A Revolutionary Breakthrough?

It has long been a matter of faith among fans that investment trusts deliver superior performance to their open-ended fund equivalents. This statement is regularly trotted out as fact and there is no doubt that you can point to a number of specific examples where you can directly compare the performance of two funds – one an investment trust, the other open-ended – which are managed by the same fund manager. In these direct comparisons the investment trust typically comes out on top handsomely over time. A good example would be the two Japanese funds managed by the recently retired Sarah Whitley at Baillie Gifford, one of our most impressive – and impressively unshowy – firms in the business. Charts that illustrate the superior record of investment trusts are regularly produced by investment company research analysts.

But how robust is that general finding that investment trusts outperform open-ended funds? And if that is indeed true, which features of the trust structure are responsible for the divergence in performance? Given that we all know how misleading statistics can be, you can imagine the interest that greeted the news earlier this year that academics at Cass Business School in London had formally tested the hypothesis and found some robust evidence that it is indeed true. The headline results of this research were presented at a conference in London in June 2018. You can see a short video summarising the event on the event website (www.mip-fit.com).

This appears to have been the first time that such a rigorous academic analysis of trust performance has been undertaken; apart from the lingering mystery of the persistence of closed-end fund discounts (a non-issue, in our view), investment trusts have remained of surprisingly little interest to academia. So this could potentially be a big deal. Yet frustratingly, at the time of writing, the formal academic research paper which sets out the results of the analysis has still to be published. (It was originally promised for Q4 2018, but I am told by the authors that it is now more likely to see the light of day in 2019.)

It is impossible therefore to do more than summarise the reported findings. Professor Andrew Clare and Dr Simon Hayley, who carried out the research, say that they found that directly comparable investment trusts outperformed their open-ended equivalents by an average of 1.4% a year between 2000 and 2016, taking net asset value (NAV) performance as the measure. (Previous studies have tended to look at share price performance, which is more volatile because of discount movements, rather than NAV performance, which is a truer measure of fund management skill.) The analysis excluded specialist sectors, such as private equity, where there were insufficient cases to study. The final study pitted 134 trusts against 1,200 open-ended funds with similar mandates, admittedly not the largest of samples. Professor Clare commented that the extent of the 1.4% per annum gap – which, while modest at first sight, would translate into significantly higher returns once compounded over several years – was unexpected.

The results suggest, he said, that the structural factors behind the superior performance included:

1. the bias trusts historically have towards holdings of smaller companies, which tend to outperform larger stocks
2. the closed-end structure, which saves managers of investment companies from having to buy and sell stocks at inopportune moments
3. the ability of trusts to buy back their shares at a discount to their real value
4. to a very limited extent, the use of gearing to amplify investment returns.

Noting a recurrent problem with many less rigorous statistical studies, Prof Clare said he wanted to do further work to make doubly sure that the results had not been skewed by ‘survivorship bias’ (the fact that poorly performing funds tend to be closed down, reducing the sample size and the robustness of the findings, unless appropriate adjustments are made).

So the Cass team are now updating the study and extending the data set back to 1994 and forward to 2018. But he did add, tellingly, “what we can tell at the moment is the level of fund manager skill tends to be higher in investment trusts compared to comparable open-ended funds”. He estimated that, even after allowing for the structural factors listed above, the average trust still outperformed open-ended equivalents by 0.84% per annum in NAV terms and an equivalent index fund by 0.58% per annum.¹ That conclusion may not be news to many of us who have followed the sector for years, but if it survives unscathed from the inevitable scrutiny that the results will attract when published, it is obviously good news for the investment trust business.

Not Much Good To Say About The FCA

One wonders however what impact, if any, this research will have as and when it filters through to the offices of the Financial Conduct Authority (FCA), the industry’s regulator. You don’t have to travel far round the City or Edinburgh before you will hear the complaint that the FCA has little or no interest in investment trusts and in subtle ways is failing to ensure a playing field between trusts and the much larger universe of open-ended funds. As noted here last year, the FCA’s successful campaign to remove the longstanding scandal of commission-driven bias in fund selection amongst financial advisers has been rightly welcomed by investment trust fans. Yet it is impossible to shake off the conviction that the FCA is more interested in advancing the cause of passive investment solutions than it is in creating a genuinely free market in which both active and passive investment firms can compete for business on equal terms.

With their long history and seemingly robust claim to superior performance, you would think that investment trusts would be of much greater interest to the FCA as a solution for informed investors than they are. As Alex Denny notes, it is bizarre enough that it appears impossible for anyone with a defined-contribution pension to allocate any part of their pension fund to investment trusts. (You can only do so if you switch to, or start, a self-invested personal pension.) Research by Lang Cat published this year also found that many financial advisers are still working with professional industry platforms that make it difficult or even impossible for them to invest in investment trusts for their clients.

For this and other reasons – ignorance, bias, the impact of holding costs – five years after the Retail Distribution Review, which was designed to eliminate commission bias in adviser behaviour, just 5% of the money on adviser platforms is invested in investment trusts.² With two such important financial channels – defined-benefit pension schemes and financial adviser platforms – difficult or impossible to access, it is not really a surprise that the investment company sector remains only a quarter the size of the open-ended fund business, despite having a 60-year head start and (so we continue to believe) a superior performance record.

The FCA’s reputation will not have been enhanced by the bizarre episode of the KID, or ‘key investor document’, which became mandatory in January 2018 for every investment trust to produce, alongside its own factsheets and other literature. Most platforms also now feel obliged to provide them. This new requirement is part of a wider EU regulatory initiative that imposes what are known as PRIIPS rules on investment products sold to retail investors.³ Like most regulation it is well-intentioned but heavy-handed and patently vulnerable to the law of unintended consequences. (A distinguished American professor named George Stigler was awarded a Nobel Prize as far back as 1982 for his part in demonstrating that the long-term effects of regulation are often perversely to achieve the opposite of what was intended when first introduced.)

As the industry’s trade association, the AIC has protested to the FCA about several aspects of these new rules, including the requirement for KIDs to include standardised risk ratings and estimates of future performance under a range of different scenarios. The way that both the ratings and the estimates are produced ensure that in both cases they generate outcomes that can only be described as absurd. Professor John Kay splendidly held up the whole process to ridicule at the annual conference of the AIC in March.⁴ Similarly, the analyst team at Numis produced a detailed study illustrating some of the anomalous results and blatant inconsistencies produced by the mandated formula imposed by the authors of the PRIIPS rules. According to the AIC, more than 50% of trusts, for example, are projected to make a positive return even in “unfavourable” market conditions. Venture capital trusts, which invest in highly risky early-stage businesses, have an average risk rating that is lower than conventional listed equity trusts. Such distortions make the new regulations both pointless and – worse – potentially misleading.

It is silly enough that regulators who insist on including the statement that ‘past performance is no guide to the future’ in all fund marketing literature should at the same time introduce a new set of rules which mandates firms to publish estimates of future returns which are explicitly derived from past performance. Because boards have no discretion over whether to produce these documents, we have witnessed the unusual spectacle of some investment firms warning their shareholders that the projections they have produced under duress are overoptimistic – an expression of self-effacement for which the financial services industry is not renowned.

To add insult to injury, the date on which the new rules are required to be introduced by UK open-ended firms has been set two years later than the requirement imposed on UK investment companies – a competitive disadvantage. The reason given is that open-ended funds are already subject to a set of EU rules known as the UCITs regime and those rules are not scheduled to be updated until January 2020. (UCITs funds confusingly have to produce something called a KIID, but it does not have the same requirements or content as the KID, which trusts are required to produce.) It may of course be relevant that the closed-ended fund is a largely unknown phenomenon on the Continent. It is true that the PRIIPS rules are an EU initiative, rather than one sourced in the UK, but the FCA has been an instrumental participant in the process and, even if it wished to do so, has clearly been powerless to prevent this particular idiocy coming into force.

Clarity And Confusion Over Costs

If you can be reasonably certain that the KID in its current form will eventually be killed off, for being both unworkable and misleading, it is equally certain that the PRIIPS rules will continue to play a part in another development to which investment trusts – rightly in this case – are having to respond. This is the relentless pressure on all fund providers, be they investment trusts or open-ended funds, to make fuller and better disclosure of the costs of ownership to their investors. The irresistible rise of the humble low-cost index fund and more recently the widespread adoption by institutional investors of its sister product, the ETF (exchange-traded fund), poses a powerful competitive threat to all exponents of active investment management, not just investment trusts.

The fees on index funds have fallen so far and have become so cheap that it is putting relentless downward pressure on all other types of fund. That is clearly to the advantage of investors in actively managed funds as well, since costs compound as inexorably as returns, and many funds historically have been able to extract handsome excess profits despite indifferent performance. That has undoubtedly been helped in no small measure by the lack of full disclosure of what those costs are. So by insisting on greater disclosure, the regulators in this case are pushing at what has become an open door. The annual management charges for investment trusts have been falling steadily for some time, and I am not aware of any cases where the external managers of a trust have decided to hand back their management contract because the viability of their contract is under threat from lower fees.

The problem here, though, is that fuller disclosure is not necessarily as helpful to the end user as you might think. Instead of clarity, sometimes the result can simply be more confusion. True to form, the PRIIPS regulations introduced by the EU adopt a different method of disclosure to that adopted elsewhere. They require funds to use a method known as ‘reduction in yield’ (RIY), which is designed to illustrate how much the return from a fund over a given time period will be reduced as a result of the costs owning the fund. This is in contrast to methods such as the total expense ratio (TER) and the ongoing charge ratio (OCR), which both attempt to calculate the current cost of ownership. In theory the figures should be broadly comparable, but in practice often they are not.

All methods of calculating the cost of ownership suffer from two defects – differences in the type of cost that are included and differences in the assumptions made about the future. Without going into all the technical issues involved (it is not the most exciting subject), suffice it to say that the PRIIPS method appears to be the worst of all worlds. Not all firms calculate the figures in the same way. In some cases the formula results in firms showing – absurdly – negative costs. In others it appears to overstate the costs, making trusts appear more expensive than they are when compared to open-ended equivalents. One fear for the trust sector is that wealth managers, who are now required to include these cost figures in reporting to their clients (even if they are inaccurate), may be deterred from adding trusts to client portfolios as a result. As wealth managers are amongst the biggest buyers of investment trusts, this could make a significant difference to the health of the sector.

The AIC’s official advice about KIDs is “burn before reading” and we would endorse that advice. The EU is due to review the regime in 2019. It does not mean that the cost of ownership is irrelevant – on the contrary, it is one of the most important criteria to look at when buying any kind of fund – but you do need clear and consistent data for comparisons to be of any use, and for now at least the OCR seems like the better option when doing your research. Faced with a chorus of complaints, the FCA has since conceded that trust boards are free to provide additional information if they feel that the return and cost projections in the KIDs they are mandated to produce are misleading.

Adapt Or Die

The investment trust business has changed dramatically in the last two decades. Gone, to all intents and purposes, are the opaque and potentially dangerous split capital trusts which once were a defining feature of the sector, but mercifully failed to survive the dismal experience of the ‘split capital trust scandals’ of 2001–02.⁵ In has come a host of alternative asset funds offering handsome yields for income-seeking investors starved of income by the fallout from the global financial crisis of 2007–08. Coupled with some overdue regulatory and governance changes, and the subsequent emergence of activist investors looking to enforce change, the crisis has helped to transform the way that trusts are priced and managed, entirely for the better.

One consequence of a more bracing competitive environment, however, is that these days the need to ‘adapt or die’ is more relevant for an investment trust than it was in days gone by. Faced with the need to compete against a new generation of passive low-cost investment vehicles (index funds and ETFs) and still easier-to-market actively managed open-ended funds, investment trusts have to work harder to justify staying in business. They have been helped by the strong performance of most types of investment since the low point of the crisis and earlier legal and regulatory changes which make it much easier than before for boards to to issue new shares and raise awareness of their existence through marketing. It has also become much easier for private investors to research and buy trusts through cheap execution-only platforms.

As Charles Cade has addressed many of the most important issues facing the sector in his Q&A, I see no need to address them here in any more detail. Suffice it to say that if 2017 was an exceptional year for the equity market and an excellent one for alternative assets – both extremely helpful developments for the investment trust sector – then 2018, at the time of writing, is shaping up to be a more mundane experience. Ten years on from the collapse of Lehman Brothers, the point at which the global financial system threatened to implode, much has changed, but fears of a further systemic collapse and a worldwide deflationary crisis have receded. As always, however, there are no shortage of opinions as to how the global economy and the financial markets will develop from here. The election of President Trump and the seemingly never-ending saga of the Brexit negotiations both pose challenges to those attempting to employ conventional analytical methods to determine the outlook.

One encouraging trend in 2018 has been the revival of conventional equity trust IPOs. As we noted last year, most of the new launches in previous years – by number at least – have been from alternative asset funds looking to tap into investor demand for income. There are some signs that, as far as renewable energy, infrastructure and specialist property funds are concerned, this phenomenon might now be getting close to saturation point. The infrastructure funds took a knock early in 2018 when the collapse of Carillion added to existing nervousness about what a Corbyn government bent on nationalisation and ending PFI contracts might do. Other types of alternative asset trusts, however, continue to be launched: among the past year’s crop of IPOs, BIOPHARMA CREDIT, which provides credit to biotech companies, and HIPGNOSIS, which is looking to exploit rights to recorded music, stand out as being particularly innovative. It is important to remember that the rationale for investing in alternative assets is not just about income, but also about diversification. There are good reasons for thinking that the returns of many types of alternative asset trust could be uncorrelated with equity markets – a useful defensive feature if we do see a market downturn in due course.

While bigger, more established equity investment trusts with strong performance records have been able to continue growing by making regular secondary issues of shares – the aforementioned SCOTTISH MORTGAGE has issued more than £600m of new shares in the last two years alone – it has proved harder to generate sufficient support from investors for new conventional equity offerings. Nick Greenwood, the manager of Miton’s fund of investment trusts, examines this issue in his article on page 139. This year, however, has seen several interesting new equity trust launches, among them Baillie Gifford’s new North American fund, a distinctive Japanese trust managed by Asset Value Investors, and a second global equity investment trust from Terry Smith’s Fundsmith group. The latter, called SMITHSON, proved so popular that it raised more than £800m from investors, making it the largest equity trust launch ever. Two former managers of well-known trusts, Mark Mobius and Stuart Widdowson, have also reappeared at the helm of smaller vehicles offering the same strategy as their former employers,⁶ while a new fund management company, Merian – owned and run by the highly regarded former equity management team at Old Mutual – were working on a mixed private and listed equity offering as I finished these notes.

Towards A New Market Environment

There is, however, a growing sense that the environment for investing to which investors have become accustomed in recent years may finally be beginning to change. The last ten years have been characterised by below-trend economic growth, unprecedented amounts of monetary stimulus, record low interest rates and a bull market in equities that has continued to climb the traditional ‘wall of worry’. With money so cheap, value investing has been comprehensively trumped by growth, and momentum strategies and small-cap funds have done better than large-cap equivalents. The search for income in a low-interest-rate world has meanwhile produced what by historical standards are numerous anomalies.

There is a reasonable chance, however, that 2018 will go down as the year when some at least of these trends finally started to reverse. Bond yields have been moving upwards and more importantly real yields (yields adjusted for inflation) have edged back into positive territory in the United States, though not yet in the UK. Negative real yields sit uneasily with the way that capitalist economies are meant to behave, and the sooner we can return to a world where sensibly invested money can earn an honest return, the sooner we can return to a world in which investors can hold fast once more to traditional investor nostrums. Whether that in turn is enough to moderate the surge in populist and antiestablishment political movements across the globe is open to question. There is little evidence of that so far.

While nobody in their right mind can forecast the short-term direction of markets, my suspicion for what it is worth is that while we are not yet at the end of the current market cycle, we have certainly advanced a good way towards its eventual demise. It remains to be seen whether the Federal Reserve’s desire to raise interest rates over the next couple of years can be fulfilled, but with unemployment at generational lows, wages starting to rise after years of stagnation, and quantitative easing in the US replaced by quantitative tightening, the benign conditions of the last ten years look unlikely to persist indefinitely. If you think that zero interest rates have helped to inflate the price of most financial assets, then it is only logical to assume that a reversal in the interest rate regime will bear down on lofty valuations. It would be no surprise in these circumstances to see some new market trends emerge – including a revival of value as an investment style, some rotation from small- to large-cap market leadership and in due course at least a temporary setback in the equity markets as profits weaken, the discount rate rises and politicians look to the owners of capital for more revenue. Investment trusts inevitably will not be immune from these effects, should they happen. With discounts so narrow by historical standards, it is inevitable that there will be periods when widening discounts and heightened market volatility test the resilience of boards that have introduced discount controls and the nerves of investors in those trusts where no such regime exists. Such an outcome, as we noted last year, will be both a challenge and an opportunity for investors who follow the sector closely.

At the time of writing, equity markets have experienced three significant selloffs in 2018 – in February, April and October. Such episodes provide prima facie evidence as to which trust sectors are most vulnerable to corrections if a bear market were to develop. In that sense they provide a more meaningful measure of risk than any regulatory-inspired formula. In the first two weeks of the October sell-off, for example, the list of biggest fallers included all the trusts with big holdings in technology and biotech companies, the same stocks that have been leading the market higher for many months. Small-cap specialist trusts also sold off more sharply than their larger counterparts, as you would expect. The decline in most alternative asset sectors, on the other hand, was more modest, reflecting their more defensive nature. It is not so easy to measure how they will be affected if we get a more enduring downturn in the markets, let alone another deep bear market, since they are mostly too new to have relevant historical experience to fall back on.

Hedge funds and private equity trusts were very popular in the run up to 2008, but their share prices were savaged during the global financial crisis because of their high levels of gearing, and while you can argue that circumstances today are very different – gearing levels in private equity trusts are generally lower, for example, and the hedge fund trusts have almost all disappeared – there can be no certainty how investors will react in a different future environment. In particular there must be a question mark over how long investors will be prepared to stick with those alternative asset trusts which are mandated to invest in illiquid assets as and when trouble next comes around. The price of their shares may well fall to testing levels as demand reduces.

The flipside of all this is that sudden sell-offs also create opportunities. Investor behaviour tends to be herd-like and that, combined with the defensive measures taken by market makers when prices move against them, can often produce anomalous share prices. Discount movements can amplify this further. That is the cue for the most knowledgeable trust investors to move back in. A good example came earlier in 2018 when fears of nationalisation and the collapse of outsourcing company Carillion clobbered the shares of infrastructure funds. That created an attractive entry point for those capable of cooler analysis. If you have been frustrated by the premiums at which many otherwise attractive high-yielding funds have tended to trade over the last few years, it may be that at this stage you should be looking forward to market downturns rather than fearing them. Experience suggests, however, that only a minority of investors have the patience and the discipline to wait for such moments to come around. In the later stages of the market cycle, where we are today, the harder part still is to have the courage and the foresight to build up reserves of liquidity and wait so that you have the cash to deploy when the next big buying opportunity comes around. Younger readers may find the perspective of the trust sector’s longest serving manager, Peter Spiller, helpful in this context.

In our view, however, there is only limited reward to be had from spending a lot of time trying to work out how the global macro-economic environment is going to pan out. Even if you get the direction right, it is hard to get the timing right as well. As with Brexit, there are still too many unknowns to make predicting the future path of the global economy anything other than an educated guess. As Warren Buffett has pointed out on many occasions, investors are best served by focusing on the things that they can understand and control, and using diversification to protect themselves against things that they cannot. If you have a strong view about politics, the path of bond yields and the imminence of a recession, and sufficient conviction to back your judgement, well and good. For most of us, however, as closely as we may try to follow events, that certainty is hard to obtain.

My personal experience over four decades in the markets is that investors are generally best served putting most of their effort into finding a few well-managed funds where the managers have both long experience and retain a close alignment with your own interests. Once you have found them, your bias should be to stick with them and, in the absence of a clear regime change in market conditions, only change your portfolio if the reasons you bought them in the first place cease to be valid, or some more compelling newer alternative presents itself. This does happen periodically, sometimes because of unjustified discount movements. It may be prudent to rebalance your holdings once every one or two years and of course to review what you own should either your personal circumstances or tolerance for risk materially change, as they might well be doing after the strong returns of the last decade.

In January 2017, as an experiment, I put together a short list of trusts, all of which I own myself, that in my view met this general test – ones I would be happy in principle to own indefinitely. The names are set out in the table on the opposite page. (Not knowing your personal circumstances or risk appetite, dear reader, I hope it is clear that you should not interpret this as a recommendation that you should also necessarily invest in these particular trusts – they are just among my personal favourites.) Since I first created the list I have – unusually – already made a number of changes in response to events (see subsequent tables). I have essentially moved in the direction of greater defensiveness and more exposure to value as a discipline. I propose to continue monitoring the way that this portfolio changes and performs over time.⁷ However the markets pan out, I shall be disappointed if the long-term results are at odds with the findings of the Cass Business School academics, and more than happy if your own experience as a trust investor turns out to be even more fruitful than mine in the uncertain times that (as ever) lie ahead.

Jonathan Davis

Oxford, 2018

 

 

¹ If you assume that a broad equity market index fund will grow at an average of 7% per annum, in line with the long run historical return, an additional 0.58% per annum of return will add an additional £27,000 to the value of an initial £100,000 portfolio after ten years.

² Source: AIC, ‘Market bias, prohibitive costs and “sketchy knowledge”’, press release, 3 July 2018.

³ PRIIPS stands for ‘packaged retail and insurance-based investment products’ – don’t bureaucrats just love their acronyms…

⁴ You can read Prof Kay’s initial denunciation of the new rules on his website johnkay.com, in an article ‘Risk, the retail investor and disastrous new rules’, dated 22 January 2018.

⁵ To be clear, split capital trusts fulfilled a useful function for knowledgeable investors, but became toxic as a result of mis-selling, poor disclosure and unseemly collusion between a number of industry providers.

⁶ The MOBIUS INVESTMENT TRUST and ODYSSEAN INVESTMENT TRUST respectively.

⁷ Go to www.independent-investor.com for more details.

 

JONATHAN DAVIS MA, MSC, MCSI is one of the UK’s leading stock market authors and commentators. A qualified professional investor and member of the Chartered Institute for Securities and Investment, he is a senior external adviser at Saunderson House and a non-executive director of the Jupiter UK Growth Trust. His books include Money Makers, Investing With Anthony Bolton and Templeton’s Way With Money. After writing columns for The Independent and Financial Times for many years, he now writes a private circulation newsletter and is researching two new books. His website is: www.independent-investor.com.