Top 10 overlooked, outperforming trusts

It is the trend-following nature of this screen that has made for a year of high drama as 12 months ago the strategy latched on to two of the biggest and most volatile investment themes of the period: China and Biotech. The rules I devised for the screen in order to limit excessive exposure to niche asset classes meant the overall performance of the portfolio was not too ridiculously skewed to the fortunes of these sectors. Nevertheless, the rise and fall of these sectors is clearly evident in the graph below.

Outperforming and overlooked trusts vs indices 

Given the negative sentiment currently dominating the market's views on China and, to a lesser extent, biotech, it may come as a surprise that the presence of both themes in the screen's selection of trusts has been a positive influence on overall performance during the year (see table).

2014/15 PERFORMANCE

Source: Thomson Datastream

The fact that sentiment switched so suddenly and strongly against China and biotech this year has led me to experiment with the impact changes to the strategy would have had on my original back test of the screen.

My original back test covered two 10-year periods: one to the beginning of 2014 and the other to mid-2014. The back testing data was provided by the investment trust team at Winterflood Securities. The back test involved switching out of a 10-trust portfolio into an entirely new portfolio once every 12 months. The results were encouraging (see table below). Overall, of the 20 12-month performance periods I assessed, the screen outperformed the FTSE All Share 70 per cent of the time and it outperformed the MSCI World index 75 per cent of the time.

10-YEAR BACK TEST SUMMARY

Source: Winterflood Securities, Thomson Datastream, IC

Prompted by the recent volatility, I reran the back test to see if a shorter holding period of six months produced better returns given the sudden change in sentiment experienced over the past 12 months. Even without accounting for fees, a shorter holding period produced a noticeably inferior 10-year performance to the start of 2014 of 229 per cent. My other experiment was to introduce a trailing stop loss, which assumed the sale of any share that fell by 20 per cent from its peak. This also produced an inferior performance with the 10-year return to the start of 2014 falling to 242 per cent and the mid-2014 return dropping to 191 per cent. In other words, shares that fell badly often bounced back very strongly within the 12-month periods being examined.

I am therefore running an unchanged screen this year. The screen uses a ranking method used by hedge fund manager Joel Greenblatt in his classic investment guide: 'The Little Book That Beats The Market'. The Outperforming and Overlooked screen uses this ranking system to attempt to select shares that combine strong recent momentum with a higher than usual discount. To do this the screen ranks shares by their Z-score and their three month share price performance. These ranks are then added together to create a combined rank which the final selection of 10 shares is based on.

While the term Z-score is widely associated with a measure of bankruptcy risk developed by Edward Altman, when it comes to investment trusts the Z-score refers to a standardised measure of where a trust's discount or premium currently lies compared with its historic (1 year in this case) range. A negative Z-score implies a cheap share compared with the historic range while a positive score implies an expensive share.

The screen uses three-month price performance rather than net asset value performance because the price may reflect the market's reaction to significant information which NAV fails to capture, such as a change of manager or the existence of potentially dilutive share classes, for example.

The screen also has several rules that attempt to: prevent it becoming one big bet on a particular asset class or investment theme; help it try to avoid illiquid shares; and keep it away from any shares trading at premiums to NAV, which back testing suggests is likely to be detrimental to performance even when the premium is “cheap” compared with the historic range.

The rules are:

Of the 10 trusts selected by the screen, six latch on to two distinctive themes: UK Small Caps and Private equities. The themes are briefly examined below while very short write-ups are provided of the investment case for the remaining four trusts.

TOP 10 OVERLOOKED, OUTPERFORMING TRUSTS

UK Small-caps

During the recent turbulence in commodities (which have a significant influence on UK blue-chip performance) and emerging markets, it is UK smaller companies that have really shone. While conventional wisdom suggests that small-caps are more vulnerable to big movements in the macro economy due to their size, they offer several other benefits in the current climate. One factor is that they are generally more likely to be exposed to the domestic economy than larger peers, which means, against a backdrop of emerging-market angst, they stand to benefit from the relative stability of Britain's economic prospects. In addition, a bad 2014 for small-caps helped create some value in the market, whereas valuation levels have remained a more pertinent risk for UK blue-chips and US stocks. The four UK Small Cap trusts selected by the screen are:

Source: Winterflood Securities

Private Equity

Private Equity is often seen as being particularly vulnerable to bear markets and was a big loser in the fallout from the credit crunch. In this light, it is therefore understandable that discounts have been pushed out by the recent market turmoil. But if we're not going to hell in a handcart, the sector may actually be set to come into its own. That's because private equity often does well later in the cycle for quoted companies when there are more opportunities for realisation and when private-equity managers have a number of good years behind them spent improving the underlying performance of the companies they own. Broker Canaccord Genuity also thinks the sector is in a far better postion now than it was at the time of the credit crunch: "There are a number of material differences between 2008 and now. Much work has been done on strengthening balance sheets at the investment company level, with many companies having net cash and medium-term debt facilities in place in case of need, while the maturity profile of the underlying portfolios is increasingly attractive." The two private equity funds making the grade are:

Source: Winterflood Securities

The Rest:

An interesting mix of themes is found in the rest of the portfolio.

The presence of an Indian fund in the form of JPMorgan Indian highlights an interesting divergence between some encouraging recent economic news coming from India's economy and the dire market sentiment towards emerging markets.

Source: Winterflood Securities

TR Property has suffered due to worries about interest rate rises and high property values, but the movement in the discount has yet to be matched by negative NAV returns.

Source: Winterflood Securities

Blue Capital Global Reinsurance Fund is one of many new vehicles pumping money into an insurance market that has gone a long time without experiencing any major capital-draining catastrophe claims. The benign conditions means dividend yields from such companies are high and Blue Capital boasts the biggest payout from the screen’s section of trusts.

Source: Winterflood Securities

As a Large-cap US equities fund, JPMorgan American has suffered from the falls in the S&P 500. Its shares represent a good way to play the potential for a bounce back by the US market following this summer's ructions.

Source: Winterflood Securities