InvestmentsMar 27 2019

Russell Taylor on 150 years of investment trusts

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 Russell Taylor on 150 years of investment trusts

The reason is simple: inflation calculations are biased towards the white goods of home creators and not the services that older citizens consume, from restaurant meals to domestic services, medicines and travel.

Income from investment is necessary to offset this inflation, and the working of compound interest makes simple errors dangerous. It is easy to lose half of an investment, but it is much harder to double an investment, and that is what you must do if you are to return to your original capital after such a loss. 

That is how bankers once made their fortunes: promising depositors interest rates of 5 per cent, they credited them monthly but debited their loans daily. The difference, multiplied by thousands and then millions, created the giants of today.

Compounding for success

These skills are available to everyone, but few use them. They are parcelled up in the form of investment trusts, and were first launched in England 150 years ago, but have a history going back a further century to Dutch stock markets. The operating purpose is the purchase of a higher-than-average income, and the method is experimentation and diversification.

Stock markets change all the time. Initially, investments were based on bullion, precious stones and mortgages, then later the obligations of governments (bonds), companies, bullion again and property loans. 

Later still, companies became sufficiently large and stable to issue shares to investors. These were initially in the format of preferred shares (or those with income paying as a priority), as well as pure equity.

Experimentation meant just that – but boards of directors never allowed their investment managers to ‘experiment to excess’ and so destroy the compounding element of that superior income. Investment trusts experimented with these new types of securities, and diversified their sources of income, so as to offer their shareholders a better return but at no greater risk.

Unit trusts take centre stage

Their success was such that they became the foundation stones of middle-class wealth. Their weakness was that they were incorporated under the Companies Act, and could only be bought through the stock market. And the wars of the 20th century destroyed much middle-class wealth, as well as the stockbroking profession and local stock exchanges. 

When wealth returned to Britain during the 1950s, knowledge both of investment trusts and of basic investment skills had disappeared, and an American import took over. The unit trust was an open-ended fund that could expand or decrease as demand and investment excitement dictated. Unlike stockbrokers, their sales forces needed no licensing and could be paid commission.

Better yet, unit trust investments could be incorporated into life assurance contracts, solving yet another marketing problem. This, the endowment policy, was the other really successful 19th century investment product in Britain. It was a long-term savings policy, pushed by life assurance salesmen and local branch bank managers across the country, concerned that their borrowing customers should learn the savings habit.

This regular savings policy, invested by the life company in a well-diversified portfolio of property, bonds and shares, and designed to pay a regular income to the family on retirement or death, ceased to be necessary as company pension funds proliferated.

Market changes and lost knowledge

The endowment policy was not very transparent. Based on individual company estimates of life expectancy, investment returns, and potential profit and loss, surrender values of endowment policies could be mystifyingly low. 

The units of third-party unit trusts seemed refreshingly simple by comparison, and pleasingly profitable. Unit trusts were soon the new investment rage, and the investment trust withered.

Many investment trusts disappeared as their advantages – the ability to invest in foreign markets, and to hold foreign currency – became attractive to other companies that were limited in their growth plans by post-war foreign currency rules. 

These businesses bought investment trusts by share exchange, thereby acquiring their easily realisable assets at significant discounts, as a cheap rights issue and a way around Treasury restrictions.

But investment trusts had not been erased entirely by the time political changes destroyed the ubiquity of company pension plans. Later, disappointment in the investment performance of private pensions and unit trust savings plans showed the transparency of their pricing structures was not all it seemed. 

Investment companies began a slow return to popularity, especially those dedicated to illiquid investments such as infrastructure projects with government guarantees under private finance initiative rules.

Forgetting first principles and operating systems

During the 1990s, investment company boards lost their heads: desperate to replicate the sales success of their unit trust competitors, they forgot the importance of compounded income. 

Financial engineering seemed the answer: split shares into different categories of high guaranteed income, rising income and capital value on redemption, and offer investors a choice.

But the next bear market destroyed the faith placed in investment trusts. Losses amounted to more than £600m with over 40 trusts bankrupted. It is rare that real life offers genuine experiments; this scandal directly proved that investment is about income and capital, and that they cannot be separated.

Those trusts that remembered their operating principles survived and prospered. The average equity income trust has increased its dividend by 4.5 per cent a year over the past 20 years. An investment of £100,000 would have produced a similar income over the years, while the capital value today would be £350,000. Another lesson: compounding income requires time and patience.

But investment success is more than a selection of individual companies. It is a choice of an unknown future made through a portfolio. This can be bottom-up – the selection of shares – or top-down: a selection of asset classes and of geography. The latter is best: strategy before tactics. 

No one can know what Brexit will bring or how long it will take to materialise, but what is certain is that it will bring disruption to current business relationships. Confusion and disruption is known to destroy profits, and even companies, so is best avoided by investors.

Table 1: An anti-Brexit portfolio update

Investment company

Initial investment at December 31 2018 (£)

UK exposure (%)

YTD share price total return (%, to February 28)

Witan

25,000

34.3

5.4

Alliance Trust

25,000

14.8

7

Personal Assets

15,000

10.3

1.7

Scottish Mortgage

15,000

3

5.8

Worldwide Healthcare

10,000

0

12.1

Polar Capital Technology

10,000

2

10.5

Total portfolio performance

100,000

n/a

6.5

FTSE All-Share

n/a

n/a

6.6

MSCI World index

n/a

n/a

5.3

Source: AIC/Morningstar. Copyright: Money Management

The Brexit portfolio in Table 1 is designed to avoid Europe by targeting three global trusts, two medical specialists and the aggressive technological trust SMT, concentrating on those companies hoping to disrupt current methods of doing business through technological or other digital developments. 

The table shows the spread of a £100,000 investment over the six trusts, selected to give opportunities in global markets but also fast-changing medical technologies – but mainly avoiding UK and EU markets. 

In cash and percentage terms and after buying expenses, investors can be pleased with a 6 per cent improvement so far this year.