Time to chop this investment trust and buy an ETF

The long-term fundamentals of the timber market remain intact. Long-term demand for timber from China and other emerging markets is growing, fuelled by urbanisation and nascent consumer spending. Timber is a scarce resource due to limited land mass on which to grow it, and timber prices are at or near the bottom so have the potential to appreciate strongly.

However, the two investment trusts that offer dedicated exposure to the area, Cambium Global Timberland and Phaunos Timber, are looking distinctly unattractive. Investors Chronicle first tipped Phaunos as a buy in October 2009 (read our tip). Phaunos has 86 per cent of its portfolio in emerging markets but its share price performance has been negative over one, three and five years, as is also the case with Cambium.

Five years ago, Phaunos traded on a premium to NAV. When we tipped the fund in 2009 its share price was $0.63 and it traded at a discount to net asset value (NAV) of 40 per cent. Now its share price is $0.58 and it trades at a discount to NAV of 42.85 per cent.

"We can see no obvious catalyst for the discount of either fund to narrow in the short term and, given continuing uncertainty over the global economy and the weakness of western consumer markets, we expect the share prices of both funds to remain volatile and would not be surprised to see discounts widen further at some point,” says Tom Tuite Dalton, analyst at broker Oriel Securities.

Phaunos has announced its intention to sell non-core and younger assets, but it is proving to be a slow process. As it is, the portfolio has just 12 investments, leading to concentration risk.

If you are a long-term investor you may be prepared to wait it out. But the high fees are a real sting in the tail. "The onerous contractual arrangements set up with [its fund manager] FourWinds at launch, entitling them to receive a c.$8m a year base fee, plus potentially a performance fee and giving them an effective 10-year lock-in to those fees, leaves a sour taste and one that will continue to eat in to future returns," continues Mr Tuite Dalton. "This effective poison pill is a key reason for our 'negative' rather than 'neutral' recommendation."

The total expense ratio (TER) of 3.21 per cent is already very high, despite the fact that no performance fee was paid for 2011. Phaunos's performance fee kicks in as soon as the NAV goes above $1.08.

Although the fund does pay dividends, Mr Tuite Dalton says it is uncertain how sustainable they are given other demands on cash. He says the $0.025 dividend for 2011 is not covered by earnings, which were negative in 2011.

If you are still taken with the long-term potential of timber we think the iShares S&P Global Timber & Forestry exchange-traded fund (ETF) is a more attractive alternative. This tracks the 25 largest and most liquid listed companies involved with forestry and timber, mostly listed in developed markets. Its TER of 0.65 per cent is appropriate to its passive strategy - and just a fraction of the costs charged by Phaunos. What's more, in contrast to Phaunos's poor performance, the ETF has made investors more than 25 per cent over the past three years.

Although Phaunos Timber offers greater direct emerging markets exposure than the ETF it has a very high fee structure and poor performance to date, so we now rate it a sell.

Read more on timber

Source: Morningstar, *Four Winds.

Performance data as at 14 May 2012

Top 10 holdings as at 31 December 2012

Geographic breakdown