Multi-assetJul 24 2014

Adding alpha with investment trusts

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Historically,investment trusts have been disregarded from multi-asset portfolios due to a belief the products are complex and expensive. But, multiple pieces of research have shown investment trusts on average tend to outperform their unit trust counterparts.

Table 1 shows the top 10 performing investment trusts and unit trusts in the UK Equity Income sectors over the past five years to 1 July according to Morningstar data. The top performing investment trust over five years is the £378m Lowland, owned by Henderson, which returned £3,470 over the period - 28.3 per cent annualised. The top performing unit trust is the £652m Unicorn UK Income fund, which returned £3,118 - 25.5 per cent annualised. Although these are just the top performers, it can be seen from the average funds that an investment trust outperforming is not a one-off. The average investment trust returned 19.3 per cent, while the average unit trust returned 14.6 per cent annually over a five-year-period.

Instead of investing directly in investment trusts, investors have the option to add the funds to their existing portfolios, or buy into the increasing number of multi-asset funds which have an allocation to the vehicle. Investment trusts have many advantages over unit trusts, and Elizabeth Savage, assistant fund manager and head of research of the Rathbones Multi-Asset Portfolios team, says using investment trusts within the funds is a great source of smart alpha. “One of the key advantages of investment trusts relates to access. You can access different asset classes that you couldn’t otherwise in an open-ended structure. One example we use is the Neuberger Berman Floating Rate Income fund, which invests in bank loans. We bought it because we were looking for assets that benefit from rising interest rates. The caveat is that we think the spreads are quite narrow now.”

“You can buy a bank loan in an open-ended fund but we don’t think it is appropriate because of the secondary period of close to 30 days in Europe. Therefore if the fund experiences outflows, there could be an issue with regards to liquidity mismatch, so closed-ended vehicles are the only type of fund we are comfortable with using for that,” she adds.

Lead generation

Ms Savage thinks that investment trusts are a great way to generate alpha when the market is at fair value. However, she says another angle to investment trusts is that there are a lot of under-researched funds. “It can be a mixed range and not that straightforward,” she explains. “Sometimes it is too much hard work for investors to really get to grips with it. But we aren’t shy to put in the legwork and do some due diligence. It can really pay off.”

For example, the Rathbones team invested in the Investors in Global Real Estate investment trust, a London stock-exchange vehicle based in Guernsey. The fund invests in a global portfolio of listed real estate companies.

Ms Savage explains, “We invested in 2009 when the sector was out of favour and a lot of funds were in distress due to over-leverage. Investors hated the sector and a lot of trusts were trading at a significant discount. We realised it was essentially just a global Reits portfolio with roughly 20 per cent in physical property. But because it wasn’t that straightforward on paper, investors thought it was a nightmare. We thought there were no problems and believed the discount had to narrow at some stage, and it has come to fruition.”

Elsewhere, for Simon White, head of investment trusts at BlackRock, using closed-ended vehicles allows the investor to access less liquid areas than a typical open-ended fund can, particularly when looking at emerging markets and smaller companies. “In many cases it is easier to manage a pool of assets where you’re not going to be hit by unexpected redemptions.”

“The other thing we have noticed when looking at multi-asset funds is that managers are looking for a spread of the index. It is often the closed-ended funds that form the core asset allocation of any region. The ETF element is used to make a tactical adjustment,” he says.

Mr White says smaller companies have proven to be strong long-term performers. Smaller companies have generated larger returns and closed-ended funds are seeing returns on individual investments.

Since the RDR, Mr White adds BlackRock has seen growing uptake among financial advisers in investment trusts. However, it has been the self-directed investors that the group has seen larger inflows from. “As the number of advisers nationally has reduced, many investors are going self-directed through fund supermarkets or sub-contracting to wealth managers.”

For advisers, many have been seeing an increase in investment trust allocation. Gone are the days when the funds were too complicated and expensive to use. According to figures from the Association of Investment Companies (AIC), more advisers have been buying investment trusts on platforms in the first quarter of the year. Total purchases of investment companies reached £106.8m in the first quarter, a 23 per cent increase on the £87.1m invested during the same period in 2013 and a record high for a quarter. Purchases of investment companies in the 12 months to March reached £394m, up from 60 per cent on the same period in the previous year (£246m).

The data also showed sales of investment companies reached a record high of £77.3m, suggesting some advisers and wealth managers are taking profits and rebalancing portfolios.

Paul Coffin, chartered wealth manager at London-based Capital Financial Markets, uses them “a great deal”. “Investment trusts usually have a lower management charge, and studies have shown them to perform better,” he says. “I prefer that they are listed on an exchange and can have directors holding the management to account. That is a major advantage over unit trusts and ETFs.”

“I usually buy direct equities and bonds, but use investment trusts for specialist or overseas exposure; for example, Murray International and RIT Capital. 3 Infrastructure and Ecofin Power and Water are two interesting specialist funds and in the Far East, Utilico Emerging Markets is interesting,” he says.

But not all advisers are fans of closed-ended vehicles. Scott Gallacher, chartered financial planner at Rowley Turton in Leicester, says some of the under-use of investment trusts might be due to advisers becoming restricted after the RDR and not having the option of recommending them. “Personally, while we always consider investment trusts, and do use them for some clients, there are some drawbacks,” he explains.

“The lower management charges are naturally a good thing, however this is not always the full story as some investment trusts have ‘performance’ fees. Effectively additional management charges over the long-term will erode investment trusts’ competitive charge advantage compared to unit trusts or Oeics.”

Mr Gallacher says his main concern is these factors are a ‘double-edged sword’ insofar as while they can add to long-term returns, they can also increase the risk on the funds. “As a result, investment trusts can be much more volatile than the alternative. In my own experience, many clients are generally risk averse to some degree or another, and this additional risk is not appropriate for the majority of our clients.”

Although not all advisers will agree on using investment trusts directly, the closed-ended structure can add real variety to a diverse portfolio and more fund of fund and multi-asset managers are looking to the vehicles.

Now more investors are creating individual portfolios, the vehicles can be seen as a smart way to generate alpha within an investment pot.