Market trends and returns

As closed-ended funds, they work like any other company where investors buy shares. The money raised is reinvested by the trust and if the underlying investments do well, the share price of the investment trust rises.

Some advisers believe investment trusts to be sophisticated or expensive compared to their open-ended equivalents. But the RDR’s abolition of commission payments and increased access to investment trusts through platforms have removed some obstacles to growth. But has this inspired any significant change in investor sentiment?

“Investment trusts have been well placed to benefit from the recent changes to pensions and increasing demand for income as they have the ability to retain up to 15 per cent income each year, which enables them to distribute a more consistent income stream to investors over time,” says Jonny Rusbridge, investment manager at Devon-based Seabrook Clark. “Furthermore, we have noticed that some investment trusts now tend to pay out dividends on a quarterly basis, which is attractive to investors from a cashflow point of view.”

Mr Rusbridge also points out that in 2015, the majority of investment trust initial public offerings (IPOs) have involved strategies which invest in illiquid assets. “One example is Woodford’s Patient Capital Trust, launched in April, which invests in early-stage and early-growth companies,” he said.

Advisers encourage their clients to invest in investment trusts for a variety of reasons. “The investment trust sector is performing really well and on a like-for-like basis, if we look at the unit trust sector, the performance is much superior in investment trusts,” says Minesh Patel, a chartered financial planner at London-based EA Financial Solutions. “The costs are a lot less and second, because it is a closed mandate, they can offer a lot more discipline.”

Growing trends

While the investment trust sector has seen some growth in popularity, other interesting trends have come to light in the past few years. Tim Mitchell, head of investment trust sales at JP Morgan Asset Management says investing in alternatives is the biggest trend at the moment, especially relating to new issues.

Mr Mitchell says “That means investing not in the traditional asset classes – equities and bonds – but more in things such as infrastructure, and wind farms and solar parks. Today I saw one of the leasing funds has done a secondary issue. There have been mortgage-backed products as well.”

He further explains that investing in alternative strategies pays decent levels of predictable and frequent income since these assets behave differently to equities and bonds and an increasing number of wealth managers are looking to get more into their portfolio.

“There are only so many alternative assets out there, but I think what is interesting about the investment company sector is its ability to reinvent itself and to utilise the structure of a closed-ended fund with a corporate body structure,” Mr Mitchell says. “It means that it is very flexible, and it can invest in all sorts of things that, frankly, more traditional open-ended fund structures can’t.”

Mr Mitchell also highlights a growing trend of people looking to invest in areas which have a chance of good capital growth. He gives the example of emerging markets which, according to market analysts, is a tough place to invest. But he says there are more and more contrarian investors who are now thinking this is the time to enter into the market.

“It is not just a capital growth story,” Mr Mitchell says. “We run a trust which has capital growth but also pays a high level of income as well and it invests across the world, even in emerging markets, but focusing on companies that have the ability to pay high levels of dividend.”

Another trend is investment trusts’ continued outperformance against unit trusts. “In the decade before the end of 2014, investment trusts outperformed unit trusts in 12 out of 15 sectors,” Mr Rusbridge says. “This emphasises the ability of fund managers to magnify long-run returns by sensibly managing the level of gearing of their portfolios. Accordingly, as long-term investors, investment trusts make up an important part of our investment process.”

Performance

While it is interesting to note the growth in alternative strategies, the big question is what impact – if any – this has had on performance?

“When we look at a lot of the alternative closed-ended funds, we really did see what we hoped they would actually deliver,” says Mr Mitchell, “which is a very consistent return, both in terms of any fees, but more importantly in share price terms. And people weren’t selling them during the period of volatility in the latter part of August through September. If anything they were buying more of them, so we saw the premium ratings sustained through that period as well.”

Table 1 shows the cumulative performance of investment trusts over one, three and five years based on an £1,000 initial investment. According to the data from the Association of Investment Companies (AIC), supported by Morningstar, a total of 451 investment trust funds are invested across 55 sectors in all.

The Table shows the top 20 investment trust funds according to three-year returns. The top performing fund in this table is Oryx International Growth which is invested in global smaller companies with a three-year return of £2,500. It is interesting to note that almost half the funds in this table belong to alternative sectors.

There is a range of sectors that investors can diversify their funds into. These are grouped under regional and alternative strategies. “The sectors I am particularly impressed by in the investment trust space are the global sectors,” says Mr Patel. “Some of them have performed really well, as has the global equity income sector. UK Equity Income is also very interesting, so I do urge other advisers to look at investment trusts and compare to unit trusts if they are looking to build a portfolio fund.”

Using the AIC data, we worked out which were the top 10 and the bottom 10 sectors in the investment trust space based on the average cumulative performance of the funds over three-years. As Box 1 shows, Biotechnology & Healthcare is the top performing sector with an average return of £2,185 over a three-year period, 29.8 per cent annualised.

“In the past few years, biotechnology and healthcare sectors have performed very strongly,” says Mr Rusbridge. “In our view, Biotech/Healthcare is an appealing area in which to have sector-specific risk in the long run, where appropriate for a client’s risk profile. The use of investment trusts allows investors to pool risk and diversify this exposure, as well as benefit from leverage to enhance returns.”

He further points out that biotech stocks have benefited from unprecedented merger and acquisition activity, as well as excitement regarding medical science advancements. “While undoubtedly there will be long-term winners in this sector, it seems as though a ‘herd mentality’ has increasingly stretched valuations, causing concerns over a possible bubble,” he says.

Adding to that, Mr Mitchell said early stage biotech companies have had a very rough ride of late along with established pharmaceutical companies. Although he warned this was based on a short-term view of the sector. “Take a five-year view, which should be anyone’s real investment cycle and investment holding period. That I am sure will continue to deliver.”

Box 2 shows the 10 worst performing sectors, seven of which have still returned average profits over a three-year period. The worst performing sector is Commodities and Natural Resources with an average three-year return of £457, an annual loss of 23 per cent. This is followed by VCT specialist: Media, Leisure and Events and Global Emerging Markets.

It is not surprising that with fluctuating oil prices, the commodities and natural resources market has had a tough ride in the past year or so.

“Commodities have struggled in the last year as prices have collapsed,” says Mr Rusbridge. “Concerns over the health of the global economy and, in particular, China have accelerated the decline. While it is always dangerous to try to catch a falling knife, a specialist investment trust such as BlackRock Commodities Income currently offers a very high yield of 8.85 per cent plus recovery potential after a fall from peak to trough of over 50 per cent.”

Another sector that analysts sometimes warn against venturing into is emerging markets. While some funds offer higher yields, it is also important to understand the vehicle you invest in.

“I think the ones that have come under pressure the most have been single country – particularly single country emerging market trusts,” says Mr Mitchell. “So our Russia trust has come under pressure with the well-publicised issues, and sanctions and so on. And then the currency weakness plays a big part too.”

He further points out that, while Russia has underperformed, Brazil has also been a tough market lately with huge devaluations of the Brazilian real. “I think that is part and parcel of investing in the emerging markets, but also when you are taking single country exposure.”

Challenges

The investment trust sector might be lucrative and offer a diversified portfolio to investors, but it does come with its own set of challenges. Although often these are quite similar to what an equity-based unit trust may face.

A number of advisers and fund managers say that the biggest challenge with the investment trust sector is its reliance on equity investments and consequent exposure to the risks of a volatile market. They are also exposed to the markets’ reaction to events such as a rate hike from the US Federal Reserve or fluctuations in oil prices, as we have seen for the commodities and natural gas sector.

The other challenge, according to Mr Mitchell, is that the investment trust sector is purely actively managed. “As active managers, we need to ensure that we continue to outperform relative underlying benchmarks.”

He further explains that the reason for this worry is the ability of investors to make the final choice of deciding whether to invest on a passive basis, and to benchmark their portfolios to a passive ETF or index fund, “what I worry most about is ensuring that we continue to add alpha through the cycle.”

Also, several investment trust companies seem to be becoming more innovative in terms of fee structure post RDR. Mr Rusbridge gives the example of Woodford paying a performance fee in the form of new shares on any return over 10 per cent per annum, rather than an annual management charge. He explains that this could put more pressure on more established companies to do the same.

Mr Rusbridge cites the management of discounts as another big challenge, with many companies undertaking buybacks in order to close the size of the discount on the fund.

With more investment trusts entering the market, offering a range of funds with exposure to various sectors, the competition is increasing. A growing number of platforms are now offering closed-ended funds, making it easier for investors to access them. But while too much choice is not necessarily a bad thing, it also means that investors need to understand the market first before taking the plunge. Higher returns are attractive, but they come with a higher risk too.