Investment Trust Portfolio: The ending of an era

The challenges

Over the years, this column has been critical of the poor economic and financial policies pursued by governments. Too much debt, money-printing and monetary growth, artificially low interest rates, and a huge tax-and-spend agenda, have not only resulted in a period of inflation, economic malaise and falling living standards for the majority – but they have also distorted financial markets to the point that most asset prices (and the correlation between them) have increased. There will need to be some sort of reckoning. Most likely, either the valuations of financial assets and debt will be eroded by inflation over time or these values will have to decline and the debt unwound. The Goldilocks scenario is unlikely to play out.

Low confidence in policymakers is not helping sentiment. Governments have been too complacent regarding inflation. As touched on in previous columns, central banks have ignored monetary growth figures going through the roof and clear evidence of pockets of inflation building. We were told inflation was not a problem. When it became a problem, we were told it was going to be transitory. When this was evidently not the case, we were assured inflation would shortly subside. Given the extent of such complacency, one would be forgiven for believing policymakers have kept interest rates artificially low so inflation could help erode the debt.

While geopolitics and the energy crisis have exacerbated the problem, it is governments that are primarily responsible for inflation. The markets also recognise that central banks are restricted in their policy responses given the extreme debt levels and scenario they’ve created. The preoccupation now is how far interest rates will have to rise. The US Federal Reserve has finally admitted there will be some pain. However, while accepting we live in unusual times, it would be truly unusual to tame the current level of inflation with interest rates that remained substantially below that level. The current policy suggests a more severe economic slowdown than perhaps markets are expecting.

The remedy

At a time the country is still mourning the passing of Her late Majesty Queen Elizabeth II, after a lifetime of devoted service and inspiration to her people, and ushering in a new era under King Charles III, investors would be wise to embrace the new investment approach required to better accommodate this changed market landscape. This is particularly the case when seeking diversification. Just as portfolio construction has evolved over time to meet changing conditions, the thinking should again evolve given the conventional 60/40 equity/bond portfolio is typically using assets that are perhaps better suited to a previous market regime. And times have changed.

The markets have grown used to a period of falling or relatively stable inflation and low economic growth. This has tended to favour fixed-interest bonds over index-linked bonds and growth over value when it comes to equities. Such assets performed well in the last market regime, but are unlikely to do so now. Previous columns have highlighted how the investment trust portfolios managed on the website www.johnbaronportfolios.co.uk, including the two covered in this column, have transitioned within their equity exposure and embraced new asset classes when seeking diversification. However, this is an evolving landscape and so these real portfolios are continuing to adapt their response.

Conventional bonds in particular remain vulnerable given the inflationary outlook, despite the many predictions and regulations of policymakers. As such, exposure to this asset class should be significantly reduced from conventional weightings. The only pockets of value are perhaps corporate bonds, given current valuations, but even here one should tread carefully – the portfolios’ main holding having been CQS New City High Yield (NCYF). And while protecting against inflation and against volatility can be two different things, index-linked bonds both at home and abroad are also evident in the portfolios as markets (and central banks) may still be underestimating just how stubborn inflation will be.

As for the portfolios’ equity holdings, broad market exposure by way of geography will continue to feature. However, the portfolios have long embraced the concept of thematic investing given the superior returns in prospect. Indeed, this concept now represents the larger component outside the UK in most portfolios. This is because sectors such as technology (especially smaller companies), healthcare, private equity and the environment will continue to be among the secular long-term growth themes of the future regardless of any short-term volatility. And volatility should be capitalised upon to build positions for those underweight.

In addition, a growing component of investors’ general equity exposure will need to embrace a higher-conviction approach to stockpicking if they are to thrive. Too many funds and institutional portfolios tend to hug the benchmark believing there is safety in numbers. This is becoming an increasingly dangerous fallacy. As Sir John Templeton reminded us, investors have to do something different if they are to beat the benchmark. Fund managers should increasingly do likewise. And as the investment landscape continues to evolve, investment trusts are superbly placed to capitalise given their structure better caters for the long-term investment needed when bucking short-term sentiment.

For example, the portfolios have been adding to their positions in JPMorgan Global Growth & Income (JGGI). The company seeks to outperform the MSCI All Country World Index (£) courtesy of a high-conviction portfolio of typically 50-90 stocks, while paying a dividend equating to 4 per cent of its net asset value (NAV) each year. Portfolio construction is steered by bottom-up stock selection rather than geographical allocation. This allows for greater flexibility of approach, which it has put to good use – the company having outperformed its benchmark over one, three, five and 10 years. Other good examples of this conviction approach include Finsbury Growth & Income Trust (FGT) and Edinburgh Investment Trust (EDIN).

In addition to the different construction of a portfolio’s traditional bond and equity exposure, when compensating for the reduction in conventional bond exposure investors will need to be more creative when seeking other ‘uncorrelated’ assets. This is specially so given current policies are increasing the correlation between asset classes in general. For despite the new market regime, it remains a truism that it is usually wise to increasingly diversify a portfolio away from equities as the investment journey unfolds in order to help cushion the effect of any market falls. This investment discipline is particularly important to those near to achieving financial objectives.

And while there are no fixed rules as to the pace and extent of diversification, my website’s Diversification page lists and quantifies the portfolios’ approach in some detail. These other ‘less correlated’ assets currently include infrastructure companies such as HICL Infrastructure Company (HICL) and International Public Partnerships (INPP), whose revenues have positive correlations of 0.7 per cent-0.8 per cent to inflation. Environmental companies also feature, such as JLEN Environmental Assets Group (JLEN), The Renewable Infrastructure Group (TRIG) and Bluefield Solar Income Fund (BSIF), which are benefiting not only from a favourable backdrop but also from increased power price forecasts.

Commodity companies also feature, including BlackRock World Mining (BRWM) and CQS Natural Resources Growth & Income (CYN), which are benefitting from higher mineral prices courtesy of the inflationary environment and geopolitics. Meanwhile, companies held within the specialist lending, capital preservation and commercial property sectors, together with gold, also aid the portfolios in their quest – examples include BioPharma Credit Investments (BPCR), Ruffer Investment Company (RICA) and Abrdn Property Income Trust (API). Many of these companies also offer decent levels of income and help the portfolios achieve respectable yields relative to remit.

But the portfolios are seeking further assets that have an even lower correlation to the economy and markets. Hipgnosis Songs Fund (SONG) invests in songs and associated musical intellectual property rights, and receives revenue whenever they are played. This revenue has grown unabated, including during the pandemic. In July, the company reported a currency adjusted NAV of £1.548, which represented a discount of 27 per cent when bought. A recent report from Goldman Sachs saw it upgrade its double-digit annual growth forecast to 2030. There may be some short-term volatility given the company’s debt is subject to rising interest rates, something it is addressing, but patient investors will be rewarded.

Another often unfashionable yet underestimated asset class the portfolios are increasing exposure to is cash. It has its critic,s particularly during times of high inflation, but it is a known quantity when markets are volatile. Together with gold, history suggests it has been one of the best diversifiers of all given its nature. It is also a ready reserve for attractive long-term opportunities given volatility will continue, including the pockets of value now appearing following the investment trust sector’s recent de-rating.

Performance

And this brings us to the subject of performance. When it comes to embracing diversification in the normal sense – that of helping to protect past gains – there is a common concern that diversification away from equities can only lead to underperformance relative to equity markets over time. This is understandable. No one knows what the future holds and humility is an essential component of good portfolio management. However, while never complacent, the performance of the website’s Winter portfolio gently suggests diversification need not be the hindrance commonly thought – indeed, quite the opposite.

The portfolio is the website’s most defensive, with currently just 10 per cent of exposure committed to mostly higher-yielding quality equities, and the balance to a wide array of alternative assets. The portfolio has tended to be resilient when markets have dipped and trailed when markets have soared. However, since its introduction in January 2014, it has outperformed the FTSE All-Share index, producing a total return of 66.4 per cent to 31 August, which compares with 52 per cent for the index. Good things often come in small parcels.My website’s Performance page has more detail.