Investment trust expert JOHN BARON gives an insight as to the factors to be considered when harnessing the potential of investment trusts – starting with an overview of some key investment principles, before suggesting how best to capitalise on investment trusts’ unique characteristics. The piece finishes with an example of a real portfolio – one of eight such portfolios run in real time by John’s company on the website www.johnbaronportfolios.co.uk.
KEY INVESTMENT PRINCIPLES
Recognising when sentiment and fundamentals diverge is the prerequisite of a good investment decision. This is no easy task but it can be doubly rewarding when it comes to investment trusts. Their closed-ended structure, ability to gear and lower cost – all of which help to account for their superior performance over unit trusts – in combination present a wealth of opportunities to informed investors.
First Steps
The prerequisite for any successful investment journey is clarity regarding financial goals and risk tolerances.
Equities produce better returns than bonds and cash over the long term, which accounts for why most investment journeys should start with a bias in their favour. But the path is rarely a smooth one. Market corrections are part of the investment cycle, which is one reason it is important to adopt a long-term investment approach.
It is also why it is important, at the outset, to ensure that portfolio construction truly reflects financial objectives, risk tolerances and time horizons. Other factors to consider can include currency exposure and income requirements.
Choosing the appropriate benchmark and timescale to monitor a portfolio’s performance can also help in attaining financial goals. However, never let benchmarks dictate how a portfolio is constructed – they cannot be beaten if they are simply copied.
Furthermore, in pursuing a long-term approach, it should be remembered any meaningful performance comparisons require a minimum five-year period. At best, over the short term, benchmarks should be seen as a reference point for monitoring a portfolio’s progress.
Time In The Market Is Better Than Market Timing
Clarity about those factors influencing portfolio construction can then be complemented by the application of tried-and-tested investment principles.
Once invested, it is important to remain so provided such an approach continues to reflect investment objectives and risk profiles. Many investors try to time the markets, and a few are successful. But for most long-term investors it is better to remain invested.
The evidence certainly suggests that the longer one is invested, the more likely a positive return will result. Recent research from Fidelity has shown that over the period 1980–2012, investing in global equities for 12 years or more produced no negative returns. By comparison, five-year periods produced a 16% chance of a negative return.
Furthermore, recent figures from Fidelity quantify the cost of missing good days. Over the ten years to 31 August 2018 (from 15 September 2008), the FTSE All-Share produced a total return of 121.85%. Had the ten best days been missed, the return would have fallen to 21.37%. Missing the best 20 days would have resulted in a negative return of -15.16%.
In terms of pounds and pence, sticking with the market over this period would have resulted in an investment of £1,000 turning into £2,218.46. Missing the best ten days would have seen this return fall to £1,213.72 while missing the 20 days would have seen the return fall to £848.36 – both being significant differences.
Bad luck aside, the evidence further suggests some investors have a tendency to buy after markets have risen, and to sell when they have fallen – and then to remain in cash for too long, and so exacerbate the original mistake at additional cost. This is easy to criticise with the benefit of hindsight, but difficult to counter at the time.
Yet it is precisely at such times that markets tend to bounce – when the bad news is in the price. The single best trading day during the past 10–15 years was on 24 November 2008 when, in the middle of the financial fallout from a ballooning credit crisis, the UK equity market rose 9.2%.
Barclays has also highlighted that investors who tried to time the market from 1992 to 2009 were down 20% compared to those who had simply stuck with it. So ignore the noise and chatter. The evidence suggests that time in the market is better than market timing.
Do Not Spend Your Dividends Unless You Have To
There is another reason to stay invested – to enable the full harvesting of dividends, which account for the vast majority of market returns over time.
The Wharton professor Jeremy Siegel calculated in 2005 that, over the previous 130 years, 97% of the total return from stocks came from re-invested dividends. $1,000 invested in 1871 would have been worth $243,386 by 2003. Had dividends been reinvested, the figure rises to $7,947,930!
The message is clear: do not spend your dividends unless you have to. Re-investing dividends is the best way of growing wealth over time – and to fully access these dividends, investors must stay invested.
However, there is a downside to this rule: the longer in the market, the greater the chance of a market setback. This can be particularly galling if one is about to realise financial objectives – especially after a long investment journey. A couple of strategies, pursued together, can help to mitigate the effect of such an event: diversification and regular rebalancing.
Diversify To Reduce Portfolio Risk
The aim of diversification during an investment journey is to reduce portfolio risk by investing in ‘uncorrelated’ assets – asset classes that tend not to move in the same direction over the same period.
Equities, bonds, commercial property, renewable energy, commodities, infrastructure, ‘real assets’ (such as gold, vintage cars, rare stamps or fine wine) and cash are, to varying degrees, examples. While few investments will escape a major market correction unscathed, adequate diversification away from equities will help to reduce losses.
This important investment discipline is often overlooked – especially in rising markets. There are no fixed rules as to the pace and extent of diversification. An investor’s risk profile, time horizon, income requirement and investment objectives are key factors. But there are some general principles used by my company when seeking portfolio diversification.
When starting an investment journey, it makes sense to focus on equities because of their superior returns and because longer time horizons usually allow greater tolerance when it comes to volatility. However, as time passes, our portfolios become increasingly diversified.
One of the key asset classes we employ is bonds – mostly corporate, as we are wary of government debt. Bonds usually act as a good counterweight to equities. Each is driven by different economic forces – as such, when one rises in price, the other usually falls.
Other less-correlated assets also become increasingly evident as the investment journey unfolds including commercial property, renewable energy, infrastructure and commodities. The open ‘Diversification’ page on my company’s website (www.johnbaronportfolios.co.uk) describes this journey in some detail.
How many asset classes should one employ? The answer, as with investment generally, is to keep it simple – five or six usually suffice. Too much diversification also increases costs.
Meanwhile, in addition to assisting with diversification, such asset classes can also help portfolios produce a higher and, importantly, still growing income – with the website’s most diversified, and therefore defensive, portfolio yielding 5.5% at the time of writing.
Rebalance – But Not Too Frequently
Rebalancing is one of the first principles of investing, and yet it is often overlooked. The concept is simple. A 60/40 equity/bond split may, because equities perform well, turn into a 70/30 split. Evidence suggests it pays to rebalance provided one’s risk profile and investment objectives remain in sync.
Forbes has shown that $10,000 invested by way of a 60/40 split in the US in 1985, and rebalanced annually, would have been worth $97,000 in 2010 – whereas an unbalanced portfolio would have been worth $89,000. However, again, do not rebalance too frequently. Keep it simple and dealing costs low – for most investors, an annual rebalance is usually sufficient depending on how markets have performed.
Furthermore, it is sometimes forgotten that as much attention should be given to the process of liquidation, as investment timelines approach, as to the running of the portfolio. A gradual and balanced liquidation as the finishing line approaches is one method. There are others. Peace of mind should never be underestimated, particularly at the end of a long investment journey!
Be Prepared To Be A Contrarian
In addition to tried-and-tested investment principles, insights borne of experience often assist when managing a portfolio. As touched on previously, in very large part, recognising when sentiment and fundamentals diverge is the prerequisite of a good investment decision.
Sir John Templeton once said: “It is impossible to produce superior performance unless you do something different from the majority.” A successful investor must be prepared to be a contrarian.
A benchmark can only be beaten when deviating from it – and it should be remembered this may involve periods of underperformance. However, such an approach should be tempered with a commitment to an over-arching strategy otherwise portfolios can be unduly buffeted by prevailing winds.
While acknowledging that a portfolio can contain a blend of strategies and preferences at any point in time, the overall objective of the portfolios run on my company’s website is to hold good quality companies, and to focus on what we know (the company and fund manager) rather than on what we have little regard for (market and economic forecasts).
Seize The Advantage!
Some have suggested it can be difficult for private investors to compete with the professional fund managers – the pension funds, banks, investment houses and wealth managers. Yet the private investor has many advantages – the most important being time.
Many professional fund managers are trapped in a three-monthly cycle of trustee or actuary meetings, which encourages the shadowing of benchmarks. Private investors are free of this restraint. They can afford to take a longer-term view, and therefore stand a better chance of recognising mispricing and being able to capitalise from it.
To benefit from this natural advantage, patience is a virtue. Unloved assets can take time to come right, but then more than make up for lost time when they do. Warren Buffett once said: “The stock market is a device for transferring money from the impatient to the patient.”
Keep It Simple
Meanwhile, it is important investors remember that investment is best kept simple to succeed. Complexity usually adds cost, risks confusion and hinders performance. When diversifying a portfolio, do not use too many different asset classes – the simpler, the better. But perhaps more importantly, investors should avoid overly complicated investments – especially if they are difficult to understand.
Accordingly, the website portfolios avoid hedge funds, absolute return funds, structured products, multi-manager funds and any other investment vehicle or approach which has high costs and poor transparency. Many tend not to live up to expectations.
In keeping investment simple, investors are also keeping costs down. Picking complicated or expensive products can easily cost a further 1.5% a year in fees – this may not sound a lot, but it can materially affect the final sum achieved.
For example, a £100-a-month investment producing a 5% annual return will be worth £150,000 after 40 years. But if a further 1.5% in annual costs is deducted, the final portfolio value will fall to just £105,000. This is a significant difference.
Be Sceptical Of ‘Expert’ Forecasts
At the very least, question consensus forecasts. The renowned economist J. K. Galbraith once said: “Pundits forecast not because they know, but because they are asked.” Successful investors tend to be sceptical – after all, one of the prerequisites of being a contrarian is to question the consensus.
In doing so, such investors are asking what could go wrong – their default position is not to own a stock. This contrasts with those fund managers who are more focused on short-term relative performance for fear of being left behind by their peers – scepticism takes a back seat as non-ownership is less of a possibility.
Embrace Einstein’s Eighth Wonder
One should never ignore the magic of compounding – allegedly described by Einstein as the eighth wonder of the world. Compounding is the regular reinvesting of interest or dividends to the original sum invested, with the effect of creating higher total returns (capital plus income) over time. Time and a decent rate of return allow the concept to fully bloom.
£100 a month invested over 20 years and producing a 3% annual total return will produce a final portfolio value of £32,912. If the rate increases to 7.5% (the average long-term return for US equities) then the final figure rises to £135,587.
The challenge is to achieve the higher rate of return. Again, the message is clear – start early, be patient and try not to interrupt the magic of compounding.
HARNESSING THE POTENTIAL OF INVESTMENT TRUSTS
This section explains some of the key characteristics of investment trusts and the factors to consider when best harnessing their potential.
Why Investment Trusts?
Having acknowledged the importance of some basic investment principles and insights, most portfolios would benefit from using investment trusts when seeking stock market gains. There are a host of reasons why they are superb investment vehicles, of which four are highlighted below.
1. Better performance
Despite not being well known or understood, investment trusts have in general a superior performance record when compared to their better-known cousins – unit trusts and OEICs. Furthermore, investment trusts have on average beaten most of the global investment benchmarks whether delineated by region or country – unlike unit trusts and OEICs.
Part of the reason is they charge lower fees. Another reason is that, like other public companies, trusts can borrow to buy more assets. Historically, this has benefitted their share prices in part because markets have risen and because of good fund management.
2. Better suited
Another reason is because of their structure. Unlike unit trusts or OEICs, investment trusts are ‘closed-ended’ – they have a fixed number of shares like other public companies such as M&S and BP. But instead of specialising in clothes or oil, they specialise in financial assets.
Accordingly, investment trusts can take a long-term view of their assets as they are not subject to the same relentless flow of monies, both in and out, as are open-ended funds. As such, they are better suited for certain types of investment – particularly those less liquid.
The closure of a number of high-profile property open-ended funds during the mistaken rush to the door following the EU referendum result reminded investors of the importance of this point. Investing in private equity or smaller companies requires a similar approach. Their very nature and therefore at times illiquidity requires the incubator effect best offered by the closed-ended structure of investment trusts.
3. Income friendly
One of the most attractive features of investment trusts is their ability to retain a percentage of their dividends and income received from holdings in the underlying portfolio, in any one year. This surplus cash is called the ‘revenue reserve’.
This reserve can be used to supplement dividends going forward to ensure a smooth progression even if, within allowances, the underlying economy and/or markets go through a rough patch and the underlying portfolio sees some dividend cuts. Such a feature is important to those investors seeking income. Knowing the extent of reserves – the term usually expressed as the number of months it could independently maintain the existing dividend – is a key factor when selecting investment trusts.
There is a growing tendency for investment trusts to dip into their capital reserves in order to supplement or pay a dividend. Provided dividends are not over-promised, this is a welcome development as it better allows income investors to access hitherto low-yielding but high-growth sectors.
4. Corporate governance
Investment trusts tend to display greater transparency in the interests of shareholders. Like other public companies, investment trusts have an independent board of directors whose brief is to represent shareholders – and these directors have teeth!
Shareholders themselves have significant powers. They can vote on issues such as changes to investment policy and the appointment of directors. They can attend shareholder meetings and ask questions about the running of the trust – it is, after all, their company.
This leads to a much more transparent environment. It is difficult for investment trusts to hide in the shadows because of mediocre performance, certainly when compared to lacklustre unit trusts. They are on notice – reward shareholders or questions will be asked.
Harnessing The Potential
So how should an investor best harness their potential? There are various aspects to consider.
The discount
The most talked about is the level of discount. As with other public companies, the share price of an investment trust does not always reflect the value of its assets – and usually stands at a discount.
This allows investors to take advantage of movements in the discount, which is often influenced by swings in sentiment towards the investment and/or underlying portfolio, and by the extent of debt which can contribute to volatility. Such is the investor’s opportunity.
As a first step to those new to investment trusts:
- The ideal purchase is when a trust, run by a fund manager with a good long-term track record, stands at a wider-than-average discount – possibly because of a market wobble or the sector and/or manager is out of favour.
- It is usually wise to ignore the short-term noise and focus on the long term. Should sentiment improve, the investor benefits from both the underlying assets rising in price and the discount narrowing.
- The ideal sale is when the discount has narrowed considerably and other factors may suggest caution, such as a change in manager or outlook for the underlying markets.
- Should a portfolio’s assets fall in price, investors can further suffer from a widening of the discount.
Needless to say, there are many nuances to such trades.
Other factors
While the level of discount is important, so are many other factors when valuing an investment trust, including:
- the reputation of the manager AND investment house
- the underlying strategy
- the outlook for the sector, region or theme
- the valuation of the trust relative to its peer group and the underlying portfolio relative to its universe
- the level of management and any performance fees
- the effect on the NAV of the level, cost and duration of any debt
- the extent of dividend cover and revenue reserves (particularly if investing for income)
- the capital structure of the company
- the nature of any discount control mechanism.
Some are particularly important. The outlook for the asset class in question, together with the manager’s long-term record, underlying strategy and due diligence processes, are key. Meanwhile, net asset values can be materially affected by the extent and cost of debt – something which is not always picked up by discount calculations.
The valuation of the underlying portfolio relative to its universe is a further key determinant which is also often underestimated – again, the attractions of a seemingly wide discount can be somewhat negated if the portfolio is expensive without good reason.
Conversations and long-term holdings
Some of these factors are best explored through conversations with the trusts’ managers themselves. When it comes to the website’s portfolios, we rarely make an initial investment without first speaking to the manager – whether they be located in Tokyo, California or elsewhere.
Changes regarding most of the above factors can, to varying degrees, influence swings in sentiment and thereby the discount and prices. Capitalising on such swings can be profitable in the short term.
However, it should be remembered that such an approach is best employed when initiating a long-term holding. Choosing and sticking with a trust which has a good track record often results in better long-term performance than constantly dealing in an attempt to capture short-term price movements.
A Holistic Approach
It is hoped this section of the chapter has allowed an insight as to the thinking behind the portfolio’s construction. The portfolio embraces a number of theme and sector preferences, but is very cognisant of the need to pursue an overarching strategy over the long-term which reflects its position in the wider investment journey.
However, it is worth repeating that enthusiasm for any particular investment should always be tempered with the need to maintain portfolio balance. No matter how compelling the investment case, an overly aggressive tilt towards a particular holding or theme not only raises the portfolio’s risk profile but can unduly affect long-term performance should it go wrong. Resisting temptation is just as important as backing conviction – within balance!
It should also be remembered that the portfolio’s preferences, and indeed changes, should not be seen in isolation. An ‘holistic’ view is taken of each of the eight portfolios. Changes need to be judged as part of the whole, rather than simply a list of individual trades, as their management reflects a range of factors and metrics – some in competition, and some not.
For example, in addition to attributing great store to our conversations with the individual investment trust fund managers – particularly when initiating a position – the Summer portfolio also balances a range of financial metrics between holdings when deciding on the final combination.
These include the extent of revenue reserves to ensure sound foundations when it comes to the portfolio’s overall capacity for income growth, a comparison of company debt levels and the ‘see-through’ effect on discounts on a fair value basis to maintain an element of robustness should markets turn down, and ensuring a balance when it comes to both company discounts and underlying portfolio valuations to reduce portfolio vulnerability should prevailing market investment approaches change.
JOHN BARON is one of the UK’s leading experts on investment trusts, a regular columnist and speaker at investment seminars, and author of The Financial Times Guide to Investment Trusts (a further edition is due shortly). He is a director of Equi Ltd which owns the website www.johnbaronportfolios.co.uk.
The website reports on the progress of eight real investment trust portfolios, including same-day details of trades, new portfolio weightings and yields. The portfolios pursue a range of strategies and income objectives, and enjoy an enviable track record relative to their benchmarks.
John has used investment trusts in a private and professional capacity for over 35 years. After university and the Army, he ran a broad range of investment portfolios as a director of both Henderson Private Clients and then Rothschild Asset Management. Since leaving the City, he has also helped charities monitor their fund managers.