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Pile into emerging markets, Asia and tech trusts

The 'overlooked and outperforming' investment trust stock screen is pointing towards a selection of risky trust sectors: emerging markets, Asia and technology
September 28, 2016

One way investors with long time horizons can attempt to beat the market is by being prepared to take on substantial risk in the short term based on the expectation that ultimately they'll generate outsized rewards - even if this means stomaching the odd disaster along the way. That said, risk for the sake of risk is to be avoided and any such approach to investing needs to be founded on a solid and sensible investment strategy that is capable of producing long-term outperformance.

When I back-tested my overlooked and outperforming investment trust screen over two 10-year periods, its appetite for taking on risk by targeting distinct sector themes was key to it achieving substantially better returns than the market (see table). The screen's results this year suggest it is definitely in a 'risk on' mode with all the potential for large gains and losses that entails.

 

Back-test

Total returnOverlooked and outperforming ScreenScreen with annual costs at 1.5%FTSE All-ShareMSCI WorldFTSE/MSCI blend
10 years to mid-2014305%247%133%95%114%
10 years to 2014253%201%132%94%113%

Source: Winterflood Securities, Thomson Datastream

 

The screen's approach to picking trusts is a straightforward hunt for trusts that show both value and momentum. The nature of investment trusts means, in my opinion at least, that any screen to find opportunities has to be very succinct in its methods if it's to have any chance of making sense of the panoply of funds on the market. That's because, the world of investment trusts is the home to some of the most esoteric asset classes available to private investors, along with some of the most individualistic fund management styles and, again in my personal opinion, many of the most worthwhile collective investment vehicles out there.

It is hard to find metrics that can draw comparisons between such a broad range of funds. Fortunately, there are two measures that I believe are up to the job and my back-testing of a strategy that combines them provides some vindication for this.

 

Value

The Z-score (not to be confused with the Altman Z-score,which can be used to assess the financial health of individual companies) offers investors an insight into valuation that can be used to compare all trusts on equal terms. The metric does this by producing a standardised score based on where a trust's share price discount or premium to net asset value (NAV) stands compared with the range over a given period (one year in the case of my screen). A negative score suggests a trust is on the cheap side (the larger the negative score the cheaper), while a positive score suggests a trust is expensive. Because each trust is having the current valuation of its shares to NAV assessed in comparison with its own history rather than the other trust, the Z-score measure can then be used to make comparisons between trusts with very disparate investment objectives.

 

Momentum

The other universal factor the screen looks at is share price performance. Specifically, the screen wants to see strong share price performance over three months. The fact that it looks at price and not NAV performance means it gives some credence to the wider market view. If sentiment has been improving towards a stock, narrowing its discount over the three months, this will benefit the momentum score the trust gets, while the market scepticism implicit in a widening discount will be taken into account because it will hold back price performance. That said, the overall objective when combining momentum with value is to find promising situations that are emerging, but are not yet fully appreciated by the market - ie when the market is too sceptical.

 

Bringing it all together

To assess both factors together, the screen uses the method devised by hedge fund manager Joel Greenblatt for use in his two-factor "magic formula". The method simply ranks both factors and then adds the ranking together to find the trusts with the most attractive combined ranking. I also have a set of rules that are applied to the screen to avoid it focusing too much on a single market niche or on trusts that are likely to prove highly illiquid.

 

The rules

■ Market capitalisation must be more than £100m.

■ No tracker or hedge funds.

■ No more than half the portfolio (five out of 10 shares) should be in funds with a niche theme. Trusts defined as niche are those focused on non-mainstream asset classes or subsectors such as private equity, debt, technology and biotechnology, and those focused on single countries (excluding the UK and US) or high-risk economic regions such as emerging markets. I also regard Asian smaller companies trusts as niche, but not Asian generalists.

■ No more than half the portfolio (five out of 10 shares) should be mainstream funds of the same type. This rule does not apply to global funds, but it does to other mainstream themes such as trusts investing in the UK (large and small companies), Europe, the US or Asia.

■ All trusts must trade at a discount to NAV.

When the screen works it tends to work very well, but it can also pick up on stocks that have been marked down for good reason. Last year's mega-dog, Better Capital 2012, illustrated the negative side of this coin. The screen highlighted a number of private equity funds last year, but due to the rules only two were chosen. Broadly speaking, the private equity theme was a good one, which was reflected in the strong performance of the Standard Life European Private Equity trust. Meanwhile, the average one-year return from direct private equity funds was 36 per cent and 24 per cent from fund of funds. However, the Better Capital trust had its own distinct problems and was a major contributor to the screen's underperformance against both indices I measure it against. On a cumulative basis, over the two years since I started running the screen, it is behind the FTSE All-Share but ahead of the S&P Global 1200, with the respective total returns coming in at 14.7 per cent, 12.1 per cent and 6.7 per cent. If I add in 1.5 per cent for costs, the screen's performance drops to 8.8 per cent.

 

2015 performance

NameTIDMTotal return (29 Sep 2015 - 20 Sep 2016)
JPMorgan AmericanJAM32%
JPMorgan IndianJII31%
Standard Life European Private EquitySEP31%
North Atlantic Smaller CompaniesNAS21%
TR PropertyTRY9.5%
Standard Life UK Smaller CompaniesSLS8.9%
Blue Capital Global ReinsuranceBCGR5.8%
Artemis AlphaATS-6.2%
JPMorgan Smaller CompaniesJMI-8.2%
Better Capital 2012 CellBC12-45%
S&P Global 1200-13%
FTSE All Share-18%
Outperforming and Overlooked-7.9%

 

Source: Thomson Datastream

 

Some distinct themes have emerged this year. The trusts selected by the screen are listed in rank order below along with a brief write-up of the key themes and noteworthy trust features.

 

Pile into emerging market, Asia and tech trusts

RnkNameTIDMPriceMkt CapDYDisc.1yr av. disc1yr disc. Lo1yr disc. HiZ ScorePerf. 3mPerf. 1yrPerf. 3yrPerf. 5yrOn-going chg
1Templeton Emg Mkts*TEM583p£1.7bn1.4%-13%-12%-9.9%-15%-1.324%46%8.2%21%1.2%
2JPM IndianJII638p£672m--14%-13%-9.3%-15%-1.223%31%103%80%1.2%
3Pacific HorizonPHI214p£122m0.2%-13%-11%-5.9%-15%-1.124%35%38%64%1.0%
4Baillie Gifford JapanBGFD544p£428m--4.3%0%7.5%-9%-1.322%33%52%184%0.9%**
5JPM AsianJAI280p£266m0.9%-13%-12%-8.6%-15%-0.930%42%39%63%0.8%**
6Allianz TechnologyATT742p£192m--10%-8%-1.9%-14%-0.924%30%49%128%1.1%
7Scottish ITSCIN702p£686m1.8%-15%-12.8%-10.6%-17%-2.214%26%30%81%0.7%
8Edinburgh Worldwide*EWI497p£244m--13%-8.7%-2%-15%-1.317%15%36%99%0.9%
9TR European GrowthTRG737p£368m1.0%-16%-12%-5%-18%-1.314%29%60%171%0.8%
10Invesco Asia*IAT234p£196m1.6%-11%-10%-7.3%-14%-0.526%46%55%91%1.0%

Source: Winterflood Securities, Morningstar, **Trust factsheet

 

Look East

Among this year's picks there is a large contingent of emerging market and Asia-focused trusts. In terms of the screen's rules, Asian generalists are classed as mainstream funds, whereas emerging market funds are classified as niche (there can only be a maximum of five niche funds in any portfolio and only two of the same type). However, in practice many of the positive influences on the share prices of these two types of funds are similar. This therefore increases both potential risks and rewards.

The prospect of 'lower for longer' interest rates, and slow and gradual rate increases when they do come, helps support hopes that recent flows of investment into the region's markets can be sustained. Investors' confidence also seems to have been boosted by the management of China's economic slowdown to date, with a consensus currently building around the process being long and drawn-out rather than presenting a sudden shock, and with less potential for contagion in the wider region than previously feared. Furthermore, the recovery in commodity prices has been seen as a big plus, which has also been helping to strengthen currencies. Nevertheless, the high Z-scores that have helped earn these trusts' places in this year's screen are a reflection of ongoing nervousness about the outlook and fragility of recent optimism.

Of note among the specific trusts picked by the screen, there have been recent changes of manager at Templeton Emerging Markets (TEM) and JPMorgan Asian Trust. Tax changes in India that will remove benefits associated with holding shares for over 12 months are expected to have a "material" effect on JPMorgan Indian, according to the trust. Meanwhile, Invesco Asia recently got rid of an obligation to offer shareholders a vote on winding up the trust every three years - the next vote had been scheduled for 2017.

Some of the positive factors affecting sentiment towards Asian markets will have benefited Japan and the Baillie Gifford Japan trust. However, the ongoing effort to boost the economy and stoke inflation through massive monetary stimulus is also a very significant issue. The Japanese market looks fairly good value in comparison with other developed markets at the moment and Baillie Gifford has recently marginally cut the fees charged for managing the trust.

 

Tech bet

While Baillie Gifford-managed Edinburgh Worldwide is considered a generalist trust, the manager is a massive fan of disruptive technology companies and biotech, with a particular focus on some of the smaller companies in this area. This means the trust has been subject to the volatility seen over the past 12 months in these sectors. High valuations have played a part in making share prices extremely sensitive to changes in sentiment. The US presidential election is also likely to be key to sentiment given Hillary Clinton's attacks on biotech companies hiking drug prices. Allianz Technology is more of a straightforward tech sector play.

 

The rest

Scottish Investment Trust is a generalist, which is noteworthy for the fact that it has recently undergone an overhaul of its management team. The trust has also been cutting costs, and earlier this year bought back and cancelled about one-fifth of its expensive (5.75 per cent) long-term bond debt, which should aid future performance. TR Europe, meanwhile, focuses on small- and medium-sized companies in Europe and as such has been knocked by fears of what Brexit may ultimately bring.

*The author holds shares in Templeton Emerging Markets, Edinburgh Worldwide and Invesco Asia