Go bargain hunting with investment trusts

However, this amount is dwarfed by the sum of money invested in open-ended funds. UK-domiciled open-ended funds had assets under management of around £1.1 trillion at the end of July, according to Investment Association (IA) data. Part of the reason for this is that investment trusts are viewed as a way to hold more esoteric assets such as infrastructure rather than mainstream investments such as equities. Shares issued by existing investment companies (secondary issuance) amounted to £4bn in the first half of 2019 and much of this was from alternative asset trusts. For example, renewable energy infrastructure trusts accounted for £1.1bn of this issuance alone.

There are many reasons for investors to favour open-ended funds over investment trusts when it comes to exposure to equity markets. This is particularly the case in more liquid markets, where open-ended funds can offer a simple source of good returns.

“About 20 years ago many asset managers had open and closed-ended versions of the same equity strategy,” says James Calder, research director at City Asset Management. “But now closed-ended funds, with the exception of some recent launches, tend to be focused on specialist assets such as micro-caps or Japan, where there’s more mid or small caps. We haven’t seen many asset managers launch a [closed-ended] large-cap equity strategy for a long time [because] many open-ended funds do that very well.”

Open-ended funds can seem simpler than trusts, and have an adequate structure for investing in mainstream markets. However, investment trusts still have something to offer when it comes to equities. They have performed strongly over the past decade and offer a flexible approach that could work well if markets become volatile. And many investment teams still run open and closed-ended versions of the same strategy in traditional asset classes.

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Investment trust shares can move in line with their underlying markets to an extent, meaning they can be more volatile than open-ended funds in turbulent conditions. However, many trusts have fared better over the longer term. Our first table, which plots how an array of investment trust share prices have performed versus the equivalent open-ended fund returns, illustrates this. Open-ended funds are indicated by an ISIN number and investment trusts by their stock market ticker.

While most of the trusts have seen their share price returns struggle versus open-ended fund returns over a volatile year to the end of August, many of the trusts' returns stand out over longer time periods. Of the 16 trusts in our sample, 10 saw their share price beat the open-ended fund's primary share class return over three years, with eight outperforming over five years and 11 outperforming over a decade.

What has driven this outperformance? In a decade when markets have tended to rise, one important advantage of the closed-ended structure has been the ability to gear – borrow money to invest more than the value of their assets. When markets are on the up, as they have been in the past decade, this can boost returns because trusts can achieve greater exposure to rising assets. It can also give income-oriented trusts greater exposure to dividend-paying shares.

Analysts at broker Winterflood carried out an analysis of investment trust returns versus their open-ended versions in December 2017, and found that the five investment trusts with the biggest five-year net asset value (NAV) outperformance versus their open-ended peers had used some level of gearing, with the average net gearing figure ranging from 1 per cent to 14 per cent.

The story is similar in our own analysis. Jupiter European Opportunities (JEO), one notable long-term outperformer, had gearing of 9 per cent on 16 September, according to Winterflood.

Trusts have other clear advantages. The fact that their shares are traded on a secondary market means the investment manager is not forced to sell assets or hold large sums of cash to meet investor redemptions, as they would have to do in an open-ended fund. This means that investment trust managers can have greater exposure to less liquid assets such as smaller companies.

“In areas where liquidity is important, such as microcap equities, it is probably better [to access them via] investment trusts,” says Matthew Stanesby, investment director at Close Brothers Asset Management.

James Burns, head of the multi-manager team at Smith & Williamson, prefers Schroder Asian Total Return Investment Company (ATR) over its open-ended equivalent – Schroder ISF Asian Total Return (LU0378802051) – due to this factor.

“We like Schroder ISF Asian Total Return Fund but think the trust has more of a bias to mid and small-caps which should drive returns,” he explains.

In your pocket

Trusts may also appeal more to bargain hunters looking for contrarian investments. If a trust invests in an out-of-favour asset class its shares may trade at a discount to its NAV, meaning adventurous investors could buy the shares in the hope of a recovery. “For the more savvy investor, we would look to buy into trusts when discounts don’t reflect the quality of the manager," says Mr Calder. "You hope that the NAV goes up and the share price does too – that’s a double bubble.”

But he adds that buying a trust purely based on its share price is unwise – your main reason should be the fundamental merit of the assets it holds. Share prices can also create problems that may persuade investors to opt for the simplicity of an open-ended fund. “Some investors are more comfortable with open-ended funds because the price you see is the price you get,” he explains.

When you put money into an investment trust the return you get is its share price performance and any dividend payments. If you time when you invest well, you could buy the shares cheaply and sell them on at higher levels. But this can be unpredictable, and some trusts whose assets are performing well may experience poor share price performance because the area in which they invest is generally unpopular. Winterflood recently noted that private equity investment trust shares have tended to trade on double-digit discounts to NAV – despite strong returns over the past decade.

This can also be the case with investment trusts that invest in mainstream markets. Because investors are concerned about Brexit uncertainty many UK equity trusts trade at discounts to NAV. Just one trust – Fidelity Special Values (FSV) – out of 13 in the AIC UK All Companies sector was trading at a premium to NAV on 16 September. 

Share price volatility also means investors have to pay greater attention to how investment trusts and their shares are performing. They could be forced to exit investment trust holdings, for example if they feel there is nothing that will drive their share prices higher.

Mr Burns felt that this was the case with Baillie Gifford Japan Trust (BGFD). Although it had strongly outperformed its open-ended equivalent, Baillie Gifford Japanese (GB0006011133), Mr Burns recently sold out of the trust in the belief that there was “nothing else that could go right” for it. “It is run by a growth house, has a mid-cap bias and some gearing,” he explains. “The discount had gone to a premium and the manager of 20 years [Sarah Whitley] retired [at the end of April last year]. We were happy to take profits.”

Gearing can be a risk because although it can boost returns in rising markets it can also magnify a trust’s losses when they fall. At an uncertain time for markets, investors should keep a close eye on trusts’ debt levels. And these can vary significantly. As our second table shows, the average level of gearing for various investment trust equity sectors differs, and within that individual trusts have different levels. However, many trusts manage their gearing levels in line with their view on markets and can reduce it if it looks as though there is volatility on the horizon.

It is also important to note how the debt is structured. Some trusts took out long-term debt in the 1990s, and while this may have seemed cheap at the time it has proved a drag on returns in a decade of low rates. By contrast, trusts borrowing now can often do so at very cheap levels, making gearing look more attractive from this perspective.

Source: Winterflood as of 16 September 2019

Where trusts stand out

Given all these considerations, the reasons to back a trust over its open-ended equivalent can vary depending on exactly what you are investing for. If you have a high risk appetite, investing in an investment trust run by a reliable manager in an out-of-favour area may pay off if its shares look cheap – especially as the trust does not have to sell assets to meet investor redemptions.

For exposure to a cheap, unloved market via an experienced manager, Mr Burns suggests Henderson European Focus Trust (HEFT). Its manager John Bennett and his team identify sector themes and combine this with bottom-up analysis of companies to create a portfolio that often looks very different to underlying markets and other funds. It tends to be relatively concentrated, and had 46 holdings at the end of July. 

Both the trust and its open-ended counterpart, Janus Henderson European Focus (GB00B54J0L85), have performed well versus markets, but the trust tends to invest more in smaller companies. It also tends to contain Mr Bennett's best ideas because of its unconstrained nature.

"Mr Bennett's view is that investment managers have to be truly active to justify fees," says Mr Burns. "He is doing that across most of the funds he runs, but in the [investment trust] he doesn't have to worry about flows."

Because many investors are wary of European equities, Henderson European Focus Trust was trading at a discount to NAV of 7.9 per cent as of 16 September, although the share price has tended to do relatively well. It fell by nearly 10 per cent during the volatility of 2018, but made double-digit gains in each of the previous three years.

Another option for investors with an appetite for risk is Standard Life UK Smaller Companies Trust (SLS). Run by an extremely experienced manager, Harry Nimmo, this comfortably outperformed its benchmark, Numis Smaller Companies plus Aim index, over one, three and five years to the end of July. And while it has suffered more than its open-ended counterpart, Aberdeen Standard Investments UK Smaller Companies (GB00BBX46183), amid recent volatility the trust traded at a 6.8 per cent discount to NAV as of 16 September so could be a contrarian play on an unloved market. But Brexit uncertainty, the trust's smaller companies focus and use of gearing – albeit low at the moment – make this a high-risk option.

If you need income, funds that buy UK equities can also capitalise on a situation where depressed share prices translate into higher yields. Trusts may be particularly well placed in such a scenario, because gearing can help them ramp up dividend-paying exposure. At the same time, some trusts have the flexibility to pay dividends from their revenue reserves if markets fall and they fail to generate income from their investments.

Dunedin Income Growth Investment Trust (DIG), for example, had a yield of 4.5 per cent at the end of July, higher than that of its open-ended equivalent, ASI UK Income Equity (GB00B0XWNB45). The trust's share price has also outperformed the FTSE All-Share index, the AIC UK Equity Income sector average share price performance and the Investment Association UK Equity Income sector average over most periods to the end of August. Its dividend also appears well protected: in its financial report for the year to the end of January 2019, the trust's board noted that it would add to its revenue reserves, leaving enough money to support 93 per cent of its yearly dividend cost at the time.

Another UK equity income trust worth considering is Invesco Income Growth Trust (IVI). The trust makes similar NAV returns to its open-ended counterpart, Invesco Income & Growth (GB00BJ04J184), over one and three years to the end of July, but outperforms over five and 10. Its yield of 4.2 per cent at the end of July was higher than Invesco Income & Growth Fund's, and the trust mainly invests in companies that pay dividends that can rise above the rate of inflation over time.

For investors with a more tactical mindset, alternating between a manager's open and closed-ended funds could appeal. Mr Calder likes to take advantage of shifts in investor sentiment via Fidelity Asian Values (FAS) and open-ended equivalent Fidelity Asian Special Situations (LU0346390601). When the trust’s shares are trading at a discount to NAV he will consider buying them, and when they move to a premium he sells them and reinvests the proceeds in Fidelity Asian Special Situations Fund. Mr Calder also likes the fact that the trust has greater ability to buy smaller companies than Fidelity Asian Special Situations Fund.