Investment trusts: Thrilling trusts

For example, how else can you make money financing no-win/no-fee lawsuits - Burford Capital offers such an opportunity - or generate an income stream from aircraft leasing (Doric Nimrod Air1 and 2)? Whether you want to invest in trees (Cambium Global Timberland and Phaunos Timber), distressed debt (NB Distressed Debt), alternative energy (Impax Environmental and BlackRock New Energy to name but two), mortgages (Real Estate Credit Investments and Duet Real Estate Finance), or even luxury yacht moorings (Camper & Nicholsons Marina), the investment trust sector has something to suit. Meanwhile, so-called single-country funds offer exposure to a number of potentially exciting regions, which are well off the beaten investment track. Examples include the recently launched Qatar Investment Fund and Aim-traded Origo Partners, which invests in private Chinese companies.

The structure of investment trusts is a key reason why they are so often chosen as a vehicle through which to offer investors exposure to exotic assets. Often these assets are illiquid, which means they take a long time to find and buy, and can only be sold quickly if they are sold well below the market price. Whereas an open-ended fund, such as a unit trust, requires a manager to buy and sell assets to match the fluctuation in demand for the fund's units, investment trusts are closed-ended, which allows the fund manager to get on with the business at hand - managing the portfolio to generate the highest possible return. The popularity, or lack of it, of a trust is reflected in the premium or discount the shares trade at compared with underlying net asset value (NAV). Investment trusts also allow managers to borrow money to invest with, which has the effect of amplifying returns and can be pivotal to some of the more exotic trading strategies.

The potential for wide discounts to NAV to emerge is a risk, and lesser-known asset classes can prove riskier than tried and tested investments, especially when high levels of borrowing by the trust and its underlying investments are involved. But one of the charms of all the choice offered by investment trusts is that it provides you with ways to diversify portfolios away from pure equity exposure, while still investing through the stock market. This looks particularly attractive right now when the markets are riddled with uncertainty.

Below we highlight five esoteric trusts on the basis of their ability to diversify investor returns.

BH Macro (BHMG)

For investors willing to take a step into the sometimes confusing world of hedge funds, BH Marcro offers a compelling story based on its past performance. Buying shares in the trust is a bit like putting money into a trading room where investment boffins try to turn a profit by spotting pricing inefficiencies in the market. Given torrid market conditions since August, the good news is that falling markets and the associated volatility make a fertile hunting ground for these traders. Indeed, BH Macro is regarded as an absolute return fund and its performance has historically born little resemblance to that of the market. Such 'uncorrelated' returns look increasingly attractive given the global economic turmoil.

The trust provides exposure to the money management skills of hedge fund Brevan Howard through its ownership of shares in the Brevan Howard Master Fund Limited - a Cayman Island open-ended fund that was launched in 2003 but which is now closed to new money. The fund invests globally and mainly in fixed income and currency. Its strategy is based on active leveraged trading. The focus on currency means recent interventions by governments, such as those of Japan and Switzerland, are a risk. There is some equity exposure, but it is fairly minimal.

Since the fund's launch in 2007 until 30 June 2011, it has achieved a cumulative rise in NAV of 76.5 per cent and an annualised rate of return of 14.2 per cent. But perhaps what is most impressive is the steady manner in which the performance has been achieved; while the share price was hit during the 2007-09 bear market, NAV carried on rising and the shares soon snapped back.

Utilico Emerging Markets (UEM)

Utilico did take a drubbing during the last bear market and has the highest beta (a measure of how closely its past performance has been determined by that of the market) of all our esoteric trusts, there is nevertheless a clear attraction in its blend of defensive investments in fast-growing emerging markets. The trust focus is on infrastructure, utilities and related sectors.

The trust has a fairly concentrated portfolio, with the top 10 holdings accounting for 54 per cent of its investments as at the end of July. It also chiefly invests in shares rather than directly into infrastructure projects. The investment team is very focused on stock selection and has put in a lot of miles visiting companies. Its heavy exposure to ports and faster-growing economies, such as Brazil, ties its fortunes to trade in these parts of the world as well as economic development. The trust's exposure to emerging market currencies has also benefited performance over recent years as sterling has weakened.

Utilico has plans to move from Aim to the main market, which could have the effect of increasing the liquidity of its shares and also increasing demand, especially if it gains inclusion in a FTSE index that would require index funds to buy its shares.

HICL Infrastructure (HICL)

Since the coalition government came to power, a lot of fuss has been made about the cost of private finance initiative (PFI) projects to taxpayers. In this regard, HICL investment trust can be regarded as offering taxpayers something of a rebate. That's because the fund invests in income-producing PFI projects. The risks of such projects tend to be low, because when the fund buys in they are normally already up and running and through the more speculative development phase of their life. That said, building projects do tend to lead to bigger NAV upside and to that end 11 per cent of the portfolio is invested in projects that are currently under construction. It has also recently been increasing its exposure to overseas projects.

Typically, once built, PFI projects - be they hospitals, police stations or other public assets - are run under contracts that extend over several decades during which the equity owners are paid an inflation-linked income stream. With inflation high and financing costs low, infrastructure funds are in something of a sweet spot at the moment. Given the recent dire turn in the economic outlook, the good times for infrastructure owners could continue for a while yet.

HICL is one of the oldest listed infrastructure investment trusts on the market and has a fairly matured portfolio of 43 investments. It has issued shares with some regularity to keep the premium rating down and has not had a problem reinvesting the money raised. Recent acquisitions have enhanced NAV. The yield, backed by inflation-linked income paid by the government, has clear attractions in the current low-yield, high-inflation environment.

Cambium Global Timberland (TREE)

In volatile markets, there is an unerring comfort in holding physical assets, and few things can provide the same reassurance as of a forest full of trees. Cambium offers investors the prospect of rising NAV based on quaintly termed biological growth - that simply means that as trees grow bigger they also grow more valuable (see Money grows on trees for more on investing in timber and forestry). But while the trust does represent a good way to diversify away from equities, investing in timber comes with some cyclical risks.

Indeed, the timber price inevitably has an effect on NAV and this is governed by demand from industries such as construction, charcoal and paper. The land that trees are grown on also has a value, which is determined by swings in sentiment towards this specialist part of the property market. Cambium's last financial year was a case in point as a weak North American market contributed to an 11 per cent decline in NAV. However, Cambium has taken action to remedy its problems.

The trust has sold substantial amounts of forest in the US and New Zealand in order to shift into higher returning geographies - notably Brazil, which represents 40 per cent of NAV and where biological growth is quicker. The trust believes values have now stabilised in the US, which following the disposals represents 30 per cent of the portfolio. It has also recently decided to stop currency hedging due to the negative effect it was having on overall performance and has said there is the potential for it to buy back shares to try to narrow the wide discount.

CATCo represents a new concept for the investment trust world. It is a reinsurance specialist, which essentially means it agrees to cover insurers should they face claims above a certain level - much like an excess on a run-of-the-mill insurance policy. The trust generates returns for shareholders from the premiums it is paid to offer this kind of protection. Investment policies for the capital that backs the business are very conservative, so performance should not be hit by ructions in the wider investment market.

The real risk is that the fund, which insurers against catastrophe losses, will be forced to make large payments to its clients. Many such catastrophes have occurred this year, such as the earthquakes in Japan and New Zealand and flooding in Australia. The flip side to the claims that result from such disasters is that they cause premiums to rise, which can substantially boost future profits. That is the attraction for investors in CATCo at the moment. However, while the trust appeared in good health when it reported half-year results in August, more large-scale disasters and associated payouts could prove painful given the number of catastrophes already racked up this year.

As well as offering the attraction of returns that are not linked to the stock market, the trust, which was only launched in December 2010, aims to pay a dividend yield of Libor plus 5 per cent based on the profits from its work.