Top-rated trust analyst CHARLES CADE, head of investment company research at Numis Securities, answers a series of topical questions about the state of the investment trust sector (interview at the end of September 2018).
How do you see the health of the IT sector as we go into 2019?
Charles Cade: The sector is in very good health, with net assets of over £180bn. There has been record levels of new and secondary issuance in recent years (e.g. £11.9bn raised in 2017 via IPOs and secondary issues). The sector’s assets grew by 13.7% per annum from 2012–17, outpacing the 11.6% growth in the assets of unit trusts/OEICs. Much of this has been driven by the strong demand for alternative income mandates given the low returns on cash or corporate bonds. However, there has also been significant growth in demand from UK retail investors via platforms such as Hargreaves Lansdown. These investors have typically focused on companies with an equity mandate, such as SCOTTISH MORTGAGE and FINSBURY GROWTH & INCOME.
What is the biggest threat to the industry at the moment?
CC: The industry faces a number of threats. One of these is the growing focus on costs, partly driven by regulation. Historically investment trusts were regarded as low-cost savings vehicles compared to open-ended funds, the fees of which typically included commission for intermediaries. However, this has changed since RDR (the Retail Distribution Review) and there has been growing pressure on investment company fees. Mifid II, the latest chapter in EU financial services regulation, has increased this focus on fees by forcing firms to show the underlying costs of fund investments.
While we welcome greater transparency of costs, we do not believe that investors should focus on fees alone. For instance, many investment companies typically focus on specialist mandates, such as property, infrastructure or private equity, where the costs of management are inevitably higher than for a mainstream equity fund.
Discounts have narrowed to record lows – is there any way but down from here?
CC: At present equity funds are trading at a discount of around 5%, while alternative asset investment companies are trading at around asset value on average (albeit this disguises a wide spread). Discounts tend to follow market movements and they could well widen if there is a significant correction in equity markets. However, we do not see discounts returning to the level of 2008 when there was distressed selling of some funds (particularly property, private equity and hedge funds). This is partly because the profile of investors has changed, with a greater emphasis now being placed on long-term returns rather than exploiting short-term discount movements. In addition, balance sheets are now in much better shape than before the global financial crisis and discount control mechanisms are far better structured, designed to suit the liquidity of the underlying portfolio. Indeed we believe that many of the listed private equity funds currently offer significant value, trading on discounts to NAV in the high teens.
Is governance really better than it was? What would you like to see more boards doing?
CC: Yes, the standard of governance is far better than it was in the 1990s. Most boards are now fully independent from the manager and are clearly focused on looking after shareholders’ interests. In addition the make-up of boards is far more diverse, which brings in a greater range of skills, and boards are refreshed more frequently. Some boards need to be more proactive if a fund is too small to appeal to investors, has a wide discount, and/or is performing poorly. We accept that they should take a long-term view and that funds can fall out of favour because of a turn in market sentiment towards an asset class or investment style. However, mergers remain extremely rare and are typically seen as a last resort as an alternative to a wind-up.
Alternative assets have delivered a valuable new source of returns to investors, but is the sector peaking (too much supply, style drift, etc.)?
CC: There has been huge growth in alternative income funds, and most typically have a yield of more than 5%. Investment companies are well suited to these asset classes as the underlying investments are often relatively illiquid. In general these funds have performed well, but some of the debt funds (notably P2P GLOBAL INVESTMENTS and RANGER DIRECT LENDING) have failed to meet investor expectations. We believe some have been overly aggressive in raising capital; for instance, CIVITAS SOCIAL HOUSING raised a C share before the ordinary share was fully invested. Others have sought to broaden their mandates to maintain their growth. For example, several renewable energy funds have started investing overseas, while infrastructure funds have moved into demand-based and regulated assets, which may have a somewhat higher risk profile than their original offerings.
What have been the most interesting launches of the past 12 months in your view (excluding your own, of course)?
CC: Our focus at Numis has primarily been on secondary issues, while our recent IPOs have been very specialist, such as the £270m we helped raise for TRIAN INVESTORS. Elsewhere I would nominate a couple of funds launched since the start of 2017.
The first is BIOPHARMA CREDIT. This is a good example of a specialist alternative income fund that is well-suited to the closed-end structure. The fund is managed by Pharmakon Advisors, based in New York, and seeks to pay a yield of 7% per annum, with a total return target of 8–9% per annum. It invests in a portfolio of loans issued by life sciences companies or secured on life sciences assets. At IPO in March 2017, the fund raised $762m, including $339m issued in exchange for a seed portfolio, and the company’s net assets have already grown to $1.08bn through secondary issuance.
The second is MOBIUS INVESTMENT TRUST. This fund has just raised £100m versus a target of more than £200m. This was a disappointing outcome which partly reflects tough market conditions for emerging markets over the past year. However, we believe that funds launched at a difficult time in the cycle often tend to be the best performers over the long term. Mobius IT will invest in 20–30 small to mid-cap companies in emerging and frontier markets with an absolute return focus. The fund benefits from a strong management team, including Mark Mobius and Carlos Hardenberg, who were formerly responsible for managing TEMPLETON EMERGING MARKET IT (£1.9bn market cap). We believe that Mobius IT has a differentiated mandate, as well as a competitive fee structure and an effective discount control policy (via an exit at close to NAV after four years). If the fund gets off to a solid start in terms of performance, we would expect it to be able to grow through secondary tap issuance.
What has been the biggest disappointment over the same period?
CC: Listed private equity funds have performed very strongly in recent years, significantly outperforming market indices. However, most of these funds continue to languish on wide discounts and the sector’s assets have shrunk through corporate action, with several funds, such as SVG CAPITAL and ABERDEEN PRIVATE EQUITY, winding up – and others (for example, ELECTRA PRIVATE EQUITY) returning capital. The listed sector includes a number of leading private equity managers such as Hg, Pantheon or HarbourVest that it would be extremely difficult for most investors to access directly. We believe these remain well-placed to deliver attractive returns over the medium/long term. Unfortunately, however, persistent discounts mean that the listed private equity sector has struggled to grow its assets, with investors focused on alternative income mandates.
Are investment trust fees now competitive enough against passive and open-ended alternatives?
CC: Numerous investment companies have reduced fees in the past few years and many of the large equity trusts are extremely competitive versus open-ended funds. For example, CITY OF LONDON has an ongoing charges figure of 0.41%. Many investment companies have also removed performance fees in recent years, although we believe that the combination of a low base fee and a well-structured performance fee should be an attractive proposition for investors as mangers will only get paid if they deliver strong returns. This is similar to the variable fee structure, adopted by three of Fidelity’s investment trusts, including FIDELITY CHINA SPECIAL SITUATIONS, whereby the management fee moves up or down by +/-0.2% pa depending on the fund’s performance relative to its benchmark. ICs should not seek to compete solely on fees, as the key is for them to use the structural advantages to deliver better long-term risk-adjusted returns (on a net basis after fees).
Are you expecting a trend to higher bond yields – and what will the impact be on valuations and discounts?
CC: Short-term interest rates have risen in the US and to a lesser degree in the UK. However, long bond yields remain low by historic standards, with UK 10-year treasuries yielding 1.5%. That is significantly less than the yield on the FTSE All-Share of 3.8%. At the start of the year, a synchronised pick-up in global economic growth was expected to lead to higher long-dated bond yields. However, the picture is now less clear as there are numerous political concerns, including an escalation of the trade war between the US and China, and the threat of a hard Brexit.
We do not expect an imminent shift to a higher interest rate environment. However, if UK interest rates were to rise significantly, this could well start to impact demand for some of the alternative income funds with exposure to longterm fixed cash flows. Many of these funds, however, have cash flows linked to floating-rate assets – TWENTY-FOUR INCOME is an example – meaning that their yield should rise in-line with interest rates. Many infrastructure funds have returns that are linked to inflation. In theory the discount rates used to value infrastructure funds should rise in parallel with treasury yields, but we believe that there is a buffer incorporated in the valuation methodology as the spreads between discount rates and gilts are wider than they were when interest rates were higher. So the impact of higher yields might not be as great as it appears.
Are there more or fewer discount opportunities to exploit than there were?
CC: There are far fewer discount opportunities at present, partly because of the benign market conditions we have experienced for several years, but also because of share buybacks and other discount control mechanisms. There are also a number of value investors, such as Wells Capital or 1607, which are out there waiting to buy funds which are trading on attractive discounts. Funds which survive despite having very wide discounts tend to be very small (and off the radars of most investors) and/or invest in a specialist asset class where the published NAV may not be a true reflection of the portfolio value. Development property is an example.
Are boards doing too much or little by way of gearing?
CC: We believe that boards should be responsible for setting the parameters for a fund’s gearing, but the actual level of gearing should be determined by the manager. Most equity funds have gearing of less than 20% of net assets, which is relatively modest. We believe that this is sensible, although we believe that boards should be willing to encourage managers to employ more gearing following a market correction. The gearing of funds investing in property is far lower than in the run up to 2008 and private equity funds have a far lower level of outstanding commitments. In our view this focus on maintaining a strong balance sheet is sensible.
Is it true that dividends are being paid increasingly from capital? If so, should we be concerned?
CC: The ability to smooth a fund’s dividend over the cycle by using revenue reserves is a key advantage that investment companies enjoy over open-ended funds. However, we believe it is vital that an investor buying a fund for yield should seek to understand how this is being generated. Most equity investment companies charge a proportion of management and finance costs (typically c.60–65% for an income-oriented fund) to the revenue account. However, some funds, such as EUROPEAN ASSETS (yield 7.3%) or INVESCO PERPETUAL UK SMALLER COMPANIES (3.9%) pay an enhanced yield financed primarily from capital. This policy has helped to generate investor buying given the strong demand for income, but it will exacerbate capital losses if we enter a bear market. In addition, equity income funds have traditionally been regarded as relatively low risk, with a beta (sensitivity to overall market movements) of less than 1.0×. However, some investment companies paying an enhanced yield (e.g. JPMORGAN GLOBAL GROWTH & INCOME, 4.8% yield) have a focus on growth stocks and may therefore perform differently from their peers in a market correction.
Are you expecting more or less issuance in the next 12 months and if so where?
CC: We expect equity investment companies trading on premiums to continue to issue shares to meet investor demand. Growth-oriented funds are in favour following a strong run; most of the Baillie Gifford funds for example are trading at premiums. Funds with a focus on capital preservation, such as PERSONAL ASSETS and CAPITAL GEARING, are also popular. The IPO market has, however, been more difficult in 2018 to date, partly because of more volatile market conditions. We are aware of several IPOs currently being marketed and there are several others at the test-marketing stage. Most of these have specialist income mandates, typically with a yield of 5–7% and a total return target of up to 10%.
It is hard to get critical mass for an IPO of a new equity investment company due to the nature of the typical buyer (retail and private wealth managers). For instance, Stuart Widdowson raised £88m for ODYSSEAN IT to invest in UK smaller companies and Mobius IT raised £100m. However, there is potential for these funds to grow in the secondary market if they perform well. To be successful we believe that an equity trust needs to have a manager with a strong track record and to be differentiated from existing open or closed-end funds. For instance, BAILLIE GIFFORD US raised £173m in March 2018 and has since grown to £267m through a combination of asset growth and secondary issuance. It is differentiated by investing up to 50% of its portfolio in unquoted securities.
How big do you need to be to have a viable launch these days (given the prospect of secondary issues also)?
CC: There are costs involved with a launch which mean that it is rarely viable below £100m. In addition, many investors are reluctant to buy small funds and institutional investors often have a limit on the size of stake that they can hold (e.g. 5–10%). On the other hand, it is important that a fund does not raise too much capital as excess cash will lead it a drag on its performance.
Where are the biggest gaps in the investment company universe from your perspective?
CC: The key advantages of ICs relative to open-ended funds are probably the ability to smooth income and to provide exposure to less-liquid asset classes. In our view multi-asset income funds combine both features and these have the potential to be very attractive long-term savings vehicles for ISAs and pensions. However, the universe is currently small (ABERDEEN DIVERSIFIED INCOME & GROWTH, SENECA GLOBAL INCOME & GROWTH, and the recently launched JPMORGAN MULTI-ASSET). Unfortunately, these vehicles are very difficult to launch at IPO because they are targeting a highly diverse retail market. The core buyers of ICs, such as private wealth managers and institutional investors, are typically reluctant to buy multi-asset vehicles as they prefer to maintain control of their own asset allocation.
What is the biggest change that you would like to see to grow the sector?
CC: I would like to see a greater commitment to the sector from some of the platforms in terms of research and recommendations, rather than just offering the ability to execute transactions. In addition, it would be good if investment companies could find a way to access the defined contribution savings market more effectively. You would think that the large private equity and infrastructure funds should be well-placed to provide exposure to alternatives in a liquid investment for that market.
Which sectors do you see having the best outlook for returns over say the next two to three years?
CC: We are a little wary of equity markets after such a strong run, and believe that it is important to maintain a diversified portfolio at this stage of the cycle, possibly reducing exposure to riskier assets and retaining some cash to be able to take advantage of opportunities if there is a market correction. That said, it is extremely difficult to time markets correctly, and we believe that ICs are still well-placed to deliver attractive returns for investors over the medium to long term. We favour backing experienced management teams who have been through previous market cycles.
Any advice for DIY investors looking to go into the sector for the first time?
CC: There is now a huge amount of information available on ICs. A good place to start is the AIC’s website and most funds have good websites, including factsheets and commentary from the managers. We would be wary of relying on information in the Key Investor Information Document as we believe many of the figures are misleading and/or not directly comparable to other funds. The key is to try to understand a fund’s risk/return profile and match this with your objectives in terms of investment time frame and capacity to take short-term losses. We would be wary of simply buying funds based on historic performance or those with the highest yield. For a novice investor, a diversified global equity fund would probably be a good starting point.
CHARLES CADE joined Numis from Winterflood Securities in 2008 to head up their investment companies team. Numis has around 50 corporate clients and regularly scores highly in annual quality-of-broker-research surveys.