This week’s portfolio clinic [see p32] features a reader who trades the investment trusts in his self-invested personal pension (Sipp) every week, selling holdings that are not performing well and reinvesting the proceeds in ones that are doing better. But this is unlikely to be a wise course of action.
This is not investing, but rather trading. Investing is putting your money into investments such as funds to express a carefully considered asset allocation over the long term.
And if you do want to trade or gamble over short-term periods collective funds such as investment trusts might not be the best securities with which to do it.
“Normally, investment trusts don’t attract short-term traders because the spreads between their buying and selling prices, and price movements tend to be slower as they usually represent a diversified portfolio of underlying assets,” says Rob Morgan, pensions and investments analyst at Charles Stanley. “Also, investment trusts typically trade on discounts or premiums to net asset value (NAV), making shorter-term share price reactions hard to gauge. Shorter-term traders tend to prefer exchange traded funds (ETFs) with narrow spreads [the difference between the buying and selling price] and valuations that represent the NAV of the underlying assets all the time. And any type of shorter-term trading is more akin to gambling than long-term investing.”
If an investment trust’s share price appears to be doing badly that doesn’t mean the assets it holds are doing the same. So, for example, selling a trust whose share price has performed badly over a short period but whose NAV performance has done well could mean missing out on strong returns. This is because when other investors eventually recognise the strong underlying performance the share price should do better and the discount to NAV should tighten.
And if you buy an investment trust that has been doing well it may well be trading at a premium to NAV. This could be a problem, especially if the trust is expensive relative to its history, and mean that the rating could go one way from here: down. So you buy a basket of assets for more than they are worth, and after you buy them the basket's (trust's) price falls down in line with or below their value. Ideally, you should try to get into investment trusts when their rating is cheap relative to their own history, which in many cases would be a discount to NAV – as long as this is not an indication of a problem with the trust or its assets, and their long-term prospects.
It is important to recognise that investment trusts aren’t individual equities, even though they are listed on the stock market. They are collective funds – baskets of several securities actively run by an investment team pursuing a strategy. This means that investment trusts are unlikely to perform in the same way as a single company might because their performance is driven by a number of different factors. And like all other funds they have charges, in some cases fairly high ones. Even if you hold them for only a week you have to pay the charges but would forego the compensation for charges that strong growth or income over the long-term gives you. If you want to make short-term trades securities that do not have charges might be better, or at least ETFs, which typically have much lower charges.
Investors Chronicle's economist, Chris Dillow, uses the 10-month average rule for investing in direct shareholdings. He buys stocks when prices are above their 10-month average and sells them when their prices are below their 10-month average. But he points out that there is less academic research on using this investment technique, known as momentum, to choose collective funds, although in the past two years a couple of research papers have been published which suggest that such a strategy could produce good results with collective funds.
But Mr Dillow adds: “There is a danger that if you buy past winners for momentum you might forget to sell when momentum turns against you. Momentum also incurs dealing costs.”
If you churn investment trust holdings on a frequent basis you will rack up a lot of trading charges. “You shouldn’t trade in and out [of investment trusts] the whole time and react because their price is down over, say, a week,” says David Liddell, chief executive of online investment service IpsoFacto Investor. “[If you do this you will] lose out because of trading costs and spreads.”
And the longer time period over which you frequently trade, and the more securities you trade, the greater the total trading costs will be. So if you take this strategy with a pension fund over many years or decades you will squander vast amounts of its value on churning holdings. If your end return is not much better, equal to or worse than if you had done nothing, you will have effectively lost a lot of value to trading charges.
And this could be a likely outcome. “Attempting to time exits and re-entries to the market rarely works over the long term,” says Lauren Peters, chartered financial planner at Fiducia Wealth Management. “You could end up horrendously mistiming your transactions by selling assets before they recover and buying new ones that start their own decline. So you could end up much worse off than if you had done nothing at all.”
This could have serious implications if you are going to rely on this pension fund for a meaningful portion of your retirement income. And if you are hoping to eventually pass this pension fund to your children, you are effectively gambling away their inheritance.
Buying high and selling low is a classic inexperienced investor mistake, whereas doing the opposite is more likely to generate good long-term returns. And although equity markets fluctuate a tremendous amount every day, month and year, historically, over the long term their general trend has been to appreciate. So why constantly churn – especially an active fund whose managers already make adjustments? Pick good equity funds, let them ride the weekly market gyrations and allow your investments to grow over the years or decades.
Churning your investment trust holdings according to their share prices could have another serious implication – it could change your asset allocation so that it is no longer appropriate for you. Your portfolio could end up being unbalanced, for example, because it is heavily focused on one geographic or industry area. And if this area you are heavily weighted to does badly this could be detrimental to your overall return. It could also make your portfolio far higher risk than you want it to be, not aggressive enough to deliver the growth you are targeting over the long term or not focused enough on income to deliver the annual payouts you need to sustain your lifestyle.
Of course, this doesn’t mean that you should doggedly hold a fund through thick and thin for at least five years after you buy it. There are many reasons to consider selling it sooner, for example, a change of manager, a change of investment strategy or focus, and many years of underperformance but no reason to believe things are going to improve. Or you might find a better fund invested in the same area, for example one that has a better performance record and/or lower charges.
Another key reason to sell – unrelated to the fund itself – is if your personal and financial circumstances change, meaning the fund and the assets it invests in no longer fit the appropriate asset allocation for you. This could be, for example, because you can no longer take such high risk, or are moving from a growth to an income objective because you have stopped working.
Or if some of your holdings have done well and others haven’t, distorting that asset allocation that you have decided is appropriate for your goals and circumstances, it might make sense to trim some holdings and add to others to bring it back in line with what it should be.
“Investment trusts are long-term investments that are usually best held for three to five years plus, and many people hold them for decades,” says Mr Morgan. "But there may sometimes be shorter-term, more tactical decisions to be made. For example, if a trust has been bought in the expectation that its discount to NAV might narrow and this happens quite quickly.”
If an investment trust’s share price increases well ahead of its NAV so that it trades at a very high premium, this could be a reason to take profits and reinvest in a fund focused on the same kind of asset that does not have an inflated price.
