Investment trusts have a long and venerable history. The granddaddy of them all, the Foreign & Colonial Investment Trust, was set up in 1868 and still operates today. But are investment trusts a relic of the past or is the model still relevant to today’s investors?
There are more than 400 investment trusts in existence, mainly in Europe and predominantly in the UK. They are quoted companies, usually launched and managed by big fund houses, but owned by their shareholders who can demand changes to strategy and sack managers if they underperform.
Investment trusts were home to some of the biggest names in the financial services industry, such as Michael Hart, the legendary manager of the Foreign & Colonial Investment Trust during its heyday in the 1970s and 1980s.
But the sector fell out of favour relative to open-ended funds. From the 1980s, when markets were deregulated and western wealth and pensions contributions rose sharply, the demand for open-ended funds spiralled. Unlike investment trusts, which were closed to new money, there was no limit to how big open-ended funds could grow, and this growth was turbocharged by a referral structure whereby financial advisers received payment, in the form of commission, from open-ended funds. The biggest open-ended funds are now mind-bogglingly huge: Pimco’s Total Return fund has assets of some $169bn, while the second-largest fund, the SPDR S&P 500 ETF manages $115bn.
However, the chances of investment trusts featuring more prominently in investors’ portfolios have been heightened by the Retail Distribution Review in the UK and similar initiatives across the globe.
The RDR, which comes into force at the end of the year, bans the commissions that have driven sales of open-ended funds and means that advisers will have to focus on providing genuine value to their clients. Put another way, if clients are going to hand over hard cash to advisers, they expect their advisers to do significantly more than simply recommend funds that offer the best commission.
“RDR is symptomatic of a trend towards greater transparency and value in savings products,” says Andrew Lebus, a partner at Pantheon, which manages Pantheon International Participations (PIP), a private equity investment trust. “As people become better educated, they will be more demanding of their savings products and over time this will start to benefit the investment trust sector.”
Proponents of investment trusts argue they have characteristics that set them above open-ended funds. Perhaps the most important of these is that there are no redemptions from or inflows into investment trusts.
David Barron, head of investment trusts at JPMorgan Asset Management, which manages 21 trusts, says: “Inflows and outflows impact your ability to hold the stocks you want. You are either a forced seller or a forced buyer and that affects performance.”
The fact that open-ended funds have to keep a cash buffer in case of significant outflows also affects performance.
“Investment trust managers do not have to worry about continuous inflows or outflows, which enables them to remain fully invested or even geared,” says Simon Elliott, head of investment trust research at Winterflood Securities. “This is a significant advantage in rising markets.”
Investment trusts are also able to invest in less liquid assets which may produce higher long-term returns. They are popular structures, for instance, for real estate, private equity and infrastructure and have the flexibility to invest in esoteric strategies such as aircraft leasing without worrying about short-term volatility and redemptions.
Returns in rising markets can be enhanced through gearing, although not all investors see that as a positive attribute. Meanwhile, fees on investment trusts have tended to be lower than for open-ended funds, although this advantage may be eroded in the post-RDR era as all funds standardise fees at lower levels.
A final advantage cited by investment trust advocates is that they have independent boards of directors who represent shareholder interests rather than those of the fund management group. “It is far from unknown for boards to change fund managers,” says Mr Elliott.
The evidence is that these factors combine to produce superior performance. Research by Investment Adviser, an FT title, this year, found that out of the 24 managers that run both an open-ended fund and an investment trust with similar strategies, only three open-ended funds outperformed their closed-end counterparts. A number of other studies support this finding.
Unfortunately, outperformance of the assets in investment trusts does not automatically lead to returns to shareholders. The share price of investment trusts can languish at 40 per cent or more below the net asset value of the trust. The average discount over the longer term is more than 10 per cent.
In the post-financial crisis aftermath, investors have rushed for the exits of many private equity trusts, for instance, amid concerns about valuation, transparency and leverage levels. Trusts with high exposure to European assets have also suffered, while trusts that focus on income are eagerly sought and are trading at close to NAV.
The huge discounts on private equity trusts are unlikely to persist, insists Mr Lebus. “The marginal investor in the investment trust sector is the wealth management segment which currently has a strong leaning to anything that produces income. Income assets are generating 5-6 per cent at the moment, and some of those income-focused investment trusts are trading at a premium. At some point, people will look for returns away from income assets and will look to investment trusts such as PIP, which has generated over 11 per cent a year for the last 25 years. That performance is now available at a huge discount of nearly 30 per cent.”
Mr Elliott says discounts tend to be cyclical. “Many private equity investment trusts are patently trading at the wrong price,” he says.
“Listed private equity funds were hit hard following the decline of Lehman Brothers in 2008 when the market moved against illiquid asset classes. Many have not fully recovered despite the fact that many of the vehicles now have low levels of gearing, modest commitment levels and are throwing off cash.”
Other investment trusts trading at wide discounts are also due for re-rating, Mr Elliott believes.
“You can buy a bucket of blue-chip European equities at a discount in the mid-teens, or a 20 per cent discount for small caps.
“For contrarians that is an interesting investment prospect.”
This article is part of a series on fund ownership structures