Using trusts to diversify

Industry expert ALEX DENNY explains how using investment trust with different styles and objectives can reduce the risk of investing in financial markets. This article was first published in the 2018 edition of the Investment Trusts Handbook and has not been updated.

When it comes to investing, the benefits of diversification are clearly significant. Most investors will be familiar with how spreading your investments across a range of areas can reduce your exposure to single-asset risk. Putting all your investment eggs in one basket can offer extraordinary returns (think Apple in 2003 or Tencent in 2017), but it can also lead to catastrophic losses (Northern Rock in 2008 or Volkswagen in 2015). Indeed, some investment fads can be so volatile that they can produce incredible returns and losses in quick succession. Bitcoin returned over 1,000% in 2017 and peaked at around $19,000 in December that year but is down more than 50% since then at the time of writing.

Everyone likes to see their money grow, but there is no risk-free way of guaranteeing these enormous returns. Turning £20 into £10,000 is the kind of gamble you might be willing to take. Turning £10,000 at the time of investment into just £5,000 at the time of redemption is exactly the kind of mistake we all like to avoid. As a general rule, the majority of investors will therefore look to build a core portfolio of diversified mainstream investments and savings, split across the three broad areas: cash, bonds and equities. This core portfolio will be held through bank accounts and, probably, funds.

The allocation or balance between these different assets will vary between different people and are clearly dependent on individual objectives and circumstances – what you are saving for, your age, appetite for risk and capacity for loss. These core asset classes are exactly that – core. They form a central component of how our financial systems and markets work, but as such they may all suffer from related setbacks. For example, an equity investor may feel confident that holding a range of index trackers provides sufficient diversification. However, in today’s global economy, major inflexion points can occur simultaneously across all markets.

Avoiding systematic risk

There are lots of reasons why global equity markets can follow each other; markets are not rational in the short term. Driven by sentiment, a sell-off in one market can often trigger a downturn in another. The trick to avoiding this sort of risk – and achieve genuine diversification – is to access parts of the market which are not well-covered or represented in an existing core portfolio. Investment trusts are nearly all actively managed and have structural advantages which allow them to avoid these systemic risk pitfalls. Their capital structure – with a fixed number of shares and no flows of cash in or out from investors – allows them to invest in much smaller, illiquid companies which fall outside of mainstream indices (or have negligible correlation to them).

They also have the ability to invest in companies before they are even listed, as well as alternative areas like real estate or long-term infrastructure projects which aren’t well represented in mainstream funds due to liquidity issues. There are investment trusts which specialise and focus on investing in these kinds of areas – smaller companies trusts, private equity and venture capital trusts, real estate investment trusts – as well as trusts which follow relatively mainstream markets from the core of your portfolio while adding these non-core elements as well.

Take Fidelity Asian Values as an example. It is an actively managed investment trust whose manager, Nitin Bajaj, focuses on buying good, well-run businesses which he judges to be undervalued by much of the market. This often entails buying companies that operate in sectors which are very unfashionable – but can still be very profitable and therefore create good investment returns. This contrarian investment style, by its nature, leads the manager towards industries and companies that do not make up a significant proportion of the regional market index. In fact, at the time of writing, the company has 99.5% its portfolio held in stocks and assets which do not form part of the MSCI AC Asia ex Japan Index, which is most commonly used as a comparator for funds investing in the region. This figure is called ‘active money’ and gives an indication of how much, or how little, a fund or company’s portfolio differs from a typical benchmark tracker.

 

With a near total lack of stock overlap, it stands to reason that a holding in the company is not closely correlated with the index over the shorter term – though it still benefits from the long-term structural tailwinds which support the region’s growth. It is therefore possible to complement a mainstream equity portfolio with this type of investment to take out the impacts of short-term trends, smoothing returns and improving risk-adjusted returns at a portfolio level (although diluting out some of the additional absolute returns that may be added by active management).

Another example, in developed markets, is the recent launch of BAILLIE GIFFORD US GROWTH TRUST which eschews simple index returns by having authority to invest up to 50% of its portfolio in companies which are not listed at all. Whether you’re looking to gain exposure to specific alternative asset classes or you are attracted to the ability to invest in small or unlisted companies, these examples highlight to good effect the benefits that investment trusts can offer when held as part of a well-diversified portfolio.

ALEX DENNY is the head of investment trusts at Fidelity International. This article does not constitute investment advice and should not be used as the basis of any investment decision. Past performance is not a reliable indicator of future results.

Taking the plunge

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.

Trusts & private investors

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. This article was first published in the 2018 edition of the Investment Trusts Handbook and has not been updated.

Becoming more popular by the day

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. 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.

China is a good example

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.

A rich feeding ground for the self-directed investor

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. 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.

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 was head of research at Hargreaves Lansdown, the UK’s largest independent stockbroking firm, from 1998 to 2020. 


The first investment trust

2018 was the 150th anniversary of the formation of the UK’s oldest investment trust, Foreign & Colonial. Historian JOHN NEWLANDS describes how this first pioneering example of an enduring new type of investment vehicle came into being.

March 19th 1868 is the date on which Foreign & Colonial (F&C) launched what is generally regarded as the first investment trust. It did so into a world that was still in the process of coming to terms, politically, socially and financially, with the consequences of the Industrial Revolution. While there were railways, steamships and telegraphic cables, there were also 50,000 horses on the ill-lit streets of London, creating a 900-ton pollution problem every day. The telephone, the motor car, wireless communication, and the light bulb had yet to be invented; the Suez Canal was not yet in use. The opening of the London Underground in 1863 had been greatly lauded, until it was realised that steam locomotives running in tunnels created a real danger of travellers choking to death between stations. On the other side of the Atlantic, Colonel George A. Custer’s defeat at the Battle of the Little Bighorn, at the hands of Sitting Bull and Crazy Horse, was still eight years away. In short, the Industrial Revolution had produced a thin veneer of modernity, but the so-called ‘developed’ world was a long way off.

The small investor could be forgiven for thinking that the same was true of the financial markets. The world was full of opportunities and risk. Some early financial disasters, such as the South Sea Bubble, were so severe that it took decades, if not generations, to restore the confidence of investors. The first half of the 19th century had seen several speculative boom/bust cycles, in commodities, in railway stocks and even in foreign loans. In the 1820s foreign loans boom, it proved possible to issue gullible investors with bonds for an imaginary country, called Poyais, mysteriously located “somewhere in Central America”. Fraud was common, usually involving false accounting and the issue of bogus shares. There were three major fraud trials in the 1850s alone. Until 1855, investors had faced unlimited liability in the event of a company’s failure, but even after limited liability was introduced, the rash of company formations – 4,859 between 1856 and 1865 – produced many new failures, frequently through mismanagement or fraud. Then in 1866 the Overend & Gurney bank collapsed, creating what a later historian described as “the greatest financial strain the City had experienced, in time of peace”. Little wonder, then, that Victorian novelists were moved to denounce the financial world in print: “so common were references to frauds, swindles, and bankruptcies in literature that … only a peculiar variation on the theme could guarantee a response”.

The solution for the rich investor, one who could afford the best professional advice, was to build up enormously broad portfolios [that combined holdings of government stock with] scores of high-yielding but individually risky overseas stocks. These portfolios were akin to investment trusts in miniature. One or two failures would not sink the ship, and, even if such failures occurred, the average yield would still be better than that available on safe investments at home. The following list, taken from a real private portfolio of the time gives a flavour of the kind of securities that a rich man would be likely to own in the late 19th century:

  • Abbontiakoon Mines Ltd.
  • Anglo Argentine Tramways Co.
  • Atchison, Topeka & Santa Fe Railroad Co.
  • Chicago, Milwaukee & St Paul Railroad Co Ltd
  • (Wisconsin Valley Division).
  • Consolidated Gold Fields of South Africa Ltd.
  • Hokkaido Colliery & Railway Co Ltd.
  • Imperial Russian Government Loan, 5%.
  • Imperial Japanese Loan, 6%.
  • Kansas City Electric Light Co.
  • Lobitos Oilfields.
  • Matador Land & Cattle Company.
  • Mexican National Railroad Co.
  • Tanganyika Concessions Ltd.
  • Wyoming Cattle Ranch Co Ltd.
  • Ural Caspian Oil Corporation Limited.

The small investor could not hope to spread his risk in this way. It is essential to realise that investment, until the turn of the 20th century, was all about income rather than capital growth. Interest rates were low and inflation, once the Napoleonic Wars had finished, was negligible. In any case, investment in ordinary shares was often reserved for a company’s proprietors, and was regarded as far too risky for all but the wealthiest. Other investors had very few options. They could invest in Consols – safe but unrewarding UK government stocks, which, staggeringly, yielded more than 3.5% only twice between 1830 and 1914. Banks offered no more than 4.5%, and “the enormous accumulations of the insurance companies have hitherto been managed on the footing that anything beyond 4% is unsafe”.

Overseas government stocks were yielding double, or three or more times, the return on Consols and justifiably so, because of their higher risk. Diversification could, however, reduce the risks. If it is true that the simplest ideas are often the best, then a pooled and managed investment scheme that owned a wide range of such stocks – carefully chosen, naturally – certainly meets the description. That is why Philip Rose, Samuel Laing and James Thompson Mackenzie, the three founders of what became Foreign & Colonial, went to work on creating a new vehicle to do just that and how, in the process, investment trusts were invented.

Philip (later Sir Philip) Rose was an accomplished City lawyer. He had a meteoric rise to fame and fortune during the 1840s railways boom and became financial advisor to Benjamin Disraeli. By the 1860s, Rose had become a specialist both in arranging and investing in overseas loans. Samuel Laing was a wealthy financier and politician. A former Minister in India, Laing was a qualified barrister, and a member of the founding family of stockbrokers Laing & Cruikshank. James Thompson Mackenzie was described in the prospectus as “Deputy Chairman of the East Bengal Railway”. He was Laing’s business partner, and a shrewd entrepreneur. Both Mackenzie and Laing had already made a good deal of money in the railway boom. The three men had, by 1868, worked together for five years, forming and managing the General Credit & Finance Company (GCFC). The GCFC, to all intents and purposes, was effectively a trial run for the Foreign & Colonial Government Trust and many valuable lessons were learnt from it.

The three men already made a strong team and they were determined that their new venture would be presented as the very epitome of trustworthiness, reliability and integrity. The trustees were selected with this aim in mind. For the trust’s chairman, Rose, Laing and Mackenzie went to the top. Lord Westbury was “the most brilliant barrister of his generation … a man who was as respected for his integrity as he was feared for his intellect”. Formerly Richard Bethell, QC, he had held the positions of Solicitor General, Attorney General and Lord Chancellor. He was also a Member of Parliament and a Privy Councillor. Yet his was a far from privileged background. When he was six, his father, Dr Richard Bethell, lost his life’s savings through investing in an unlimited liability clothing company which collapsed. For a time, the family were deeply in debt and Dr Bethell almost ended up in a debtors’ prison. The event had a profound effect on the young man.

Richard Bethell’s abilities had, to say the least, been recognised early. At 14, he was accepted by Wadham College, Oxford. By the age of 17, he had broken a number of records by simultaneously taking a first in classics and a second in mathematics. By his early 20s, he had become a Fellow of Wadham, and at 23 he left academia for the Middle Temple and the Bar. Bethell’s wit, turn of phrase and cutting satire soon became a legend. News of his ability to demolish opponents with such phrases as, “What he pleases to call his mind” soon spread, gaining him many admirers, and not a few enemies.

In Parliament, the prospect of listening to his verbal exchanges with Gladstone ensured a full house. He could be especially scathing about judges and the clergy. On one occasion, when asked why Lord Cranborne always sat with the Lord Justices, he replied, “I take it from a childish indisposition to be left alone in the dark!” When Bishop Wilberforce proved to be a tougher opponent than he had anticipated, Lord Westbury ventured that he “had never met a clergyman, with the exception of your Lordship, who had a mind”. Westbury’s professional income in the 1860s approached £30,000 – an astronomical sum in those days. Despite this, he could be an exceedingly frugal man, who put tuppenny pieces aside to use as tips.

The most important of the other trustees was Lord Eustace Cecil MP, who brought with him “the most distinguished lineage, and his own achievements as a prominent Member of Parliament”. Lord Eustace Cecil was to be involved with the Foreign & Colonial for 51 years, including 32 years as Chairman. The two final trustees, apart from Philip Rose himself, were George Sandiford, who was another prominent MP, and George Woodhouse Currie, a well-known banker. The team, as a whole, had a formidable breadth of expertise and influence, as well as, in Rose’s personal relationship with Benjamin Disraeli, access to a man who had just become Prime Minister for the first time a month before the launch. Few ventures can have been so well-founded.

 

The prospectus for the new vehicle, though aimed at those of modest means, could not be described as a light read, running to a daunting 76 pages. The Foreign & Colonial Government Trust – the word ‘Government’ would be removed from the name in 1891 – was structured initially with a fixed ‘Schedule’, or portfolio, of investments. All the stocks purchased were to be deposited, for safety, with bankers Glyn, Mills, Currie and Co. Changes in the portfolio were not expected to be a regular feature: “…a power of sale, under special circumstances, will be vested in the Trustees and a committee of five certificate holders, to be chosen at general meetings, held annually for this purpose, and for receiving a report and accounts from the Trustees”.

The trust was initially planned to have a fixed life of 24 years. The offer was in the form of £100 certificates at £85, repayable at par, giving an expected yield of 7% on a forecast dividend of 6%. Detailed estimates of future income and capital prospects were given, having been checked by Mr C. Jellicoe, former President of the Institute of Actuaries. Mr Jellicoe calculated that the actual return on the portfolio, assuming there were no defaults, would be 8%. The surplus funds thus generated would allow the creation of a “sinking fund”, which would be used for “repaying certificates at par by annual drawings”. As the Schedule shows, the launch sought to raise just over £1m for a fund investing in a spread of 18 foreign government bonds or fixed interest stocks.

Although the coupons of these bonds varied from 3 to 8%, they were nearly all bought at well below par. The actual yields, therefore, were higher, and varied from 5.05% (New South Wales 5 per cents stock – clearly very creditworthy) to 13.69% (Turkish 5 per cents – credit rating not so good). Italian ‘five per cents’ were purchased for £49.75, so the initial yield was just over double the ‘five per cents’ coupon, at 10.11%. Nova Scotia 6%, on the other hand, clearly had a much higher credit rating, and was bought for £102.75. The yield was in this case 5.84% – slightly less than the coupon.

Every one of these overseas stocks looked tempting on a yield basis. Consols, comfortingly secured on the massive assets of the Bank of England, were in 1868 yielding a mere 3.3%. Future prospects therefore depended on how safe the foreign loans really were. Foreign securities were often regarded, with good reason, as high-risk vehicles in dubious emerging markets, including the United States. There had been several defaults on foreign bonds before 1868, some producing a total loss for investors. There was, therefore, bound to be a degree of scepticism in some quarters about the F&C’s likelihood of success.

Initially the new trust scarcely received any publicity. On the launch day itself, a small paragraph, well down the ‘Money Market and City Intelligence’ column of The Times mentioned that: “It is understood that a new company for the investment of capital in all the principal dividend-paying foreign securities is about to be brought forward, so as to enable persons to employ money in this manner without incurring the entire risk incidental to any one particular stock. As a rule, foreign securities have produced a good average return, while there have been some deplorable instances of individual loss”.

No more details were provided, not even the new company’s name. It was a subdued start to what was to become a great financial institution and far from newsworthy. Over the next few days, advertisements for the Foreign & Colonial Government Trust were published, and coverage in the financial columns increased. The Times was an early supporter: “The scheme in its principle supplies a want that has long been felt”. The Scotsman, however, was more sceptical: “A prospectus has appeared of a Foreign & Colonial Loan Trust scheme for £1,000,000, based on the principle of average risks. Investments in low-priced foreign securities look very tempting on paper, but recent experience should induce caution before adopting new speculative projects.”

The Economist noted the originality of the new venture, saying “…the shape is very peculiar; it is not a company, and yet it is to do things like a company; it promises great gains without risk; the exact idea upon which it starts has never been used before. In our judgment, the idea is very good”. It was more sceptical about some of the forecasts made in the prospectus. It did not care for the intention to put over a quarter of the trust’s funds into Danubian, Egyptian and Turkish stocks, or what it called “loans to semi-civilised states … which will go on borrowing as long as they can, and when they cease to borrow, they will also cease to pay interest.” Some of the promises, in fact, were “far too sanguine to ever be performed”.

The Economist’s point about the Foreign & Colonial being like a company, but not a company, is an important one. Rose, Laing, Mackenzie and Westbury used their unique combination of experience and talents to ‘invent’ the investment trust. The fact that the Foreign & Colonial exists to this day, and flourishes, is a tribute to their ingenuity. On the other hand, all modern-day investment trusts, as we colloquially describe them, are really investment trust companies. In the legal sense, they are not trusts at all. The Foreign & Colonial, however, was a trust and not a company until 1879. (Having been registered as an unregistered common law trust, it changed to a corporate form in 1879, following a court judgement, later reversed on appeal, that investment trusts were illegal, being “associations of more than 20 persons for the acquisition of gain”.) This was at least partly for marketing reasons. In the financial panic of 1866, many shareholders and creditors had lost everything, and companies had, not for the first time in history, gained a bad reputation. As The Economist went on to observe, the trust form was “an evident attempt to avoid the now unpopular name of company”.

The stock market in late March 1868 was variously described as idle, dull and inanimate. There were also fears of an early general election. It did not help that the newspapers were still full of articles reviewing the Overend & Gurney collapse and losses incurred in the latest railway mania. At first, the rate of applications for the new trust was slow, but, as a more favourable press developed, subscriptions picked up. The Standard suggested that “in consequence of the manner in which this proposal has been received, it is said that other trusts will be formed for general securities, with a view to paying average dividends on invested capital”. How right it was!

By the end of the subscription period, just over half of the £1,176,500 stock offered had been taken up. It was a slow start, but the concept of a professionally managed trust, smoothing out the investor’s risk and enhancing his rewards, rapidly found favour. Within eight years, 17 other investment trusts had been launched and were quoted on the Stock Exchange. The Foreign & Colonial Government Trust itself made five separate issues of trust certificates, raising the total subscribed to £3,500,000, and in 1873 the F&C’s managers also launched a second trust, the American Investment Trust, specialising in US railway stocks.

Having started life perceived as a high-risk venture, the Foreign & Colonial Investment Trust has long since proved its staying power and vindicated the vision and investment philosophy of its founders. It remains today, 150 years later, one of the largest UK investment trusts, with total assets of over £3.5bn and a highly creditable and consistent long-term performance record. As far as The Economist’s “semi-civilised states” were concerned, only one of the original 18 government stocks defaulted, namely the Spanish New, 3 per cents. The stock missed its coupon payment in 1875, reducing the trust’s income for the year by £4,099. In the finest tradition of a soundly managed investment trust, the deficiency was by then so well-covered by reserves, and by the success of other stocks, that the investors could be forgiven for not having noticed.

JOHN NEWLANDS is the author of Put Not Your Trust in Money, a history of the investment trust industry from 1868 to the present.

Wealth managers

JAMES BURNS, a partner at Smith & Williamson, explains why investment trusts are favoured by firms that manage private client portfolios. (Note: this interview was first published in the 2019 edition of the Investment Trusts Handbook and has not been updated since). 

Why are investment trusts popular with wealth managers?

James Burns: Investment trusts have always been popular with wealth managers, and have become more so in recent years as more and more asset classes have opened up as options in the investment company space. As the sector has morphed from consisting mainly of conventional UK-registered companies into a much broader investment universe, we have become even bigger supporters. We are always among the first to get an early call for brokers promoting new launches.

The sector has changed a lot since the financial crisis. Up until then it was primarily equity trusts. There was a very small fixed income sector and we had a big boom in property investment companies leading up to the financial crisis. Hedge funds also came in for a while. But since the financial crisis there has been a massive explosion in different asset classes to access. The easy explanation is that the banks have come out, or at least had to retreat, from many parts of the market. So now we have things like commercial property lending, aircraft leasing and more specialist property sectors, such as student and healthcare property. There have been a few more private equity launches too.

Overall there are far more different asset classes to play with now. The financial crisis has been good for the sector in that respect because the investment company structure is an absolutely ideal vehicle for these less-liquid pools of capital. At the same time, the investment company sector has really benefited from wealth managers looking to build diversified multi-asset class portfolios, an approach which is becoming much more common.

How do you use investment trusts within the firm?

JB: One is as a core building block for a portfolio. Conventional equity investment trusts such as MONKS and SCOTTISH MORTGAGE have good management teams and are very attractively priced these days. The sector also offers good income vehicles with revenue reserves and good historic payout ratios. With trusts whose managers have the ability to invest in smaller and less-liquid shares than they are allowed to do in their open-ended funds, you are hopefully getting their best ideas as they can afford to take a longer-term view.

The second attraction is the ability to access multi-asset trusts which give you diversification away from conventional equity and bonds, whether that is in the form of commercial property lending, renewable energy or whatever. I always look at the sector in these two ways. The key thing for me is that natural selection works in the investment company sector. If you are not performing, or the management house is not performing, shareholders and boards are much more active now. Poorly performing vehicles will die out. Dead wood gets kicked out relatively quickly.

Do you expect fees to continue coming down?

JB: Yes. There is certainly a long list of funds that have cut performance fees in the last few years. I think that boards of trusts now realise that they are able to assert their strength in negotiations with management houses over fees. Their argument is that as investment companies have the advantage of permanent or semi-permanent capital, so their fees should be coming down. Trusts like the ones I mentioned, Monks and Scottish Mortgage, are now charging incredibly attractive fees for active management.

Are trusts doing too much or too little by way of using gearing?

JB: On the whole I think the use of gearing has been pretty good. There are different approaches. Some boards are involved in every gearing decision. Others give managers leeway up to a certain level. Some trusts say that as we have a longterm view, we are going to be geared pretty much all of the time. Other managers look to reduce gearing when they think that valuations are looking potentially stretched. We have seen very few increasing their gearing recently.

What about the added volatility that shares in investment companies have?

JB: You can’t dispute that trusts will be more volatile than open-ended funds in terms of price because of the supply-and-demand dynamic and also potentially because of gearing. We always say that, if it is part of a sensibly constructed portfolio and if you are happy with the level of volatility, then investment companies make absolute sense. A lot of people use the sector for income and as long as that income is being paid, that is the key thing. In 2008 in the equity income sector, only one trust cut its dividend. Every other trust in the sector held its dividend while open-ended funds were cutting. That is important for clients because they want to know that their income will keep on growing and they can afford to hold for the longer time.

Are the regulators doing enough to promote investment companies as an alternative?

JB: The Financial Conduct Authority has probably been showing a bit more interest lately. The AIC lobbied hard to make sure that investment companies are not classified as complex investments under the latest European legislation. The truth is that investment companies are slightly more complicated investments, but it is really just a case of having a few more moving parts to look at. You have to do a bit more research. The good thing about investment companies that needs to be emphasised is that in this post-RDR, governance-driven world there is a board of directors there to protect shareholders’ interest, which is a big positive.

But has the quality of investment trust boards improved? They were the butt of many jokes not so long ago…

JB: Over the last decade boards have been showing far more independence over fees and moving management contracts around. We have seen more examples of directors taking their responsibilities more seriously than they were. There is definitely still room for more improvement. I can think of a couple of cases recently where boards have failed to bite the bullet and move the management contract when they should have done.

Are you in favour of more boards introducing discount controls?

JB: I am actually quite relaxed about that. I am still of the view that there are few things more fun than buying a really good investment trust that is trading on a discount because of some short-term wobble in the market. What I don’t like to see are boards turning to cash registers at the wrong time, purely because they have put a line in the sand. The risk is that they end up shrinking the trust to a point which may not be in the interest of everyone. That said, what you don’t want are no controls at all and boards adopting a laissez-faire approach, with a discount staying at 20% forever. I quite like the idea of trusts with a fixed life, giving us as investors the ability to get out after a few years. While the discount may move out a bit in the short term, you know that on a three- or four-year view you can exit at NAV.

Is there a limit on how large a trust has to be for you to invest in at IPO?

JB: Ideally we are looking for investment companies with £100m in assets, but we won’t say no if it is less than that, particularly if we think it has the potential to grow, and will be able to raise more money with secondary issues. There is no one absolute limit. £100m is our unofficial limit. At some other houses it is £250m. I can understand why they do it, but it also means that there are trusts in the area that they don’t consider at all, so they are missing out on some very good vehicles. While we monitor our holdings, we do allow exceptions. We think our approach is more flexible.

What has been the driving force behind the wave of recent launches?

JB: Yield has been a big driver of new issues and that makes sense. Things like REAL ESTATE CREDIT INVESTMENTS we really like because you are getting attractive income yields from the lending and still have an equity cushion above you. If you buy Land Securities, by comparison, you are just taking the equity risk, so if you can get 6% yield on real estate lending, that is attractive. The search for income has been a particularly big factor behind all the new issues in the alternative asset space. In 2017 nearly all IPOs had an income story behind them. PERSHING SQUARE, one that wasn’t, was a big launch that has not been particularly successful. This year, however, we have seen some interesting new issues in the conventional equity sectors.

Are you not worried that income-based IPOs are becoming too much of a fashion thing?

JB: Yes. I am becoming a little concerned. The investment company market does have a tendency to get quite excited about certain asset classes. Some of the issues recently have become very niche-specific, particularly in the REIT space.

Has the alternative asset sector grown too far too fast? Some of them seem to be running out of opportunities…

JB: I have some concerns on that score, but there have been further bright spots too. The bid for JOHN LAING INFRASTRUCTURE earlier this year at a 20% premium showed that there is still interest in the assets among large institutional players in the market. Some trusts like CARADOR are winding up, and there are others which have not quite done what they were meant to have done, but the positives still outweigh the negatives in my view. As income sources they have mostly been great for private clients.

How has your view of the outlook changed over the past 12 months?

JB: The whole investment trust sector has done incredibly well since the financial crisis. It has grown in size, there have been lots of success stories and the alternative asset trusts have introduced some great new choices for investors. It is probably only natural that we should have turned a bit more cautious now. Both the sector and the markets would probably benefit from a pause for breath.

In general we still think the outlook is positive for both bonds and equities. Interest rates are rising, but slowly. Of course the markets are vulnerable if we get an inflation shock, particularly in the United States. I am probably a bit more cautious than some of my colleagues, but for now the outlook appears to be relatively benign. Let’s hope that it stays that way.

What changes have you made to your portfolios over the last year?

JB: We have not made a huge number of changes. We have taken a bit of profit on our private equity trusts. SYNCONA has been a terrific performer for us and so we have sold that down a bit. We first bought in at the launch price of 100p and it has more than doubled since then. We never expected it to do as well as it has so quickly. It has still got exciting long-term prospects, but we won’t be chasing it at this price. We have also added a holding in DIVERSE INCOME TRUST on the view that it will provide some portfolio protection as a diversifier. In general we have become slightly more defensive.

With the markets being quite richly valued, and discounts tight by historical standards, it has been hard to get too excited. We have mostly been looking out for specific opportunities rather than adding to existing positions in the market leaders. For example we added a holding in RIVERSTONE ENERGY earlier in the year, on the view that the oil markets were likely to be stronger than most people had thought, and the discount had gone out a lot. The UK income trusts have taken a bit of a beating, too, which could become interesting.

And you have been sticking with Mark Barnett’s trusts, which have underperformed for some time now?

JB: Yes we have. I have probably had more grief about that from my colleagues than anything else! However, I don’t believe that Mark has lost the ability to run money. There is always a danger of overreacting to a run of poor performance. His value style of investing has gone massively out of favour but I hope – and expect – that the performance will come back, although it may take a change in the market environment before it happens. [Editor’s note: Barnett is the manager of both the EDINBURGH INVESTMENT TRUST and PERPETUAL INCOME AND GROWTH, which together have assets of more than £1.1bn.]

Have you been taking stock in this year’s IPOs?

JB: We have done a few. We supported Baillie Gifford’s new American trust, for example, which has already done remarkably well, given how tough it is to outperform in the US market. They are in a bit of a sweet spot at the moment; everything they touch is doing well. Mostly, though, we have concentrated on secondary issues. We are going to be seeing Mark Mobius to talk about his new emerging markets investment trust and there is also a new Japanese trust that Asset Value Investors are hoping to launch which looks interesting.

What do you think will happen to discounts if the market does have a significant downturn?

JB: If the tide does turn, then discounts will obviously come back off current levels, but by how much is an interesting question. We have been looking for opportunities to add some further portfolio protection, as I mentioned. It is not that easy. Trusts that have a fixed life offer some protection, as you know that you can get out when the wind-up date comes round. Of course, if discounts do widen a lot, that could be a good buying opportunity, and I would hope that we could profit from that. Nothing is ever black and white in this business!

 

JAMES BURNS is a partner in Smith & Williamson and responsible for leading the firm’s research into investment trusts. He also manages three multi-manager funds that invest in investment trusts and a number of private client and discretionary management portfolios, and co-manages the firm’s Managed Portfolio Service.

Global equities

Global equities specialist SIMON EDELSTEN, lead manager of the Mid Wynd International Investment Trust, gives a manager’s perspective on how he is handling today’s market conditions. (First published in 2018 and not updated).

How did you come to be managing this trust?

To start at the beginning, I got to know Nils Taube [a legendary equity investor] in the ’80s when I was a stockbroker. I was one of his firm Taube Hodson Stonex’s closer stockbrokers. I’d talked to Nils about leaving broking and moving into fund management quite frequently in the 1990s, and then, in 2000, it seemed like a good time to do that, and so I joined in 2001.

I think you’ll find most of the way in which we run money will remind you of the global, growth-oriented and thematic approach that Nils’ funds tended to have. I think that we have added some enhancements, particularly, about risk management, use of data, and use of modern technology, which has moved us a bit away from his more artisanal style. We use more data and structure, and less of a call on experience, because we have less experience!

In 2004, Cazenove rang us up and asked us whether we’d be interested in sorting out an investment trust called Electric & General, which was the rump of the litter in the Henderson stable, and we took over this fund, which had a 200 stock portfolio, a little bit of this, a bit of that. Nils had been on the board for a while, but it had rather lost its brand, nobody quite knew what it was there for, it had been used as an in-house vehicle by Henderson to pay people in shares to avoid tax, and of course, it was surrounded by other funds like Witan and Bankers which, for various reasons, had a higher profile and higher priority. Henderson’s marketing department couldn’t sell five trusts which were all in the same sector.

The takeover worked pretty well. We tightened the list up. We gave the trust our own rationale for trying to increase people’s real wealth patiently. We probably made it more capital-protective than the other Henderson trusts. We ran net cash positions, where the other trusts were structurally geared.

After Nils passed away, and John Hodson wanted to leave, I decided I wanted to go for a much more structured and disciplined approach to running money, less artisanal if you like. I felt it was time for me to move on.

Fortunately, I only had to move a few floors in the building, as Artermis, which was another firm I’d known from my time in broking, worked in the same building. The Scottish clients were on my patch when I was at Phillips & Drew, so I’d known John Dodd particularly and Adrian Frost very well from my years in broking. They had just bought out the business from ABN and it was very UK-oriented, they had ambitions to grow the business again because they had a new funding partner and they knew that I could bring them a disciplined, sensible approach to global equity fund management.

From my point of view, it was also another partnership and could underwrite my building a business without there being much time pressure. The lack of timetable pressure – wanting to know when you were going to be profitable and so on and so forth – allows you to run money the way in which you want to run the money rather than take on a higher risk profile in your early years because you’ve got to get that critical mass to attract retail attention.

We launched the unit trust here six and a half years ago now, called Global Select Fund. Then, lo and behold, a couple of years after that, in 2014, Cazenove again rang up and said we’ve found this Baillie Gifford fund which is a bit overshadowed by other Baillie Gifford funds, and the board and the family, with a big shareholding in the fund, feel that it won’t get the attention and profile of the other funds. I think 27 firms pitched for it. The shortlist included the incumbent, a shortlist of five – and the chairman of the board who set that ball rolling, by the way, was Richard Burns, the ex-senior partner at Baillie Gifford, which surprised me and other people even more.

As you can imagine, our proposition was to move it to a much more capital-protective structure, with a more focused portfolio. But that did not involve us having to sell the large number of internet stocks in there, which have done terribly well, so the reorganisation wasn’t that vigorous. The number of stocks in it went down to about a third of what it was. Mike McPhee [the previous manager] always had a section of the fund he called “get rich slowly but surely”, I seem to remember, and that is a bigger part of what we do than what he did, but he always did that.

The trust started life as a family trust, you said?

Yes, and there are a number of family members on the board. The Mid Wynd International Investment Trust is the family trust of jute mill owners in Dundee. It came to the market very late compared with some others, so it was floated in 1981, and Richard Burns was the first fund manager of it when Baillie Gifford was quite a small firm and very dependent on its investment trust client base. It was before the heady uplands that they’ve headed into since. Richard sorted the fund out, taking it on himself, and Mike McPhee was the only other fund manager that they’ve had.

The whole extended family probably owns about 13% or 14% now, because we have expanded the trust quite significantly since we took it over. When we took it over, it was just over £70m of assets. It’s now about £145m, so that’s a combination of performance, the market going up and net share issuance. I think it’s found a niche here in the global equity universe as being targeted to be a bit more capital-protective than the others.

How do you manage the trust with your team?

There are three of us doing the job: I’ve had my THS background; Alex Illingworth ran very similar funds at Rothschild and Insight; and Rosanna Burcheri comes from a European background and worked for M&G and Shell. We’ve got three experienced fund managers. It’s a bit like the old THS style of having three grumpy old people who argue endlessly until, finally, somebody shuts up. But that keeps your standard and quality up. The hurdle to get in the fund is set really very high. But it also means, even though there are very few of us, we know a lot of stocks, and what we’re looking for is pretty consistent and we agree on the quality that we’re prepared to go down to.

What is different about your approach to managing a global equities fund?

There are some very good trusts out there in the investment trust universe, with excellent performance, but because it’s 10 years now since the financial crisis, many have forgotten how badly some of the global equity funds did at that time. Structural gearing works in both directions! This is an ungeared trust basically. Although we do have a credit facility, we don’t often use it, whereas for most of the trusts which have outperformed us, the contribution from their structural debt is quite significant. Some of them have also picked stocks better than us, but generally we are pretty solidly in the pack on the stockpicking, if you de-gear the performance figures.

When I look at the universe, what surprises me is how unbalanced some of the other portfolios are becoming because they allow successful holdings to keep going up and they don’t trim them. We are the other end of that policy. We take more active bets and are more valuation-sensitive. When we took over the trust, we had as many internet stocks as other people, we had consumer staple stocks like other people, which were the right things to own, but as valuations have carried on going up we started selling our consumer staples 18 months ago, because we felt that paying over 30 times earnings for Nestle when it’s only growing, top line, at 3% per annum is just not very good value for money. As we have quite a broad view of interesting stocks around the world, we generally think we can find something more interesting to do.

Can you give an example of how the profile of the fund has changed?

This year, we sold our biggest holding, which is Amazon, when they did the Whole Foods acquisition. We have no criticism of that. We understand what they’re trying to do, but it’s just a valuation issue. If it means that they’re becoming more capital-intensive than the other internet companies, then they shouldn’t be on a rating as if they are very low capital intensity. As the market moves on, and particularly in the last couple of years, our portfolio – which was quite like other global growth-oriented managers when we took the fund over – is becoming less and less like them. We are trying to find decent quality growth themes that are on more modest ratings.

We’ve also sold our Facebook recently, as we think some of the internet stocks are now quite pricey. We’ve built up a new theme recently in automation stocks, which seem to be having a boom and which has led us back to Japan. You won’t be surprised that the average multiple of cash flow of the stocks we’re buying is a fraction of the internet stocks, however you analyse them. The growth rate will not be quite as heady, but some of the robot companies are seeing 20% or 30% increases in order books. One of them saw a 100% increase in order books this year.

Again, I think this is very like the way we managed money at THS. You never know that you’ve got a new theme coming along, but if you find that you’re starting to get a bit uncomfortable with one part of your portfolio, that it seems to be a bit too fashionable, and the multiples really seem to have gone through the limit of where you think things should be, you always have other themes and new ideas you have been working on in the background to fall back on. There’s generally something out there which allows you to recycle money gently over time into a new idea which is less fashionable and certainly more modestly rated and yet keeps the fund reasonably fully invested.

You also have a sizeable personal stake in the trust?

Yes. I always have been an investor in my funds. When I turned up to THS, I put as much money into that as my mortgage would allow me. Personally I happen to think that my fund is the best way to make real returns for savers out there! I back it up personally in quite a lot of size. While I’m open to ideas, I really can’t think of anything better. It’s an enormous privilege being allowed to buy little bits of other people’s hard work globally, and currently, with no exchange controls, the investment trust allows me to invest in an efficient manner round the world, keep my money outside the UK, which is not a currency I particularly want to invest in, not that I have terribly strong currency views, and to invest in growth where I can find it round the world.

It is important for investors to know that the fund manager has a similar attitude to risk, is it not?

Yes. If I lost all my money now, I haven’t got time to make it back again, and we’re quite a long way into a massive bull market, which was, to be blunt, one of the other reasons that I left THS. In 2009, I thought this is the best opportunity to invest I’ve ever seen and probably the best I will ever see, and so I was, I think the correct term would be, “aggressively bullish”. You have got to take these opportunities. Does that mean that I think it’s now time to sell equities? No. I don’t think you make that decision on the basis of whether you’ve made a lot of money out of the bull market. You make it on the basis of whether the valuations are telling you that there’s a problem, or whether the macro is telling you that there are imbalances you need to worry about.

But I prefer to own the equity of the stocks that we own in this fund than have my money in anything else. Gold? I’ve never met anyone who comes up with a sensible view of what the price of gold should be – people have very strong views on which direction the price of gold should go in, by and large always up, and it’s always the same people – but if I can’t value something, I don’t want to own it. And any bond I look at in the world either is what Buffett calls “reward-free risk”, as far as I can see.

So what I spend my time worrying about for the fund is of course informed by my own caution and desire for capital protection, and it is: can I find assets in global equities which will balance the fund if things go wrong? The main thing that could go wrong is that inflation goes from massively subdued and much lower than people expected to something different. It has undershot everyone’s expectations in major economies for the last seven years.

Are you as surprised by that as many economists seem to be?

No. When I went to college in 1980, it was all about monetarism, and quite clearly Milton Friedman’s proposition that, if you expand money supply this much, you will get inflation, is wrong. It is interesting that there are still global equity managers who try to run money using economic theory when it clearly is of no practical use at all while secondly, the central banks are also listened to with enormous awe and wonder, when, quite clearly, they haven’t the faintest idea what’s been going on at all! It is much easier having a stock-picking approach to have confidence about the future.

My confidence in the future of my savings is principally down to the 20 big holdings that we have in the fund, which are fine companies, which I meet every now and again and seem to me to know how to run capital much better than anyone else I meet. They are also diversified. We have half the money in America, but we also own Chinese banks and many other quite different things. If you look at the THS long-term record and the unit trust record, you’ll see that, over the whole piece, including big bear markets, we’ve been chugging along at 11% per annum in real terms.

I’m not confident that I’m going to carry on doing that, but even if I miss that by quite a bit I can afford to have a couple of bear markets. And where else are you going to put your money? What on earth is the argument to put some money in an infrastructure fund or something like that if equities generally deliver that kind of return for the patient investor? That’s the key thing: you’ve still got to be patient. We do say to anyone considering investing in the fund, what I used to say at THS as well, which is this is for people who can afford to wait.

If you’re serious about trying to deliver an equity product for investors, it is worthwhile giving up quite a lot of the last bit of the bull market to put that insurance in place so that people don’t panic. Even people who don’t need the money panic in bear markets. The best work we did at THS was making sure that none of the clients were panicking in 2003, at the bottom of the bear market. That wasn’t the worst bear market I’ve sat through, it was nothing like ’87 in terms of panic, but goodness me, people were still ringing up saying, “Oh, should we sell everything and buy bonds?” and all sorts of nonsense went on. We also kept people in successfully in 2008 and 2009.

I think that our policy is quite a distinct policy compared to others and as long as you’ve got that mindset, the tools you use to bring it about are quite technical: they are concentrating on valuation, trying to make sure your fund is diversified by stock, theme and country, trying to make sure that currencies and interest rates don’t hit you too hard. This is where I think I’ve tried to improve the use of data compared with the THS approach, which was quite artisanal.

What does that mean?

I set rather stricter limits on how much money we can have in any one theme, any one stock. The portfolio is built around eight or nine investment themes, which is the same as it was before, but we take the stocks we have in each of those themes and then we analyse the historic correlations between those themes. You can’t have an oil theme and an emerging markets theme and call them two separate themes without spotting that they go up and down completely together and they’re both very volatile. If you want to have those two themes, that’s fine, but you need to limit the total amount of capital you have between the two themes. What we want here is to have eight or nine themes which are properly diversified, at least in terms of their historic correlation. It does not guarantee that they will not prove to be correlated in the future, but at least you’re trying.

Just like at THS, we have an emerging market consumer theme – much smaller than it was because that tailwind is less vigorous than it was. Some of these countries are getting to have an aging population issue rather than a youthful population advantage. That emerging market consumer theme clearly has a correlation with another theme we had at THS, which is called tourism here, but was called ports and airports there. As tourism is now dominated, 15 years on, by Chinese tourism, in terms of the heady growth rates, there will clearly be more correlation now than there was 15 years ago.

Of course 15 years ago, media and technology stocks were very highly correlated, but now, as you may have noticed, the media sector is seen as complete trash and nobody wants to have anything to do it with it while the internet is going to dominate everything. The two are completely uncorrelated. It is a great thing to have seen through cycles in markets. I remember Nils always saying every year that he hoped he might get it right this year and eventually he would get enough experience! But you can also be wedded to some mythology you’ve built up for yourself, believing that you know what a defensive stock is and how to make the fund cautious, while actually markets move on, and sectors that were defensive prove not to be defensive the next time round.

So, consumer staples might be a good example of that?

Well, one of the things that I personally think makes a stock enormously undefensive is being on completely the wrong valuation. And yet I sat through a lecture the other week from the biggest endowment in the country, where they said, “Because we have such long duration, it doesn’t matter if we’re paying huge multiples for Unilever and Nestle because we know that they’ll be around forever, so we’re not taking a risk”. If you’re paying 38 times earnings for something and it goes down to 20 times, it may not be permanent loss of capital, which is bankruptcy, but Vodafone at £2 today compared with £4.75 in 2000 is a pretty substantial temporary loss of capital! lt’s certainly more temporary loss of capital than I’m prepared to put up with.

Now, I’m not saying that the valuation of Amazon or whatever is as stretched as the valuation of Vodafone was in 2000, but I am saying that some of the same mindset is creeping in, that it’s more important to have the right stocks in your fund than to worry about the valuations. That’s not what we think active fund management is all about. As long as people are trying to do the valuation, if they want to put in very low discount rate and say that they’ve done a valuation, that’s fine, but you will find some people who are saying “we just think this is a great stock and we won’t do the valuation”.

How do you prepare for the next market downturn?

My view of active fund management is that you apply common sense and are always on the lookout for getting carried away. I do these old-fashioned thought experiments like pretending that we had an 1987 moment and I walked in and the market was 25% lower, and there was no liquidity, no opportunity to trade, and then you sit there and you look at your list of stocks and you think: which of these stocks would I really regret having in the portfolio if that had happened? Not which stock would have gone down the most, in a way, I don’t care about that. It’s which stock would I just say, “What on earth did I buy that for?”

And are there any stocks where I think I’d get no liquidity? Obviously the great advantage of a closed-end fund is that you don’t have to trade in a bear market, but it still matters if you’re in an emerging market whether they suspend the currency or whatever. I think some of those differences in mindset do come about by having some money in the fund. I just think it makes life easier. It does help being a global equity manager if you think global equities are the best way to make real returns! I’m very glad that I didn’t end up as an expert in say Algerian small caps because then I’d feel very reluctant to have all my money in the fund. Having your own personal greed and fear instincts totally aligned with your job and your friends’ savings and endowments that you care about, I think that just makes life quite easy. It really does make making decisions terribly simple.

Can you give me an example?

When Trump got voted in, for example, we had half a day to make decisions before Wall Street opened. We looked at all these American banks we bought last year, and saw that they were all going to get marked up a lot because everyone would get terribly excited about the reflation trade, but we basically also thought this man Trump is a bit odd. Our thinking was along the lines that this was a bit of a windfall that we hadn’t been expecting. I’m very pleased we’ve made this much money much more quickly than we expected to, but we bought these bank stocks expecting Hillary Clinton to have got in, and Elizabeth Warren too, but they’re not that good! They’re still banks.

There’s this big growing sector of the savings market who have chosen to find their own way to invest, and we’ve seen that on the shareholder list here – it is one of the reasons we’re issuing stock very consistently. People are finding their way to the fund despite it having had a very low profile under Baillie Gifford. People are finding it and I think are just picking up that we’re offering, hopefully, a smoothed version of the market cycle. They may not understand the maths that means you end up with a better return over a number of cycles. That ratchet effect hasn’t been apparent for the last eight years, and that’s quite a long bull market. But I think people coming to the market now looking for a way to get more of their savings outside the UK appreciate the point of giving up money to a fund manager who is taking a relatively cautious view on valuation, and yet keeping fairly fully invested most of the time.

The board are keen to grow the trust, however…

Well, it would be nice to get it up to £250m-odd because you’re running this losing battle at the moment where the large wealth managers keep getting bigger, and they keep saying the smallest fund we’ll look at is £250m, or whatever. Do we need them to pay attention to it? I don’t care that much. I’m perfectly happy to spend my time talking to the medium-sized wealth managers who are interesting and care and it’s not as if this fund is really in competition with anything. It’s a solution for a particular sort of client. Most wealth managers, the old stockbrokers, have got plenty of people this fund suits, and we probably couldn’t accommodate those who have rules that say it’s not big enough.

My experience is that managing global equity portfolios is not easy and successful fund managers in that space are quite few in number.

We won’t really know which of the global managers who’ve done well this decade understand all the tricks of it until we’ve seen a proper correction. When we saw a little bit of the correction back in 2015, people noticed that suddenly we went right to the top of the pops, and a lot of the funds which people felt very warmly towards, or were putting fresh money with after the market had gone up a lot, had a dreadful time because their portfolios were very lumpy. There are people who say “you should buy and hold these consumer staple stocks forever because they never go down”. Well, it’s not that long ago that Unilever was the lowest rated stock in the market! I got shouted at the other week by a 32-year-old discretionary manager, who told me that I was talking nonsense about Unilever and it should never be sold.

That’s the kind of idiotic remark you look for, anecdotally, as a sign that things are getting a bit silly.

Yes, but I wouldn’t go over the top on this. I think Amazon is on the wrong valuation. Nestle was the main stock we sold 18 months ago, but we recycle the money and we put in the fund a company called Daifuku recently, which, as I’m sure you know, is the world’s leading maker of automated warehouses, which is having a boom with e-commerce, but, being Japanese, that stock was on about 15 times earnings when we bought it, cash on the balance sheet, orders up 30% year on year. So there are bits of the market where I’m worried about valuation, but not too many, and then there are bits of the economy where I’m worried about debt. The level of debt in private equity seems to have got very high, moving so much into infrastructure funds and that sort of thing.

My list of 60 stocks has enormously stronger balance sheets than average so why wouldn’t I want my money anywhere other than large, listed, profitable, successful businesses? These businesses may trade on a slightly higher multiple of earnings or cash flow than we were used to in the past, but their margins are fat. On top of that, they’re incredibly financially strong. When I worry about a recession turning up in America, or a big interest rate cycle or whatever, these stocks aren’t going to be that troubled by it. One or two of them will have a worse time than others, but most of them will sail through that pretty well.

So, your point there is: where is all this debt going then if it’s not going into these places?

Well, the debt must be somewhere else. Another fascinating thing at the moment to me is that most of the M&A in the world is happening in private equity and not in public companies. It is extraordinary that all these big businesses, with good credit ratings, strong P&Ls, are not tempted to go and buy anything cheap, even when all the investment bankers of the world are running around, knocking on the doors, saying if you buy anything, I can issue you a bond to make it earnings-enhancing in week two. And yet the level of discipline being shown out there by chief executives of large companies is unusual to say the least!

The last big deal we saw was Bayer buying Monsanto and that was debt-funded, weirdly enough, by Germany’s second highest credit-rated company. Why did they buy it? Because they could afford it. I mean, there’s not much strategic value, but they are buying quality. Nobody is buying anything because it’s cheap. I think that’s one of the reasons why the value trade isn’t working very well. There’s not much mean reversion going on. People don’t want assets at a discount. They want decent businesses with new products which are fully invested. The fact that there’s very little of that going on is quite a healthy sign. It certainly doesn’t feel end of cycle-y. We may well get there because that’s one of the things I worry about. But there’s no sign of it at the moment.

I am sure that when the next crisis happens, everybody will say, “Of course, we should have seen that coming…”

Well, also, I think back to retail pressures. It’s hard for young fund managers to make heavy counter-cyclical calls. People are quite comfortable sitting there waiting for something to go wrong and then saying, “Oh, how on earth could I be expected to tell?”! Take Brexit. I did a presentation that week, and there were three UK fund managers, me and a bond bloke, and the three UK fund managers all said, “Oh, we work in big houses and we know that we’re going to stay in, so we’ve positioned our fund for Brexit”. I said, “Well, I do global, and I think politics is unpredictable, so I’ve taken all my money out of sterling for the week because it’s easy.” For me, it’s not a very big decision. There’s a big old world out there. You were saying that you thought global equity management is hard. In some ways, I think it’s easy because the number of options you’ve got is always quite high, and so the hurdle to move on to something less troublesome is quite low. You’ve always got choices.

Yes. I take that point.

When Trump came in, we sold the American banks because it was easy and we had other things we could do. You could just afford to take some money out, take your profits, move on to the next thing, sit back. Being able to duck political issues is a great advantage. It’s a shame that politics is mattering more in the market than it has for most of the rest of my career. I would make one caveat on that, which is that I think people are worrying about politics more than they should. I try to stick to listening to companies and trusting them to get through the political cycle. On the other hand, you can move money around from place to place easily enough, in order to step back from the politics.

SIMON EDELSTEN is a partner in Artemis and has been managing the Mid Wynd International Investment Trust with his colleagues Alex Illingworth and Rosanna Burcheri since 2014.

Investing in China

DALE NICHOLLS had never managed a closed-end fund before being appointed manager of the Fidelity China Special Situations investment trust in 2013. He followed one of Fidelity’s most successful fund managers, Anthony Bolton, whose original idea it was to launch a trust specialising in China-related equities. After four years at the helm, which has seen the value of the trust’s shares more than double, he reflects on what he has learnt so far and the prospects of investors in China.

How did you work with Anthony before you took over this job?

When he was in Europe, he was spending a lot of time looking at China. I was managing Asian equities in my open-ended fund. We would spend time talking about different ideas. We’d find ourselves ending up in the same meetings, being in the same company, and I think we just developed a pretty good dialogue about our thoughts on different stocks. The relationship was really just sharing ideas and thoughts.

Then when the decision was made, I think it was a well planned transition. It was announced, I think, a year before. We were working really closely together ahead of that. And in the last quarter, before the actual changeover happened, we agreed that we’d agree on all trades. So we were pretty well aligned. There wasn’t a huge amount of trading that we needed to do upon the actual handover.

How would you describe your style compared to his? Was there more in common than differences?

I think definitely more in common. I think that’s why we found ourselves in the same meetings, looking at similar types of companies, and definitely in terms of looking at the small and mid ends of the market – more off the beaten track in terms of the types of names that we’re looking at. In terms of background, obviously his being in Europe and me being in Asia, we’re influenced by that. I spend a lot of time in Japan so was probably a little bit more familiar with things like the tech areas. It’s hard to say.

In retrospect, it looks like you took over at a pretty good time. Is it fair to say you’ve always been bullish about the opportunities in Chinese and China-related equities?

I think so. China has been a great stockpicking market from a number of perspectives. As an individual stockpicker I try to let the stockpicking drive portfolio construction. It’s a big market and a very diverse market, and a big and diverse economy. You’ve got great variances between different parts of the economy. There’s a great amount of structural change.

We’re talking about a market where there’s been a lot of macro concerns, some of them pretty well justified – most obviously, the concern about slowing growth and the buildup in credit. But from a bottom-up stockpicking perspective, if you’re selective, you’re benefiting from those macro concerns bringing down valuations and you can focus on the companies that are benefiting from structural change. There has also been a huge amount of fear and negative sentiment. For a bottom-up stock picker, that’s a pretty good environment.

I think that general sentiment is starting to adjust somewhat. The collapse that a lot of people have been predicting hasn’t happened. Don’t get me wrong, some of the concerns are valid. The build-up in credit is clearly a concern, but as far as the people that were thinking that it could lead to a Lehman-style financial crisis are concerned, I have always found it really hard to understand how that would actually play out in China.

What are your reasons for saying that?

There has been a very rapid expansion in credit over the last 17 years. Since the global financial crisis, credit per GDP has increased a lot. History teaches us that you’re going to have credit issues as a result of that. I have no doubt that China has those problems as well. It’s part of the reason why I continue to own none of the Chinese banks. Amazingly, the top banks are reporting non-performing loans of just 1.8%. I suspect the real number is higher and needs to be going higher.

But then, when we talk about financial crisis, what really defines a financial crisis? One thing that tends to define it, based on the work that I’ve done, is a lack of liquidity. When you think about what happened during the global financial crisis, you had the banks stopping lending to corporates and also stopping lending to other banks. That’s when you have real liquidity problems. In the China context, first of all, for better or worse, the banks all have one big shareholder – the government – who’s shown that it is quite willing to drive lending when it needs to, but you’ve also got good deposit support in the system. The fact that you’ve got a very strong consumer base and a high savings rate has been what has driven high levels of bank deposits.

So when we think of loan to deposit ratios, you need to think about it in a broader context, not just the formal banking system but the informal banking system. A lot of credit has grown off the balance sheets of the banks. Even when we bring that back onto bank balance sheets, we still get a loan-deposit ratio of below 100%. Compare that to where you’ve had real problems in the past, where you generally have pretty highly wholesale-funded banking systems in which credit can disappear quickly. In China you’ve got this deposit support in the system.

So a real liquidity driven financial crisis I find hard to imagine. What concerns me more is a Japan-type scenario where you’ve got bad loans that just sit on the balance sheets of the banks and that doesn’t get worked out. Then you get poor allocation of capital and that can affect growth. That’s why I spend more time focused on how fast the non-performing loans are being dealt with. I think progress is being made there; but it could be faster.

I’m also more encouraged, particularly in the last six months, by the rhetoric that I hear from the government. At the very top, there’s more awareness of the risks and less of a focus on growth, which I think is positive and shows that things are moving in the right direction. I think there will be less of a focus on growth and more focus on the quality of growth.

Growth definitely will slow. I think that’s natural and necessary. Why? Mainly because you have so much investment-driven growth funded by credit. There’s a real awareness that there needs to be a shift in the structure of the economy towards consumption and away from investment. It’s happening. Consumption is the key thrust of the portfolio. Regardless of what the final GDP number is, whether it’s 6.5%, 6.25% or even 5.0%, you know that consumption is going to be growing faster.

I’d be pretty disappointed as a bottom-up stockpicker if I couldn’t find some decent ideas in an economy that’s undergoing a lot of structural change and has still got a decent consumption growth story. It’s always good when you’re investing in China to think about what the government wants to achieve. You generally want to be aligned with that. The broader growth driver is really just the natural development of a middle class. Across a range of sectors, people want their appliances and their cars, there’s real aspiration. That just seems like a really strong theme that you can invest in, on a five-, ten-, fifteen-year basis.

How much of the portfolio is driven by the Chinese domestic economy?

The majority of the portfolio is about the domestic economy in China. Obviously, I am concerned about trade policy and that sort of thing going forward. If you look at the revenue exposure of the companies that I’ve invested in, you’re looking at over 90% in Greater China. You can invest in that theme across a range of different exchanges and different countries. So I have holdings in Singapore, Taiwan, the US through ADRs (American Depositary Receipts) – these companies that may be listed in different markets, but their prime exposure is China.

Has that percentage changed at all over your tenure?

Only marginally. The proportion of US-listed companies has definitely increased, with the listing of companies like Alibaba and the fact that the ADRs are now coming into the index. The other big change is A-share exposure. There was a lot of negative sentiment around the A-share market when I took over. In many cases the dual-listed companies were trading at a discount to the H-shares. So I shifted a fair bit of exposure into the A-shares. In the last 12 months the market has become more rational. The exposure to the A-share is still relatively high at 10% of the portfolio now, but it’s come down, though it is still above where we started.

More institutional flows, I imagine, are inevitable now that China has been included for the first time in the MSCI world index?

I invest on fundamentals, but when you step back and think about the dynamics around flows, China represents a percentage of global GDP which is in the teens, compared to its share of global markets which is less than 3%. I think that gap is going to close over time. Obviously, MSCI inclusion is clearly a movement in that direction. A lot of global investors could afford to ignore China in the past, but that’s going to become that much harder for them to do.

The A-share market is a fascinating market. For me, it’s one of the most inefficient markets that I’ve seen. It’s not a great surprise when you think that the majority of traders are retail. You have a lot of small, fast-growing companies that are trading on huge multiples, and larger caps – generally pretty good businesses generating strong cash flows – that are largely ignored and really cheap. That structure is clearly going to change over time. You’ve got greater foreign participation in the market and that will increase.

Before you took on this job, did you have any experience with closed-end funds?

No. I was completely from an open-ended background, so this is a new departure for me. It’s definitely been positive. It allows me to reflect the opportunities I see in the market. When things are looking really cheap, when sentiment is negative, or when I am feeling more bullish about the holdings of the portfolio, it is a time to increase gearing, and vice-versa. When we talk about gearing, we should probably distinguish between gross and net gearing. The structure of the trust gives me the ability to go short as well. I can make bets against companies. That obviously gets included in the gross gearing, but is deducted when calculating net exposure. I focus more on net exposure.

Is this a decision that you make? Does the Board delegate that to you?

They’re obviously kept informed about everything that I’m doing, but it’s really my decision within the parameters that I operate in. On a formal basis, every quarter I explain how I’m looking at things, but also on an informal basis as well, I let them know pretty regularly how I’m looking at things and roughly where the gearing is running at.

What other advantages have you found in the closed-end structure?

Not having to worry about flows is a huge positive for me. I have a mid to small-cap bias in the trust, so liquidity [how easily shares can be bought and sold in size] is always something that’s at the back of my mind. Not having to worry about flows gives me more freedom. When there were discussions about my taking over the trust, that was a very positive factor for me.

How much overlap is there between the trust and the Fidelity Pacific fund you also run?

Significant. Obviously, China being a sub-set of the Pacific region, I definitely wouldn’t own a Chinese stock in my Pacific fund and not own it in China Special Situations. So, everything that’s in China, in Pacific, is part of China Special Situations. The overlap is pretty significant. With the trust, again I just get a little bit more flexibility, particularly around liquidity, and probably more exposure in the small-cap space.

The discount widened steadily for quite a period and then started to reverse. How much of that do you think is due to the share buybacks and how much to improving sentiment?

I think it’s improving sentiment, to be honest. It’s quite hard to control the discount. Part of the recent closing of the discount is just a recognition that the doomsday scenario that some people were predicting for China just hasn’t played out and now doesn’t seem likely to play out. I think it’s also a recognition that there’s actually just some great companies in China – the likes of Tencent, Alibaba – which continue to execute and have really strong management teams.

Corporate governance is not always a great strength of emerging markets. You get a lot of semi-state-owned or family-controlled businesses that aren’t particularly shareholder friendly. How does China fit into that category?

As you said, corporate governance is a challenge in any emerging market. It just takes time for the systems to develop. China’s no exception. It’s a challenge for a lot of companies. We’ve spent a lot of time doing as deep research as we can, building relationships with management and building a conviction over time about the management teams. There’s still a pretty significant proportion of state-owned companies.

I don’t ignore the state-owned companies, but the focus for me really is on the private companies. I think that’s where so much of the growth is coming in the economy. And obviously, they’re the biggest investors, the biggest employers, particularly from a growth perspective.

Looking at any company, management is a big factor in how they’re incentivised and the fact is there are a lot of state-owned companies whose goals are not necessarily aligned with ours as minority shareholders. The way the banks have grown since the crisis, obviously there’s government policy behind that. When I think about the big energy companies, I could come into the office tomorrow and there’s been an acquisition made somewhere in the world which may be more about energy security than economics. So, that’s something that’s in the back of your mind all the time.

The state-owned companies I focus on are the ones that have really good assets. I’m a pretty big investor in the airports in China, for example. I think that really fits in with the consumption theme. The growth in travel in China just continues to march along at a good rate – double-digit growth both overseas and domestically. I look at something like Shanghai Airport, which has hub status. Shanghai Disneyland is being built as well, which will continue to drive traffic. You’ve got pretty good expansion prospects.

There are good opportunities to improve the returns on those assets as well. I don’t know if you’ve been through Pudong Airport, but it’s not the most exciting retail offering that you’ve ever seen. If you benchmark against the likes of Heathrow, there’s pretty good potential for even better returns. Valuations also compare well globally.

Looking at the risks as well, what do you think are the major risks that you face in having this big exposure to the Chinese economy?

The development of the middle class is a very strong trend that’s hard to see reversing. When we think about the goals of the government, they want to see that trend happen, they want to see full employment, they want to build welfare, healthcare, and so on. That’s something that’s definitely a strong underlying driver.

In terms of the risks, I’m somewhat concerned at the margin. From a political perspective, you think about censorship and that sort of thing. I don’t think that’s a problem in the short term but if you think about things in the mid-term, obviously as people get richer, I think they’re going to want to have more of a voice. They’re travelling more, they see things that are happening overseas. And so there’s potential for people wanting to have more of a voice over time.

The government at the same time is very focused on that. I don’t think it’s something that we need to worry about in the next five years. But if you think on a longer term basis, I would like to see things politically moving more towards a freer approach. Obviously we need to think about geopolitical risks as well, things that are happening in North Korea now. That’s a risk as well.

From a policy perspective, when you think about the direction the government has set, it’s pretty positive in terms of the way they want to transform the economy. When you think about the predictability of policy, we’re talking about a government that has a five-year plan that’s extremely detailed about what they want to achieve and has a pretty good track record of hitting it.

When I compare that to policy predictability in some of the Western economies, from a policy perspective you know what the government in China is trying to achieve and the direction that’s been set. Yet China has lagged and continues to lag in terms of valuation.

It’s closed some of the gap versus the Western markets, but it’s still a pretty big gap. And at some stage that might start to get reflected in valuations for the markets.

You haven’t mentioned currency so far. How do you manage the trust from a currency perspective?

I think purely in local currency terms. I’m thinking about companies that are trying to grow their business as much as they can in local currency. I’m not overly concerned about the Chinese currency. I think there was probably some concern 12 to 18 months ago when the US was hiking interest rates and other markets were cutting. You saw that reflected in some pretty significant capital outflows out of China. That’s clearly changed now. It’s under control and the reserves are building again. I don’t think you’ll see any significant rate cuts in China. Obviously, the government keeps a pretty firm hand over rates. That will change over time. The clear goal is to free up the capital accounts over time. But it’s going to be a slow process, I think.

How do you see the trust developing?

We’re really committed to China, we continue to build the research team and we’re out there focused on the best ideas. We’ve been looking at the A-share market for quite some time. I think a lot of our competitors were late in getting to look in depth at a lot of the A-shares. I think the commitment that we’ve made to building research is crucial. The fact that we can invest in unlisted companies as well gives us exposure to a broader part of the economy in China. There’s so much happening in the unlisted private space. There’s a great amount of entrepreneurial activity there. It takes a fair bit of time in terms of looking at the companies but it’s really valuable as well. You can find some great ideas and it gives you a sense of what’s coming down the road as well, in terms of companies when they do list.

How much value have the unlisted holdings added?

Pretty significant. Obviously, it’s hugely biased by our investment in Alibaba. But if I look across the other holdings as well, we’ve had pretty significant uplift post our initial investment. We’ve got four holdings now, we’ve had uplifts across three of those. The biggest holding in the unlisted now is Didi, which is effectively the Uber of China. They’re delivering more rides in China than Uber does globally, to give you a sense. This is what I was trying to get to earlier about the pace of structural change. In a lot of industries, it just happens to be faster in China. The penetration of e-commerce has already surpassed the West, surpassed the US. You don’t have legacy retail bricks and mortar investment in third and fourth tier cities. So it makes sense that the transition happens faster.

The Chinese stock market has always looked cheap compared to other markets. Where do you think Chinese equities should trade relative to the US amd other markets?

The growth prospects are clearly stronger. As an emerging market, it still trades at a discount, but when we’re looking at the price to earnings, when the US is close to double China, I think that gap should be closer, particularly when you think about the structural change that’s happened. Now that you’ve got the likes of Alibaba and Tencent – which I think are definitely comparable to the big internet names, your Facebooks, Amazons etc. of the world – with those representing 25% of the index, I think that gap should definitely close. I think you can argue that the growth prospects are at least as good as the US-listed peers for better valuations.

As I said earlier, I think China is going to become harder to ignore. The fact that we’re seeing some great companies coming through, really delivering on their strategies, it’s going to become more of a mainstream market. We have some big investors who like the fact that the trust is big and liquid, unlike a lot of the other options out there. If you put those things together, I think there’s pretty good potential for the discount to close over time and for us to bring in new investors, and as you said, more institutional money.

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