but can also buy in shares if they are cheaply priced. Finally, they scrutinise performance, cross-examine the managers and keep them on their toes far more effectively than happens under the internal governance of OEICs.
Of course, there are some excellent open-ended funds while some interesting segments of financial markets are poorly or not at all served by closed-end funds. On the other hand, there are some areas of the market where open-ended funds with daily liquidity simply don’t work because the underlying assets are too illiquid. Examples include funds investing in private equity, property and the fast-growing area of alternative assets. Alternative assets encompass funds investing in infrastructure, loans, aircraft, alternative energy and a growing list of other tangible or intangible assets. These funds generally offer a high yield, moderate dividend growth and the prospect of some capital appreciation. This makes them attractive relative to cash, corporate or government bonds and their consequent popularity has led to a flood of new issuance in recent years.
After a slow start, equity issuance in 2018 has accelerated but is unlikely to exceed the 2017 record. As last year, little of it is in the conventional equity space. Investors need to be wary of stock issuance whether for new or established funds as it is often opportunistic, driven by current investor fashion and of more benefit to the sponsors and managers than the investors. As shown in recent years by WOODFORD PATIENT CAPITAL and PERSHING SQUARE, the more popular the new issue, the worse the subsequent performance. But wariness should not extend to a full aversion; BAILLIE GIFFORD US has risen 30% since its flotation early in 2018.
Fund flows are far from being one way but good performance and low discounts mean that buybacks and liquidations are diminishing. Funds reach the end of their pre-determined lives, continuation votes are voted down, boards decide that the investment thesis no longer works and so wind up the company, or boards – whether of their own volition or at the instigation of activist shareholders – return capital to investors. In closed-end funds, disappointing performance usually leads to action but in open-ended funds it often leads only to stagnation.
A key indicator of disappointing performance, or merely that the fund’s investment focus is unappreciated or out of fashion, is the appearance of a discount to net asset value in the share price. Clearly, this cannot happen in an open-ended fund but in a closed-end fund it reflects an excess of sellers over buyers and it makes the share price somewhat more volatile than the net asset value. For existing investors, a widening discount is a problem, at least in the short term, as it constitutes a drag on the share price. For boards, it may represent an opportunity to enhance performance by buying in shares cheaply, and for new investors, an opportunity to buy the shares cheaply.
However, investors should regard a sizable discount as enhancing the case for purchase but not the main reason for purchase. Maybe the fund, the sector or the market is currently unpopular but will soon bounce back, with the discount disappearing again, but maybe the discount reflects structural issues which cannot be easily addressed. Many good investment trusts habitually trade at a premium but are still worth buying, while discounts will not necessarily narrow if performance is good. That said, there is a long-term trend towards narrowing discounts so that the sector average is now only 2%.
Getting access to information and good research is becoming less of a problem for private investors. Reports and accounts, interim reports and monthly fact sheets are usually available on websites and these contain details of past performance. Click the professional investor/financial adviser tab on the website rather than the private individual one as the latter gives access to much less information. Comparative information on investment companies is available on the AIC website, together with helpful information on them generally and links to research notes. These have usually been sponsored and paid for by the companies so are not independent but they are a good source of information – and it’s in nobody’s interest for the writers of them to be less than honest.
Many funds and management companies go to considerable length and expense in marketing, providing updates from the manager, podcasts, links to media coverage and easy access to statutory information. There is some very good coverage in the financial press – including, I hope, my own modest contributions in MoneyWeek. Finally, it is always worth turning up to annual general meetings, even if you can’t vote in person. These almost invariably include a presentation by the manager and an opportunity to ask questions either in public or face-to- face afterwards.
Time, however, is not necessarily on the investor’s side. Opportunities can be fleeting so there is little time for homework. Waiting for a setback in the share price or the market or for any discount to asset value to widen is nearly always a mug’s game. Remember the response of Nathan Rothschild when asked the secret of his success: “I never buy at the low and I always sell too soon.” Expect the share price to dip after your purchase and be pleasantly surprised if it doesn’t.
As important as picking good funds is putting together a coherent portfolio. This should include core generalist funds as well as specialist thematic funds. It makes sense to invest in technology, smaller companies, emerging markets and so on but not to have too much in any one niche. It’s good to have a reasonable level of income but this usually involves some sacrifice of total return. A bird in the hand is more highly valued than two in the bush but you may prefer the latter.
Investing in cheap trusts on wide discounts or in unpopular, undervalued areas of the market can be lucrative but be careful; ‘reassuringly expensive’ trusts often perform much better than ones that are visibly cheap. Everyone loves a bargain but real value is reflected in long-term prospects while wide discounts reflect serious trouble as often as investor short-sightedness.
The most difficult question of all is when to sell. As Warren Buffett said, “My favourite holding period is forever.” You don’t need to sell or take some profit in good investments unless you need the cash. I still hold the shares I bought on the flotation of WORLDWIDE HEALTHCARE TRUST at launch in 1995, and have only added to the holding along the way. I was sorely tempted to sell out of BLACKROCK WORLD MINING a few years ago but the share price doubled in the next year. I missed selling out of POLAR CAPITAL TECHNOLOGY in 2000, but can’t be sure I would have bought it back lower down.
Many investment sages point out that nobody ever went bust taking a profit. True; they went bust selling winners and reinvesting in losers. Sell if the investment thesis changes or you have made a mistake but don’t assume that the departure of a good manager is your cue for an exit. The directors are not fools and will be rigorously looking for a worthy replacement. But isn’t the stock market heading for another meltdown? Isn’t this the time to hold cash and wait for the bargains that litter the bottom of a bear market? The Jeremiahs worry that the economic up-cycle and the bull market have continued for longer than normal and must surely die of old age. At the start of 2018, many pundits predicted that the technology sector and the US market would suffer a setback as the rest of the world caught up. In fact, the reverse happened with the technology sector pushing historic US outperformance ever higher.
As always, there are reasons for concern. Monetary policy is being progressively tightened, especially in the US, and bond yields are pushing remorselessly higher. Emerging economies have, at best, hit bumps in the road, at worst are in crisis. Growth in the eurozone has fizzled out and the political tremors are worsening. The UK looks committed to a bungled Brexit. Against this, the signs of euphoria and complacency which normally mark market peaks are conspicuously absent.
Valuations, barely 16 times forward earnings in the US and lower elsewhere, are not stretched by historic standards and look cheap relative to cash or government bonds. There is no sign of the recession which would send earnings tumbling in the US, Europe or almost anywhere else. After the first decade of the new millennium saw two of the four worst equity bear markets in 100 years, caution and nervousness still prevail. A setback, as seen earlier in 2018, is always possible but more than that looks unlikely.
Geopolitical concerns abound but their impact on markets is highly uncertain. Though the long bull market in government bonds is surely over, the constraints on banks that prevent another credit boom and consequent bust look unlikely to be lifted. This should keep inflation and interest rates moderate by historic if not recent standards. Waiting for a better long-term buying opportunity could mean missing years of steady returns with little bank interest to compensate. Nick Train, manager of FINSBURY GROWTH TRUST, likes to tell investors each year that he is bullish; he points out that markets rise in three years out of four so that is the smart way to bet. Even if next year turns out to be the one in four, don’t panic. Buying at the high is not the biggest mistake an investor can make – selling at the low is. In time, markets recover and setbacks become barely visible interruptions of the long trend upwards.
MAX KING was an investment manager and strategist at Finsbury Asset Management, J O Hambro and Investec Asset Management. He is now an independent writer, with a regular column in MoneyWeek, and an adviser with a special interest in investment companies. He is a non-executive director of three trusts.