Money Makers | 2019 Handbook

Rating investment trusts

27th November 2018

TONY YOUSEFIAN, investment trust research analyst at FundCalibre, explains what he and his colleagues are looking for when assigning a rating to an investment trust.

Investment companies have been around for 150 years. Having survived a number of world wars and stock market crashes, the longevity of many surviving trusts is impressive. A key advantage is that the closed-ended structure of investment trusts lends itself to taking a long-term view on investment opportunities.

According to the Association of Investment Companies (AIC), more than half of investment companies have had the same fund manager at their helm for more than a decade.* Almost a quarter (23%) have had at least one of their managers in charge for 20 years or more. Considering how many of us in other roles change jobs far more regularly, this is a surprisingly large percentage.

Another important factor is that investment companies have a board of independent directors who oversee the management of the investment company and provide continuity. With 400 trusts from which to choose, selecting the right one for your portfolio can be daunting, especially if you are also looking at the 3,000 rival open-ended funds on offer. But there is help at hand. Fund researchers have the job of narrowing down the choices on offer to a more manageable number of funds they think are the best. It is notable, however, that only a few conduct research into investment trusts. FundCalibre is one.

The way we analyse investment trusts

For us the longevity of the manager is vitally important. This is because we like fund managers, whether they run open-ended or closed-ended vehicles, with longterm track records. It means they have experience of investing through all the different stages of a stock market and economic cycle, not just the good times. You should never confuse a bull market with investment genius, as the old saying goes.

The longer the track record, the more effectively we can analyse the value they add. To do this we use a proprietary screening tool, AlphaQuest, that we have developed ourselves. AlphaQuest is the first stage in our fund-rating process. It is a quantitative screening system that analyses the past performance of a trust. We do this by stripping out the impact of market movements to identify the returns which can be directly attributable to its fund manager. It then measures the consistency of the returns that the fund manager produces, to help us determine whether they are genuinely skilled or merely have been lucky.

While many screening systems that analyse past performance exist, we think ours is unique because we attempt to calculate the probability of future performance as well. Our process is designed to produce an estimate of how likely a manager is to continue to deliver superior returns over the next 12 months. Managers must have a track record of at least three years to be considered and a trust must pass this screen before we will proceed further with our research. The best trusts on our analysis are then eligible to be given an ‘Elite Rating’.

Our process has three steps:

We start by running the AlphaQuest screen, as outlined previously. Only trusts that pass this screen and whose managers we think show a high probability of continuing to deliver over the next 12 months will proceed to the next step of our process.
Those fund managers who pass the AlphaQuest test are then subjected to further detailed qualitative analysis. Our experienced research team will interview the fund manager face-to-face, on at least one occasion, to better understand and assess how their investment process and style gives them an edge over other managers.
Once this analysis has been completed, the research will be subject to peer group review within our team. Only then will those trusts, whose managers we believe to be the most skilful, be awarded our Elite Rating.

Only a minority of trusts – about 30% of the total – survive the initial screening. To qualify we need to be able to assign at least a 60% probability to a trust’s next-year outperformance. Those trusts which qualify typically register between a 60% and 90% probability of achieving that; we have never found a fund that has more than a 90% probability of success, underlining that there are no sure things in investment. Since we launched the process three years ago, the open-ended funds we have given a top rating to have subsequently outperformed. We don’t yet have similar figures for the investment trust process, so it is too early to demonstrate a similar result.

We do want the Elite Rating to be a badge you can believe in. Unlike some agencies, we don’t run a tiered system of funds rated 1 to 5, or gold, silver and bronze. Our philosophy is simple: a fund is either good enough to qualify for a rating or it’s not. This means that we rate far fewer funds than our competitors (around 150 compared with more than 400), leaving investors with a much more manageable number from which to choose.

Other factors to consider

While the aim of an investment trust is the same as an open-ended fund, they do have other elements which we also need to analyse when considering them for a rating. From the perspective of a buy-and-hold investor, perhaps the biggest difference is that inflows and outflows of money do not affect the investment strategy of a trust. If a lot of investors all want to redeem their money from an open-ended fund all at once, it can result in the manager being forced to sell positions he still likes purely in order to meet those redemptions. This is not the case for investment trusts. That is what makes the closed-ended structure particularly suitable for specialist trusts holding assets that cannot be easily or swiftly bought and sold (such as property, private equity or very small companies). Trust managers don’t have to sell their holdings in order to release money back to investors looking to liquidate their investments.

(a) Discounts and premiums

Because an investment trust has a limited number of shares, the price of its shares is affected not only by the performance of the underlying investments, but by investor sentiment towards the trust itself. Sometimes in life, the more popular something is, the more expensive it is, and vice versa. The same is true for investment trusts. The price you pay for a share is based on the value of the investments held in the trust, but also on how popular the shares are.

If the shares are seen as desirable, their price may rise to a premium to its net asset value (NAV). If they are not so appealing, their price may fall to a discount. This means you are sometimes paying a bit more for a share in a trust or could be getting a ‘bargain’.

In theory, a discount allows you to buy into a trust for less than the value of the assets, but it is important to think about why it is trading at a discount. Is it a function of short-term negative sentiment or has the market identified a fundamental flaw with the investment strategy or fund manager? It isn’t a given that the discount will narrow or become a premium. Some trusts trade perpetually below NAV. You have to look at the history of the premium and discount.

Likewise, while you need to be wary of paying more for the value of the assets than you need to, some sectors have a long history of trading at a premium. Infrastructure trusts are a good example. This sector has traded on a premium, as high as 20% on occasion, for the best part of a decade or more. You need to look at a trust’s historic pricing to understand whether or not it is offering good value or not.

(b) Gearing

Another key element of an investment trust is gearing. This is the mechanism by which an investment trust borrows money in order to make extra investments, with the aim of achieving a return greater than the cost of the borrowing. For example, take an investment trust with a value of £100m. If the stock market is rising, the fund manager may see lots of potential opportunities. But to take maximum advantage, he or she might want to invest an extra £20m. Having borrowed the money to do this, the investment trust is now ‘20% geared’.

In the right hands and benign market conditions, having the flexibility to allocate more capital to favoured assets can pay off. When the market gathers momentum, an investment trust with gearing gets an extra boost. In 2012, for example, when Shinzo Abe became prime minister of Japan promising wholesale reform, the Japanese stock market was seen as attractive by many investors. Abe’s reforms (later coined ‘Abenomics’) held out the promise that he could finally lift the Japanese economy out of its longstanding deflation. Investors who were convinced that, after many years of false dawns, the reforms would have the desired effect were highly rewarded if they invested in a geared Japanese equity trust, such as the BAILLIE GIFFORD JAPAN TRUST. While the average open-ended Japanese equity fund returned 130.23% from 5 December 2012 to 1 October 2018, and the average Japanese equity investment trust returned 233%, Baillie Gifford Japan Trust (which is Elite Rated by FundCalibre) returned 332%.* On the flip side, of course, gearing can also exacerbate losses and volatility during times of market stress.

So investors need to look closely at how much gearing is permitted in an individual trust (a matter for the board to approve), how much gearing the manager tends to use and how and when they use it. This will differ from trust to trust. Investors need to be comfortable with the level of gearing, as it can increase the risk significantly.

Saving for a rainy day is an idiom we all know well. Investment trusts can do this too, via a ‘revenue reserve’. When an economy is strong, dividend payments from companies can be a great source of regular income for investors, but how reliable they are can be anyone’s guess. As we have seen in the past, companies can cut their dividend payments or stop them altogether if times are bad and they don’t have the spare cash to return to their shareholders.

During the good times, investment trusts can retain up to 15% of the dividends they receive in a pot called the revenue reserve. The more dividends the fund manager generates from a trust’s investments, the more money can be put aside for the future. During the bad times, when dividends become scarce, the fund manager can tap into the reserve and boost what might otherwise be a lacklustre dividend to produce a more steady return for the trust’s shareholders.

This stability of income can be especially attractive to investors who need a consistent income, such as those who need the income from their investments to help pay monthly bills. The AIC has a list of investment company ‘dividend heroes’ – trusts that have increased their dividends for at least 20 consecutive years. The dividend hero with the longest history, CITY OF LONDON INVESTMENT TRUST, managed by Job Curtis from Janus Henderson for the past 26 years, is one of our Elite Rated trusts. It has increased its dividend in each of the past 52 years. During that time Job has dipped into his revenue reserve on seven occasions to maintain its income-paying track record.

(d) The independence of the board

Last, but by no means least, accountability is becoming increasingly important to investors. Having an independent board is one way of ensuring this accountability. An independent board will be made up of a group of experienced professionals whose job is to support the fund manager, but also have a responsibility to identify if the fund manager is going o ff track and the authority to question how performance may be improved. They also act as a fair and objective earpiece for investors.

The quality of the board will depend on the quality of its members. We would also suggest that investors carefully examine the qualifications and track record of an investment trust’s board. How active have they been in looking after shareholders’ interests? Is there a discount control mechanism in place? Are they willing to issue shares when demand is high to avoid the investment trust moving to a high premium and to buy shares when demand is low and a discount has got too wide?

Conclusion

There is a lot to consider when choosing an investment trust but, with the right guidance, it is possible to make more reasoned choices and the outcome can be rewarding. We currently have assigned an Elite Rating to just 12 trusts. You can find more details of the trusts which have qualified from our website. The regulators rightly require us to say that past performance is not a reliable guide to future returns. When you buy shares in an investment trust you may not get back the amount originally invested and tax rules can change over time. However the knowledge that professional analysts have analysed a trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to have more confidence in making their own decisions.

12 Elite-Rated funds (as at the time of writing):

Baillie Gifford Japan

Baillie Gifford Shin Nippon

F&C Global Smaller Companies

Fidelity China Special Situations

Fidelity Special Values

Jupiter European Opportunities

Lowland Investment Company

Murray International

Schroder Oriental Income

Scottish Mortgage

The City of London

TR Property

Source: www.fundcalibre.com.

* The Association of Investment Companies, 19 June 2018.

* Source: FE Analytics, total returns in sterling, for the IA Japan sector, IT Japan sector and

Baillie Gifford Japan Trust, 5 December 2012 to 1 October 2018.

TONY YOUSEFIAN has been involved in discretionary investment management for both private client portfolios and funds, as an analyst and fund manager, since 1987. He joined FundCalibre as a research analyst in 2016.

Good directors are essential

27th November 2018

GEORGE KERSHAW, partner of the headhunting firm Trust Associates, which specialises in recruiting investment trust directors, explains what makes a good board member and why it matters so much. (Note: This article was first published in November 2018 and has not been updated).

What makes a good trust director?

George Kershaw: When trust boards approach us to help them identify new non-executive directors, they will usually have a formal or informal skills matrix. This will show us which specialist skills they would like to find in successful candidates to complement the existing skill base.

In addition, there are two important overlays.

The first is the character of candidates. Specialist skills can be hired in to cover particular issues. The non-executive director is expected to be able to put areas of specialisation into the broader context of the governance of the trust. To do this, he or she must be blessed with a wide breadth of view as well as good judgement and the charm to put across ideas and suggestions constructively. It is important that they are easy to work with.

We also observe that many successful candidates have impressive academic credentials. Sweeping generalities have many exceptions but it is probably fair to say that investment company directors require more cerebral excellence than entrepreneurial talent.

The second important overlay is diversity, in particular, gender diversity. When we started in 2002, only 6% of non-executive directors were women and a significant proportion of trusts had male-only boards. It happens that 30% of successful candidates appointed through ourselves have been women. That figure has been constant over many years, as well as more recent periods. The installed base of directors is indeed now rising towards that figure and has reached 22% as of July 2018.

Has the process by which they are chosen changed in recent years?

GK: Considerably more care and time is required of boards in appointing new non-executive directors than in years gone by. Much of this increase has followed from the introduction and refinement of governance codes. The Code of Corporate Governance (the Code) is advisory and relies on the principle of ‘comply or explain’, meaning that boards must give an explanation if they fail to follow the code’s guidelines. (This is in contrast to the Listing Rules that trusts agree to when they list their shares on the stock exchange, which are compulsory.)

Many boards have tended to opt for ‘explain’ rather than ‘comply’ to justify the continuation of their previous practices, but the increased focus on governance has meant that boards feel under increasing pressure to comply. The relevance of this to the process of new appointments is that the code enjoins boards to recruit new directors through open advertising or the use of search consultants (principle number 20 in the 2018 Code).

This has now been in place for several years and there are now very few boards which ignore this principle. In practice, very few boards opt to advertise new non-executive director searches as they do not have an HR department to process applications. One of the more obvious changes to the recruitment process has therefore been that search consultants are involved in the vast majority of appointments.

Many boards are more clear about which set of skills are required in the successful candidate as a result of two other governance-oriented practices which are increasingly commonplace: an ‘away day’, when all the directors can meet to discuss the progress of the trust without the distraction of normal board business, and a formal process of board evaluation which is now required at least once a year.

As the use of search consultants has increased, we notice that most boards now require more than one firm to pitch for the business. In the early days, it was much less common for consultants to be appointed through a competitive tender process.

Is the quality of directors higher than it was?

GK: The make up of boards has changed significantly in the 21st century, largely as a result of changes to the Code – in particular, the requirement to use headhunters and the encouragement to limit the terms of non-executive director to nine years. Shareholders, and their voting agencies, also more frequently vote against the reappointment of directors. Boards were accused, before these changes, of being ‘pale, male and stale’ and ‘clubby’.

There was a certain amount of justification to this comment. ‘Pale’ is still an accusation with some validity, although that is beginning to change as more non-gender diversity feeds into the areas from which candidates are selected. ‘Male’ is much less of an issue in even quite recent history as the installed base of women directors rises towards 30%. For search consultants, it remains quite a challenge as the percentage of women who have achieved senior positions is lagging so far behind the percentage of women appointed to boards.

Successful candidates have mostly achieved very senior status by the time they are likely to be considered for board positions. However, the percentage of women who occupy the senior roles in fund management, for example, is still only about 7%. In consequence, successful women can be in strong demand and some individuals can receive a large number of approaches. One impressive woman, who we were fortunate to put onto a board shortly after she retired from her executive career, subsequently received no fewer than 40 invitations to join boards as a non-executive director.

‘Stale’ is also much less of an issue now, largely because of the Code. The 2018 version of the Code, due to take effect in 2019, has clear language discouraging chairmen in particular from serving more than nine years. The use of headhunters has significantly increased the pool of potential candidates and reduced clubbiness. The average number of directorships per director has now fallen to 1.3. Interestingly, the figure for women is 1.6.

The use of search consultants has also tended to reduce the influence of their investment managers, who were frequently previously invited to act as search consultants. This, together with the more strongly worded Code and the increased propensity of shareholders (and their voting agencies) to vote against director re-appointments, has resulted in increased director independence from the investment manager.

Most observers would agree that these changes have resulted in higher quality directors who are paid more than they used to be and take their duties more seriously. It is also fair to point out that some investment managers have not welcomed these changes and accuse boards of focusing too much on corporate governance and not enough on encouraging, and assisting, the managers to produce good returns.

What in practice are the board’s most important functions?

GK: The role of directors of investment companies has changed over the years. If you travel back far enough in time, investment company boards met monthly to make changes to the trust’s portfolio as they thought fit. The role of the manager was to implement the changes which the board had decided upon and to deal with the administration of the company. The key skill of the directors was therefore experience of fund management. These trusts were almost all ‘self-managed’. Over several decades, this has changed markedly in both respects.

There are only a small number of self-managed investment trusts where the investment management company is owned by the shareholders of the investment trust. Alliance Trust is the largest such example today. The board of such a trust is therefore responsible for the running of the company through the executives of that company. The board is ultimately responsible for all issues such as the remuneration of the senior executives and corporate acquisitions and disposals.

The vast majority of trusts, however, have no employees and deal only with third-party organisations. The role of the boards of such companies is to represent the interests of their shareholders who also are their customers (unlike most PLCs). Most directors of investment trusts would agree that the most important function of the boards of these companies is to check that the portfolio of the trust is run in accordance with the mandate which has been explained to shareholders and that it is run as well and as cost effectively as is possible.

Where the performance of any of the third-party suppliers is deficient, it is the board’s role to assess the alternatives and, if necessary, to cancel their existing contract and to select an alternative supplier.

Many boards nowadays will have an ‘away day’ to address these high-level responsibilities as well to consider any significant changes that they should consider in terms of mandate or investment manager or, indeed, whether they should consider winding up the trust and returning the proceeds to shareholders.

If we look at the board’s functions through the eyes of a search consultant, we can focus on the skills criteria that we are instructed to use. In each case, boards are after individuals who know which questions to ask and are able to understand whether the answers are satisfactory. The criterion which arises most is experience of fund management; not perhaps surprising as these are investment trusts. Boards are after an understanding of what the selected fund manager is trying to achieve and, ultimately, whether they are doing it well enough. Should the board need to interview alternative managers, experience of fund management is essential.

The next criterion which arises frequently is a requirement for an accounting qualification, normally in the case of a search for an audit chair. While not a Code requirement, most boards do now require the chair of audit to have such a qualification. This might easily be added to one of the other skillsets which the board has identified as being desirable, such as investment management as per above.

Less frequent, but still quite common, is some experience of marketing. One of the ways of minimising the discount of share price to net asset value is to ensure that the shares of the trust are being well marketed.

An understanding of the technical aspects of investment trusts is also quite a frequent criterion. This has become more valued as the range of tools available to trust boards has increased.

For example, boards now have considerable powers to influence the level of discount at which the share price stands to the NAV. Discount control mechanisms (DCMs) are now commonplace and varied.

Where can boards go wrong?

GK: Unfortunately there are many examples of boards which have failed to use these powers wisely. A typical example is of one trust which invested globally. It had had a share buyback programme in place which had kept the discount at less than 10%. The chairmanship changed as a matter of course and after his departure the board lacked both technical investment trust knowledge and anyone with marketing experience. The buyback program was abandoned without putting anything else in its place.

Predictably the discount widened and that prompted a hedge fund to pick up a significant holding in the shares at a discount of 15%. The board then reversed its decision and brought back the hedge fund’s holding at a discount of 5%. The hedge fund consequently made a profit at the expense of shareholders and questions were rightly asked about the quality of corporate governance. Other international trusts have made similar mistakes, which all stem from a failure to understand why the discount was so large and how to address the problem in a way which benefited the current shareholders.

There are many examples of boards which have made unwise decisions because they did not have appropriate experience. One notable example occurred when the board of an investment trust with a mandate to invest in Japan, despairing of the Japanese market’s continual weakness, switched the investment manager and gave the mandate to a company running hedge funds.

This might have been a smart move, but for two factors. The first was that the switch was made just as the Japanese market rose by nearly 10%. The new manager had hedged the portfolio against further falls. Shareholders therefore were both sorely disappointed and surprised that they had gained nothing from the rise in the market.

The second was a serious lapse of good governance by the board. They had failed to canvass the views of shareholders. Had they done so, they would have known that most shareholders held the shares because they wanted some limited exposure to the Japanese market. It was not the role of the board in this instance to take a view about whether Japan was a good place to invest without asking shareholders and explaining very clearly how they had changed the mandate of the trust.

It is not surprising that the consequence was that the board was replaced on a shareholder vote and the trust was liquidated. These examples are now quite rare because directors take their duties more seriously and the standard of corporate governance has significantly improved across the board. Investors who buy shares in investment trusts are entitled to think that the board is acting in their interest and should rightly be held to account if they are not, as increasingly they are.

GEORGE KERSHAW co-founded Trust Associates in 2002 and focuses principally on finding non-executive directors for investment companies, as well as a variety of other projects, including research into shareholder attitudes, share buybacks and corporate governance. He led the CSFB investment trust team from 1996 to 2000.

Investing in alternatives

27th November 2018

Investment trust expert MAX KING provides an introduction to the fast-growing alternative assets sector. (First published in 2018 and not updated but still very relevant).

According to Simon Elliott of brokers Winterflood, only 55% of the investment funds sector is accounted for by funds investing in equities. The remaining 45% – and the fastest-growing part of the sector – is accounted for by funds investing in ‘alternatives’ to equities. This growth has been fuelled by an insatiable demand for high-yielding funds. Charles Cade of brokers Numis estimates that alternatives accounted for 65% of issuance in the sector in the first half of 2018, after 76% in 2017 and 85% in 2016.

Lumping all these investment companies into a single category risks masking the diversity of where and how they look to make money. The alternatives sector comprises a number of quite different vehicles. The main sub-sectors are property, debt instruments, infrastructure, private equity and renewable energy. In addition, there are specialised companies that invest in niche areas such as aircraft leasing and music rights.

There is clearly no lack of choice – and, if this rate of expansion continues, alternatives will soon be dominating the whole investment funds sector. Some caution is advisable. History shows that issuance of new trusts is often the result of investment fashion as much as of soberly-judged opportunity, and fashions tend not to last. None of the Lloyds insurance vehicles launched in the 1990s, for example, now survive; they turned into insurance companies before being taken over. The listed hedge funds or funds-of-funds which were popular a decade ago are steadily disappearing as a result of disappointing returns. A number of the income funds launched in the last ten years have recently hit pockets of turbulence or worse.

Nor are alternatives a new phenomenon. Many of the UK’s oldest investment trusts, including FOREIGN & COLONIAL (dating back 150 years) and SCOTTISH MORTGAGE, were not founded to invest in equities but in fixed-interest securities. They switched from ‘alternatives’ to equities along the way and would probably not have survived if they hadn’t. Living up to the promises and projections in terms of investor returns made at launch has always been a challenge, especially as the world changes.

Driven by the search for income

There is little doubt what has powered growth in recent years: it is the search for income. Negligible interest rates and very low bond yields have compelled investors to look elsewhere for income to live off. Equity income has been popular, but investors have also sought assets which have a low correlation to equities (which are assumed to be volatile and risky). The one thing you can rely on is that whatever investors want at any one time, the eggheads in the City will always provide.

The core problem for investors is that when interest rates and bond yields are low, a fund that pays a yield of 5, 6 or 7% without drawing on capital has to be taking a lot more risk. Its investment return before costs will be even higher unless returns are leveraged up with debt, which is risky in itself. Unfortunately, there appears to be a behavioural flaw in the thinking of many investors; they assume that the yield, if not its upward progression, is guaranteed. This is certainly the belief of a fund’s managers and sponsors, but it doesn’t always work out that way. If things go wrong, or the rules and regulations change, the danger is that a promised payout will be cut.

Investors also forget the old adage that ‘a bird in the hand is worth two in the bush’. Turned around, it means that income now will be coming at the expense of rather more capital growth in the future. Ideally, investors would maximise total return (income plus capital gain) and be happy to draw on capital to supplement income, or to invest in funds that do that. But the Victorian belief that spending capital is a sure path to the poorhouse persists.

The reality is that income certainly matters, but so does income growth – and it is the latter which is the driver of future capital gains. With capital gains subject to taxation only on sale, and even then only outside SIPPs and ISAs, investors should logically be happy to sacrifice some income for capital growth. But that is not the way fund flows into the trust sector have been running. So before investing in an alternative asset fund paying a generous yield in a world of 2% inflation, it is important to understand where the yield is coming from and how sustainable it is.

Gauging the risk of a particular trust is not always easy. Be extra careful when there is an assurance, implicit or explicit, that a trust is somehow ‘low risk’. Don’t automatically assume that those managing or promoting a fund fully understand the risks behind their business models.

Breaking down the risk spectrum

At the top end of the risk spectrum sit listed private equity funds. Many of these funds came a cropper in the financial crisis due to leverage and excess commitments to new investment. Some were panicked into distress fundraising, some went into wind-ups and some ploughed on. Since then, they have, with one or two exceptions, prospered, benefiting from good underlying performance and narrowing discounts to asset value. In some cases, returns have been spectacular. Although the private equity cycle is now well advanced, there could well be more to go for. According to the Financial Times, the private equity industry worldwide has $2trn of uncommitted funds to invest, meaning it’s a better time to sell assets than to acquire, but managers have learned their lesson and become more cautious than in previous cycles.

The sector divides into direct investors and funds which invest in a range of unlisted private equity funds. The higher visibility of the investments of the former generally results in lower discounts to net asset value. Asset values are usually conservative and out of date so value is often better than it appears. Funds such as 3I, HG CAPITAL and (until Edward Bramson seized control) ELECTRA, which consistently sold assets at large premiums to book value, demonstrated this. They have been the ones to own, while those that sold at poor prices or failed to sell, such as CANDOVER and BETTER CAPITAL, have been poor investments despite being available on enticingly wide discounts.

Funds-of-funds suffer from an extra layer of fees, but they provide a diversity of managers and access to funds otherwise not available to most private investors. An average return of 75% over five years is impressive and suggests that the double-digit discounts at which all five of them have been recently trading may be unwarranted.

The private equity sector is shrinking with seven funds in ‘managed wind-up’ and one (Candover) already gone, compared with just one recent arrival – APAX GLOBAL ALPHA in 2015 – with the highest yield in the sector at over 6%. The trusts in managed wind-up offer a guarantee that their discounts will disappear as the date of wind-up approaches, but they cannot guarantee how well their investments will perform, not least because the remnants of their portfolios – the ‘orphan assets’ they have not so far managed to sell – are likely to be among their least successful investments.

Also investing in private equity are a few specialist funds such as RIVERSTONE ENERGY and SYNCONA. Riverstone invests in oil and gas fracking prospects and projects in North America; given how strong oil prices have been in 2018, the flat performance of its shares and the persistent double-digit discount to net asset value must count as disappointing. That could not be said of Syncona, which is transitioning from what was an innovative investment fund-of-funds to a UK-focused investor in early-stage life-science companies. Its shares have risen 50% in a year.

One of the most remarkable fund issues of 2017 was the raising of over $500m of new money by CATCO, which uses its capital for catastrophe reinsurance. This was in the wake of a disastrous sequence of hurricanes and fires which halved its share price. Presumably, investors who subscribed for the new shares blamed the weather rather than the managers. Catco has always been open about the risks in its business, but investors may have been lulled by the high yield paid in good times.

Possibly less risky but also promising high yields are the £720m BIOPHARMA CREDIT fund, which is investing in the debt, secured on royalties, of life sciences companies, and HIPGNOSIS SONGS, which recently raised £200m to buy catalogues of old songs. Whether either fund has secured the right deals to deliver the promised returns over time remains to be seen.

Infrastructure funds have come in for considerable criticism not so much for taking excess risks as for being overpaid for the supposedly low risks of privately-financed investment in the UK public sector. The high returns have largely been the result of falling bond yields which made the income streams from these projects, secured for up to 30 years, especially attractive, but the politicians who were once desperate for this investment don’t like being made fools of. Dire retribution is threatened, regardless of signed contracts.

This type of project accounts for a diminishing proportion of the infrastructure funds, who are busily diversifying into private sector and international projects while showing much less interest in dealing with the UK’s public sector. The long-term consequence will be a drying up of private capital for public investment in the UK but that is not a concern for investors. The recent bid for JOHN LAING INFRASTRUCTURE suggests that all the political scare did was create a long-term buying opportunity.

Less controversial are the infrastructure funds which focus on renewable energy. Investors have steadily overcome their initial suspicion of these new vehicles, meaning that they all now trade at premiums to asset value. The suspicion was based on the large subsidies that solar and wind power have needed to be economic, the cost of which is passed on to consumers in higher prices. But so long as the consumers haven’t noticed, or aren’t bothered by this hidden tax, then the politicians, hungry for green credentials, don’t seem to care. Anyway, the subsidies on new projects are falling as efficiency improves.

The funds investing in debt are returning to the roots of the investment trust sector. Some funds invest in fixed-rate debt, some in floating, some in long-dated income streams, some in short-dated. There are funds investing in high-yield bonds, distressed debt, unlisted loans and regulatory capital for banks. There is no emerging market debt fund, but that is probably not for want of trying. The diversity reflects the ebb and flow of sentiment towards fixed-interest securities and trends within the market rather than a campaign to cover all bases.

They all offer attractive yields but the opportunity for income growth and hence capital gains comes largely from retained earnings, which in turn depends on the skill of the managers. Yields are higher when the income is secured on specified assets rather than on the company as a whole, justified by the struggles of some funds whose security turned out to be faulty. Is the 6.9% yield on UK MORTGAGES too good to be true or a bargain? Its manager, TWENTYFOUR ASSET MANAGEMENT, is well regarded and manages two other listed income funds but the security of residential property could prove illusory in a recession.

The financial crisis and subsequent restrictions on banks led to a surge of interest in peer-to-peer lending. The result, inevitably, was the launch of six funds with £2.5bn of capital, appealing to those who prefer a collective vehicle to direct lending. Unfortunately, we will not know how good their credit control is until we have the next economic downturn. One fund has already had to make material provisions for credit losses, but it could be a mistake to be too cynical. The quality of credit control in commercial banks has always been low, particularly for smaller commercial and personal loans handled out of bank branches. These funds, helped by more modern IT, may be able to do it better.

Once upon a time, you had to be really rich to invest in hedge funds. These funds, discreetly boasting stellar returns, were famous for their exorbitant fees (a 2% annual management charge, plus 20% of all returns) and the doors were firmly closed to latecomers. Their managers billed themselves as the cleverest whizz kids on earth, enjoyed rock-star status and even greater riches. Then the exclusive clubs opened their doors to everyone, the mystique vanished and it was downhill all the way in terms of performance. Some managers were too rich to bother to come into work anymore, some lost their ‘magic’ touch, some failed to recognise that market conditions no longer favoured the strategies they had followed.

As a result the ranks of the investment trusts following hedge fund strategies grow thinner every year, but it may be too soon to write the sector off. Aftermseveral years of dull returns, BREVAN HOWARD posted a 9% return in the second quarter for its macro fund and 5% for its global fund, as some big bets on bond spreads in the eurozone paid off. Bill Ackman’s PERSHING SQUARE, whose fortunes peaked when it listed in Amsterdam in 2014, appears to have returned to earlier form after three down years. It still trades at a 23% discount to asset value.

The final segment of the alternative funds sector is property. Confusingly, many property companies are structured and taxed as ‘real estate investment trusts’ (REITs) but are not included in the investment trust sector. As a generalisation, property funds seeking to harvest the income from property ownership are in, while development companies which focus on adding value to their holdings are out – but this is not a hard-and-fast rule. SEGRO (out) has owned the Slough Trading Estate for 100 years, while F&C COMMERCIAL PROPERTY TRUST (in) has been a fairly active developer. Many conventional property companies also pay generous dividends and trade on large discounts to net asset value. They may prove a better investment than some of the property investment companies with high yields, which have less potential for added value and trade above net asset value.

Among the specialist funds, PHP (not in the sector), MEDICX (in) and ASSURA (not in) all own doctors’ surgeries on long-term leases which have been guaranteed by the NHS, making them comparable to infrastructure funds. IMPACT and TARGET HEALTHCARE do the same with care homes, but without the guarantee. EMPIRIC and GCP STUDENT LIVING own and rent out student accommodation, supported by partner universities but so does UNITE, the first operator in the area, which is a company rather than a fund. There are funds owning and leasing supermarkets, logistics warehouses and social housing; all of them promise a high and rising income, but with very different risks. The NHS will always pay for doctors’ surgeries, but care home operators can (and do) go broke. Well-located logistics warehouses may be irreplaceable, but student accommodation may not be. Housing associations should have access to cheaper finance than they can get through a listed fund.

Other property funds invest more broadly, focusing on generating an attractive and rising income from higher-yielding properties, plus an element of added value. Five funds invest in Europe of which two are focused on logistics warehouses and one on flats in Berlin, but the best exposure to Europe (62% with the rest in the UK) comes from TR PROPERTY, the only investment trust which invests in property company equities (93% of the portfolio) rather than directly into bricks and mortar (7%).

In conclusion, alternative funds are a disparate lot and investors need to tread carefully, thinking objectively about the sources of income and risk. High income does not come without risk and income growth is important for capital returns. Issuance is often a reverse indicator of future performance, so it is usually better to wait until they have proven themselves before investing. But alternative funds can also provide excellent opportunities. The shares of private equity fund-offends PANTHEON INTERNATIONAL, which sunk low in 2008, have since multiplied tenfold in value. There may be hidden jewels in what investors throw out, but all that sparkles is not gold.

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 two trusts.