With the retail distribution review only a few months away there has been an increasing amount written on the opportunity for the investment trust sector to at last compete properly on a level playing field with open-ended funds. Many commentators (and indeed the Association of Investment Companies) have over the years argued that the lack of commission available to advisers by recommending investment trusts to clients has held back the distribution opportunities for the closed-ended industry.
Under RDR, independent advisers are required to give equal consideration to investment trusts, although in practice some may find this hard to implement as few fund supermarket platforms support closed-ended vehicles. However one way to address this is may be by using multi-manager funds that focus on investment trusts.
While the benefits of investing clients in multi-manager funds have been well-known for almost 25 years, the funds industry has in that time almost exclusively focused on the design, launch and promotion of multi-manager funds of open-ended funds (investing in unit trusts and Oeics). It could be argued that there is a good knowledge of a wide range of these funds, all offering by-and-large a similar concept. What is perhaps less well-known is that there are numerous benefits to investing in investment trusts, with a small number of product providers offering multi-manager funds of investment trusts.
There are many “best in class” fund managers in the investment trust sector and some are already well-known due to their open-ended offerings (these include Neil Woodford, Hugh Young, Richard Buxton), while others are perhaps less so (for example Gerald Smith and Susie Rippingall). These fund managers are able to manage their portfolios exactly as they see fit and are not subject to large amounts of money flowing in or out of their funds that can affect what they are trying to do. This closed-ended nature also enables investment trusts to access asset classes that may be inappropriate in an open-ended fund due to their illiquid nature. These include private equity, hedge funds and property.
From an investor’s point of view there are other advantages using investment trusts. Investment trusts are of course closed ended and have a net asset value (the value of the portfolio divided by the number of shares in issue) and a share price that trades at either a discount or premium to the Nav. The sector is still an under-researched part of the market and there are often discount or premium anomalies that can be taken advantage of to generate extra returns. Cost of investments has become a thorny subject in recent times and yet again there are plenty of examples where investment trusts have an edge. The allure of permanent capital for a management company is strong and so investment trust boards (which are required to be independent) are often in a good position to drive a hard bargain on management fee arrangements meaning that there are many investment trusts that have pretty attractive total expense rations.
Perhaps one of the most powerful tools of an investment trust is its ability to use its balance sheet, not only to employ gearing in a rising market but also to use their revenue reserves to smooth out dividend payments, even when dividends across the market are under pressure. This proved to be invaluable to an army of private investors during 2007 to 2009 when many open-ended funds had no choice but to cut their payouts while relatively few investment trusts did so.
All of these positives have led to some impressive long-term performance from the investment trust market, particularly when compared to their equivalent open-ended peers.
There are a small number of multi-manager funds that specifically invest in investment trusts and other closed-ended companies. Many of these take a multi-asset approach and make full use of the range of asset classes that the investment trust structure affords - cash, equities, fixed interest, hedge funds, property and private equity have all been represented in many portfolios. Many multi-manager products operate exclusively in the open-ended arena and ETFs, meaning they ignore some gems that can be found in the investment trust sector. Investment trusts, in my view, are ideal vehicles for asset classes which are not highly suited to the open-ended structure such as property, private equity and hedge funds. Their use can help to achieve a multi-asset approach which mitigates risk and enhances returns across a selection of asset classes. This multi-asset approach that investment trusts offer is perhaps not as generally recognised by advisers as it could be. To attempt to achieve ‘balance’ without considering investment trusts makes no sense.
In the current climate, where market sentiment seems to lurch between ‘risk-on’ and ‘risk-off’, most advisers seem understandably afraid to make any significant calls on the market for fear of being overweight or underweight equities ahead of policy announcements on Europe. The potential binary outcome makes putting new money to work a tough decision, as holding onto cash, which offers very little return and will probably see its value eroded by inflation, is not ideal. One way in addressing these challenging market conditions is by investing in the investment trust sector and specifically those trusts that have a fixed life and currently trade on a discount to their asset value. In the scenario that the market moves ahead their asset values could also increase and the return will be enhanced through the discount naturally narrowing. In a less rosy scenario the asset value may well fall but this could be partially or fully offset by the discount narrowing. The key consideration here is how well the current asset value will hold up against the backdrop of weak equity markets. For example the listed fund of hedge funds sector has been shrinking fast in recent years. Average or poor performance has been punished with substantial discounts that have proved almost impossible to eradicate. The boards of many of these trusts have taken the decision (sometimes with a gentle shove from shareholders) to call time on their existence. Several others face continuation votes in the near future with the strong likelihood that they too will join the list of ‘dead men walking’. What makes this an interesting part of the market is that the winding-down process can take a lengthy period of time due to the illiquid nature of the underlying hedge funds. Several of these vehicles are therefore still trading at wide enough discounts to offer relatively attractive return profiles.
There is another also potentially powerful dynamic in place. As of April this year investment trusts have had the option of paying out dividends not only from income but also from realised capital gains, including reserves. This could potentially lead to many more well-established trusts with substantial capital reserves offering an enhanced dividend stream, thus increasing their appeal to investors in the current low interest rate environment. Westhouse Securities earlier this year released research on this topic that concluded that up to a certain level of yield there is a broad, direct relationship between yield and ratings (that is, those that pay better dividends witness narrower discounts, or even premiums).
In conclusion, the ability to access investment trusts should potentially be a key part of any portfolio, particularly in a post-RDR world. The features and benefits of multi-manager investing have been very well-known by advisers for many years – effectively delegating both the initial and ongoing asset allocation decisions, and the initial and ongoing fund selections, to a specialist third-party fund manager. The imminent arrival of the brave new world of RDR is putting investment trusts, in theory, on the map. It is a large market that requires specialist fund management knowledge, as although the biggest investment trusts are on the whole very good, there are a great number of gems that may get overlooked. For those advisers not wanting to directly access these bigger vehicles or who indeed would like a true range of trusts across the market cap spectrum, then a well managed fund of investment trusts could be an ideal solution. And to do so through the multi-manager route, using funds widely available on fund supermarket platforms, could well be the neatest way to meet RDR obligations – and consider the whole of the investment market thoroughly for clients.
James Burns is director and head of multi-manager of Smith & Williamson Investment Management
