Investors need to keep an eye on long-term trends lest changes barely noticeable from month to month or even year to year catch them unawares. Lessons that seem clear with the benefit of hindsight are easily missed at the time as investors are lulled into a false sense of security by the implicit assumption that nothing much has changed or ever will. At this time of year, then, it pays not only to review the last 12 months but also to examine the longer-term picture to see what we can learn.
This year has been a good one for equities, with markets recovering from the late 2018 setback and, in the case of Wall Street, regularly hitting new highs. Earnings growth is likely to have been disappointing, but this was discounted last year and the outlook for 2020 is much better. Bond yields, already negative in real terms, continued to fall to well below 1% in the case of ten-year gilts and not much more for high-quality corporate bonds. Unsurprisingly, investors have been on the hunt for income, finding it in the “alternative-income” section of the investment-trust sector.
Around £8bn has been raised by investment trusts this year, but only 20% of that has been for equity funds. Just under 50% of the Numis Securities universe of 400 London-listed investment companies, with a combined market value of £190bn, is now accounted for by alternative-income funds invested in infrastructure, debt, property, private equity and a proliferating number of sub-categories.
With the exception of private equity, these funds provide a generous dividend yield of over 4%, the prospect of moderate capital growth and a low correlation to equity markets. Despite markets’ strong performance, investors have remained cautious, which explains the low level of issuance by equity funds. Much of that has come from trusts that trade at a premium to net asset value (NAV) issuing new equity to meet demand rather than from formal offerings.
The sector in 1994
Now for the bigger picture. Charles Cade, the recently retired head of investment companies at stockbroker Numis Securities, has compiled a retrospective analysis of his 25 years in the sector. In 1994, gilt yields rose to 8.6% and inflation dropped below 3%, but there was little confidence that it would stay there. Yet it did, and it then fell further after the financial crisis of 2008. Investors wishing to diversify their portfolios away from volatile equities had no need for alternative-income funds; they simply bought gilts, which subsequently proved to be an excellent investment.
The investment-companies sector, however, valued at £53bn in total, was predominantly invested in listed equities; 38% of it was accounted for by “global” funds, though in practice most of these had UK weightings of around 50%. UK specialists accounted for another 23% of the total and private equity, following the flotation that year of 3i, for 12%. Enthusiasm for emerging markets and the Far East following the collapse of communism meant that they made up 16%, but North American, Japanese and European specialists made up less than 10% combined. Investors were eager for new launches, with no fewer than 43 of them occurring in 1994 compared with a mere six in 2019. Nearly £3bn was raised in 1994, including more than £1bn from the flotation of two giant European privatisation trusts in addition to nearly £2bn from the listing of 3i. Only £500m stemmed from secondary offerings by already listed companies. These accounted for 90% of the money raised in 2019.
The enthusiasm for new issues in 1994 accompanied a dramatic fall in the average discount to NAV of share prices in the sector from the high teens in 1990 to a low in 1994 below 3%. But this proved unsustainable and discounts widened back to the mid-teens in the rest of the decade. Share buybacks then became possible and, for this and a variety of other reasons, discounts embarked on a downward trend until 2018, reaching 3% again, before moderately widening this year. Poorly managed trusts or those in out-of-favour sectors still languish but, as Cade says, “ignoring the discount is not a long-term strategy”. A wide discount often prompts corporate raiders or disgruntled shareholders to take action.
The 1994 peak for equity issuance was not passed until 2016, when £15bn was raised, followed by another £12bn in 2007, much of it for listed hedge funds. The large majority of the issuance was still for new flotations and Cade’s analysis shows why this has subsequently changed. “Many initial public offerings don’t survive a decade,” he says, including those privatisation trusts and most of the listed hedge funds. No wonder that, in recent years, most of the issuance has been for existing funds with a proven record.
Management has improved
A handful of investment trusts, including Lowland, Herald and JPM Emerging Markets, have continued with the same mandate and the same manager for 25 years, but most of the long-term survivors have seen managers leave, retire or move on when performance flags. Mandates have evolved. For example, the global funds have become truly global. Trust boards, now truly independent and diverse, have become far more willing to move trusts to new management companies. Edinburgh Investment Trust is making its third move since 1994.
The investor base then was dominated by insurance companies and pension funds, though the launch of personal equity plans was bringing in private investors. The “wealth-management” function was carried out by private-client stockbrokers, usually on an advisory basis. The privatisation programme had encouraged many banks to open up low-cost share- dealing services, but internet dealing was for the future. Now investors are typically wealth managers – people using online platforms or multi-asset enthusiasts who use trusts, especially alternative-income ones, to fill the gaps they can’t address directly. Institutional investors are steadily exiting.
Investment trusts outperform unit trusts
The key question is whether investment performance has improved. Studies show that closed-end listed funds, such as investment trusts, consistently outperform open-ended ones, even those with the same manager and mandate. Corporate governance has improved, discounts to NAV have fallen (helped by discount control mechanisms), fees have come down, communication with investors has improved and the internet has made fund information more accessible.
Nevertheless, the Patient Capital fiasco shows that the scrutiny of malfeasance by those who are supposed to be the private investor’s gatekeepers hasn’t improved enough. Fashions, driven by over-enthusiastic marketing at the wrong time in the investment cycle, come and go. The alternative-income sector already contains a number of walking-wounded funds and more will surely follow. It seems likely that average performance has improved, but there are many pitfalls for the unwary investor. Cade has come up with a list of nine lessons he has learned.
Ten key lessons to take away
1. Be wary of blockbuster new launches (such as Patient Capital).
2. Follow secular trends, but don’t lose all grasp of valuations.
3. Don’t ignore the discount. High discounts often present an opportunity, high premiums are rarely sustained.
4. Be prepared to take a contrarian view, investing in out-of-favour areas.
5. Avoid the latest fad, although fads are easier to identify with the benefit of hindsight.
6. Don’t buy if you don’t understand the risks, such as in complex mandates, structured products and funds with high borrowings.
7. Be aware of fees, but don’t let them drive the investment decision. You often get what you pay for.
8. Volatility is not the same as risk; volatility represents a temporary loss of capital while real risk threatens a permanent one.
9. Corporate governance matters, so avoid funds where you don’t trust the managers or the board.
He could have added a tenth: recognise mistakes. Nobody can call themselves an experienced investor until they have made a disastrous investment and regarded their loss, once taken, with equanimity.
The growth of investment trusts has exceeded that of unit trusts since 2013, but the latter, with £1,215bn of assets, dwarfs the former. Investment trusts remain the Cinderella of collective investment schemes despite their outperformance. A few mishaps are inevitable, but they remain the best vehicle for investment for private individuals.