Readers will be aware from previous columns, including ‘Of testing markets and troublesome KIDs’ (IC, 11 Sep 2020), and perhaps from their own experience, of the real concern within the investment trust industry about Key Information Documents (KIDs). The EU’s core retail financial services regulations – known as Packaged Retail and Insurance-based Investment Products (PRIIPS) – had KIDs at their heart which every investment trust has had to produce.
These regulations were poor and even dangerous. The central problem has been that KIDs can be very misleading regarding the assessment of risk, the projection of returns and the comparison with open-ended ‘sister’ funds. There was no balanced approach. Little wonder the media, consumer champions and industry generally have been critical, believing them to be potentially harmful to investors. The Association of Investment Companies (AIC), the sector’s respected trade body, advised investors to ‘burn before reading’.
I raised the issue directly in meetings with the capable John Glen MP, the then economic secretary to the Treasury, and with Andrew Bailey, the then chief executive of the Financial Conduct Authority (FCA). Both realised the extent of the problem. The FCA launched a Call for Input consultation but the EU was unsympathetic to the investment trust cause. Last week, as part of The Edinburgh Reforms seeking to capitalise on the freedoms from no longer being in the EU, the government proposed abolishing the PRIIPS Regulation.
KIDs will no longer plague the investment trust sector. This is excellent news. However, the FCA now needs to step up to the plate and speedily replace these confusing disclosure requirements with a more transparent framework which helps investors make better investment decisions and which treats investment trusts and open-ended funds fairly. The sooner this can be done, the sooner investors will finally benefit.
Seeking the right kind of diversification
My last column suggested policymakers remained behind the curve in not realising inflation would remain higher and more volatile than consensus forecasts recognised – the column ‘Preparing for inflation’ (12 March 2021) first detailing concerns. It also posed questions of investors’ equity strategy and other asset selection when seeking diversification. One of the challenges regarding the latter will be to ensure the balance of alternative assets chosen has sufficient correlation to inflation.
As highlighted previously, the more traditional 60/40 equity/bond portfolio benefited from falling or stable inflation and reasonable if increasingly mediocre economic growth. Such an environment tended to favour fixed-interest bonds over index-linked bonds as the main source of diversification, and growth over value when it came to equities. But times have changed given the new environment of higher inflation and possibly slower growth, and portfolios need to adapt accordingly.
Bonds generally perform poorly during periods of rising and high inflation as they pay a fixed income – government bonds in particular because of the modest income generated. As we have already seen, investors tend to move on. While financial repression may affect this traditional relationship somewhat, and despite their recent setback, investors should only have modest exposure at best to gilts given the inflationary outlook.
Within the reduced bond exposure, higher-yielding corporate bonds offer better protection in part because higher inflation is usually associated with stronger growth, which should reduce the risk of company defaults. However, for reasons highlighted in the last column, economic growth may be harder to generate. Moreover, courtesy of QE and artificially low interest rates, the increased number of unviable ‘zombie’ companies may result in more defaults than expected as interest rates rise. Company selection will remain key.
CQS New City High Yield (NCYF) is the portfolios’ key holding. The company invests predominantly in fixed interest securities at the upper end of the yield curve, while possessing some exposure to high-yielding equities. It has a sound track record under its long-serving and respected manager, while maintaining substantial revenue reserves equating to c.75 per cent of the current dividend which help to support a handsome payout.
Seeking inflation beneficiaries
In compensating for a reduced exposure to bonds, it will be important to achieve sufficient exposure to those alternative assets which benefit from inflation. There are some where the correlation is high and so the impact is more immediate, and others which usually benefit over time. When assessing the merits of the former, it is important to balance the risk to net asset value (NAV) from higher discount rates, driven largely by higher government bond yields, against the uplift to NAV from a company’s assumptions regarding inflation.
An example of the former is infrastructure. HICL Infrastructure Company (HICL) is a core holding and possesses a 0.8 positive correlation to inflation. Recent results revealed a NAV of 164.3p, which represented an increase of 0.7 per cent over the period. Higher long-term government bond yields and discount rates increased the portfolio’s discount rate by c.60 basis points (bps) to 7.1 per cent, which in turn reduced the NAV by 8.9p. But this was more than offset by largely higher actual and forecast inflation given the company’s conservative assumptions.
Another such holding is International Public Partnerships (INPP), which has a correlation of 0.7 per cent and seeks to invest responsibly in public and social infrastructure projects while providing inflation-linked returns by way of dividend growth and modest capital returns. The NAV at 30 June was 157.3p – an increase of 6.1 per cent over the six-month period. The key drivers were changes to near-term inflation assumptions and a revaluation of the Thames Tideway asset.
Renewable energy is another asset class with a high correlation to inflation. A key holding is JLEN Environmental Assets (JLEN) which possesses a diversified portfolio of assets including onshore wind, waste & bio-energy and anaerobic digestion. Diversification will be improved further courtesy of an aquaculture facility in Norway. The recently reported NAV increased by 7.9 per cent to 124.4p and this was helped by prudent assumptions regarding power price forecasts being upgraded to reflect the latest forward pricing and actual inflation.
The portfolios covered in this column, together with the other real investment trust portfolios managed on the website www.johnbaronportfolios.co.uk, also hold assets which usually benefit from inflation over time. As such, it is important to recognise the various elements to each equation when assessing relative merits. An example is commercial property. This sector benefits courtesy of rising rent and income levels, but concerns about the economic outlook, leverage and rising debt costs presently weigh heavily.
Abrdn Property Income (API) is a core holding given its well-managed exposure to UK property assets and strong record under its respected manager, Jason Baggaley – with whom I spoke recently. The portfolio focuses on industrial and office assets at the expense of retail, and so is better positioned than many. However, an expensive refinancing of its debt and economic concerns has impacted sentiment. This may be overdone given the 45 per cent discount at the time of writing, its dividend appears safe and the quality of its assets.
The portfolios also hold BlackRock World Mining (BRWM), CQS Natural Resources Growth & Income (CYN) and WisdomTree Physical Gold £ ETF (PHGP). Commodities and gold usually shine when the inflationary genie is out of the bottle. The column ‘The case for commodities’ (10 July 2020) explains why the sector was on the turn – particularly the mining sector. The investment case remains intact. Gold will also continue to produce attractive returns, especially when the consensus realises inflation will be ‘sticky’.
Remaining on the defensive
Further assets held with a more indirect link to inflation include the capital preservation trusts – Ruffer Investment Company (RICA), Personal Assets Trust (PNL) and Capital Gearing Trust (CGT). These tend to combine a defensive equity approach with decent exposure to index-linked bonds. The pricing of the latter is sensitive to consensus forecasts regarding inflation, which these respected managers believe the market continues to underestimate. To this end, the portfolios also hold iShares Index Linked Gilts ETF (INXG).
In combination, whether companies with a direct or indirect correlation to inflation, these non-equity sectors typically comprise around two-thirds of the portfolios’ exposure to alternative assets – regardless of the extent of that exposure as a percentage of the portfolio overall. For further details of the website’s five-portfolio risk-adjusted investment journey, the website’s open Diversification page provides a table showing the extent and nature of their exposure to these other asset classes as a journey in numbers.
But what of the remaining exposure committed to achieving diversification? Rising interest rates allow for cash to better compete for investors’ attention – at least as a staging post and port in a storm. Many are critical of cash given high inflation erodes its value in short order, but it is a known quantity during market corrections and is therefore possibly the best ‘diversifier’ of all. The new investment landscape will warrant higher levels given increased volatility will be a new guest at the investment table.
The portfolios also have exposure to the specialist lending sector. Holdings include BioPharma Credit Investments (BPCR), Sequoia Economic Infrastructure Income (SEQI) and GCP Asset Backed Income (GABI). Sentiment is poor in part, again, because of economic concerns. Lending to businesses, sometimes because the banks will not or cannot, is deemed to be risky. However, these companies possess the required expertise, have proven track records, and stand on handsome yields and discounts which leave little to trust.
My column next month will focus on the equity strategy required given the new market regime, while again referencing the portfolios. It will also reflect on the portfolios’ performance over the year.
Portfolio performance
Growth Income
1 Jan 2009 – 30 Nov 2022
Portfolio (%) 390.9 274.7
Benchmark (%)* 220.0 150.1
YTD (to 30 Nov)
Portfolio (%) -11.6 -7.2
Benchmark (%)* -2.9 -5.9
Yield (%) 3.4 4.1
*The MSCI PIMFA Growth and Income benchmarks are cited (total return)
