Sep 28 2016

Spotlight: Changing tides

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Spotlight: Changing tides

When the investment background changes, so too should investment strategies, says Russell Taylor

When Shakespeare said, “There is a tide in the affairs of men, which, taken at the flood, leads on to fortune,” he was not only thinking of war and love, but also money. As one of Tudor England’s more successful entrepreneurs, he knew how important it is to be aware not only of changes to society itself, but also how they are reflected in business.

The actions of George Ross Goobey, head of Imperial Tobacco’s pension fund, provide a modern-day example of how to capitalize on life-changing moments. Mr Goobey made himself famous, and his pensioners rich, by switching from fixed interest investments – the safe and conventional choice for pension funds – to shares in British and American business during the 1950s. Thus was the ‘cult of the equity’ born. 

Mark Weinberg, first with Abbey Life and then Hambro Life, took this insight directly to British savers. Recognising in the graduates of the 1940s educational reforms a source of financially sophisticated employees who would upend the savings offers of traditional insurance/banking partnerships, he set up direct selling networks to offer share investment through equity-linked life policies.

That equity tide flooded well. From 1900 to 2000 the real – or inflation-adjusted – return on shares was 5.9 per cent a year. Add inflation at over 5 per cent a year, and those returns enabled sales people and their investors to do well out of equity investing, especially as those returns more than doubled to 15-18 per cent in the last two decades of the century.

Turning of the tides

But tides turn, and this one turned either in 2000 with the bursting of the tech bubble or in 2007-8 with the crisis of the world banking system. Since then, returns have collapsed in all asset classes, economic growth has all but disappeared, and the developed world is facing a pensions crisis. 

So, this letter from an adviser reader seems pertinent: “Having been a satisfied holder of Personal Assets for some years, I thought to myself that it could make sense to look for a fund of investment trusts. Although there would be additional costs to pay the manager of the fund, the lower-cost investment trusts within it would, presumably, lead to better results than with funds of unit trust-type funds. Looking under the Global section of fund statistics in Money Management, I see only three products – from Halifax, Jupiter and M&G.

“While I like the idea of funds of funds, I dislike the costs.  Really, I just wondered if you have an opinion on why they are doing so relatively poorly, compared to other unit trusts, and why they are so few in number. Also am I missing some convenient means of investing in a ‘basket’ of investment trusts, with the oversight of professional managers?”

Risks of the ebbing tide

The phrase, “While I like the idea of funds of funds,” may be a misconception. It is worth reminding ourselves of the original idea behind investment trusts, more or less up until the arrival of unit trusts in the early 1960s.

Until that time, private investors either bought investment trusts (unpopular or unknown for technical reasons in the decades after the war) or a portfolio of 15-20 individual securities. Such portfolios needed to be ‘diversified’, with perhaps a third in preference shares or other fixed interest stocks, and the remainder in a choice of companies ‘diversified’ among different sectors of industry or business services. 

The former supplied income, and a degree of capital security when markets were volatile, while the latter supplied the ‘growth’ or increase in income on a yearly basis, the function for which the portfolio was managed. This increasing income, in time, justified a higher valuation for some of the individual equities that made up the portfolio.

A unit trust, with its much larger portfolio, apparently offered greater security and so, theoretically, greater diversification and safety. Mostly sold by insurance salesmen on commission, since stockbrokers initially regarded unit trusts as competition, quickly unit trust investment ceased to be about the purchase of an income with spare capital, but the attempt to obtain ‘capital gains’. Unit trust managers also discovered their game was not about investment performance but size, or the gathering in and holding on to assets – that is, customers’ money. This suited all parties – managers, sales people and investors. If the first bet did not succeed, try another, with a different style, investment aim or geographical focus. 

This worked as the world recovered from the depression and war years, with an increase in prosperity and rises in the value of ‘real assets’ such as property and shares. 

Investment managers such as John Bogle, founder of Vanguard Group, understood that by reducing costs through portfolios not managed but which replicated an index, they could offer savers a cheaper and better deal than ordinary unit trust managers. While markets overall continued to increase in value on an annual basis, this type of index-linked investing made sense, but no longer.

Swimming with the new tide

In normal investment times, the skill is not found in spreading positions by following indices or markets, but through the identification of those few firms out of the many thousands of quoted companies that have the ability to get a better than average return on invested capital.

This focused approach can be taken to extremes, but that is where the investment trust corporate structure helps; the board of directors supervises and controls the investment manager, and is responsible to shareholders for that oversight. The board controls costs and ensures the modest returns of investment success accrue to the investors.

“I dislike the costs,” the letter-writer says, and rightly so. Those costs come out of the profit you should be making for risking your money. When markets were producing double-digit returns, unit trust costs of anything up 3-5 per cent a year were affordable; but not any more, and this is why the funds of investment trusts you looked at are bad value for money.

Economic growth is stuttering across the world, while central bankers are conducting on our behalf great, and not fully understood, experiments with the value of money. Now you need careful managers, controlled by sensible boards of directors. The only way you will get that is through a competently managed investment trust.

Finding the right wave

Any fund with more than 30 to 50 securities is sufficiently diversified for safety, and all you should be concerned with is that board and manager are as one on strategy and tactics. This means reading the comments of both in the annual report over several years – available on the Association of Investment Companies or Numis Securities websites.

Look at the annual reports of Caledonia Investments and RIT Capital Partners – these are the family vehicles of rich people, with no more desire than your clients to risk their fortunes. Then use your own common sense. What do you want – income or capital growth? Technology or consumer brands? Europe, America or Asia? Research the company reports of Scottish Mortgage and Personal Assets Trust – these give two extreme examples of different, but successful, ways of investing. 

No more than half a dozen investment trusts are needed to give you adequate and comprehensive geographical, industrial and technological cover of the world’s investment market. Since the banking collapse, such growth as there has been has been in Asia, not the developed world.  

Two final rules: never pay a premium – they never last with investment trusts; and do not conduct a horse race. Investment is a marathon, and provided every trust does better each year, you are making money.