A world of wealth

Investment trusts are not better or worse than open-ended funds, but they have some differences that can be beneficial or detrimental, depending on how they are used.

Investment trusts do have more complicated structures than open-ended funds. This doesn’t mean you shouldn’t invest in them, but it does mean you need to do even more due diligence before investing in one, and understand what these added elements – such as discounts and premiums to net asset value (NAV) are. And investment trusts have a number of risks and downsides, but if you know what the risks are and how to manage them, you can still get good results. 

But these are maybe reasons why investment trusts are definitely for the discerning investor – you need to be well informed about how they work, and the constantly moving figures that relate to them, including their share price, discount/premium to NAV and level of gearing (debt).

A way to sensibly use investment trusts is to pick ones that suit your investment profile and objectives, within an appropriately diversified portfolio that includes various types of funds and assets. Assessing funds on the basis of their structure, and pitting open-ended funds against closed-ended investment trusts is not a good approach, any more than pitting active funds against passive funds. The savvy or discerning investor knows that the smart thing to do is to be open to using both active and passive funds, picking the best option in different areas for their portfolio and investment needs.

And you should take the same line when allocating between your active funds: it is not important whether a fund is open-ended or closed-ended – just pick the best one available to cover the given area that you have decided you need exposure to. Funds should earn a place in your portfolio because they will add something to it – not because they have a particular structure.

>Many mainstream equities trusts in sectors such as Global and UK Equity Income – the types of funds you might have as a core holding in your portfolio – are reasonably priced

Performance and cost

Over the 12 months to the end of August 2017, investment trusts outperformed their open-ended equivalents in 14 out of 16 sub sectors, when comparing share prices for investment trusts with open-ended NAVs, according to broker Winterflood.

The investment trust sector with the largest outperformance was European Smaller Companies, which made a share price return of 41.3 per cent, ahead of the 25.9 per cent return for the equivalent open-ended sector and HSBC European Smaller Companies Index’s 26.8 per cent.

However, this was driven by one trust – TR European Growth (TRG) – which made a return of 55 per cent. This trust has benefited from a significant re-rating, so has moved from trading at a discount to NAV to a premium. The trust's performance was helped over its financial year to 30 June 2017 by factors including the weakness of the pound against the euro and it made a NAV return of 54 per cent over that period. It also benefited from good stock selection, with drug discovery company Evotec (Ger:EVTX) returning 290 per cent and Dutch wealth manager Van Lanschot (Ne:VLK) returning 50 per cent.

Global investment trusts also did well over the 12 months to 31 August with a sector average share price return of 31 per cent, against 17.2 per cent for open-ended Global funds and 18.9 per cent for FTSE World index.

Investment trust sectors which underperformed their open-ended equivalents include North American Smaller Companies, which returned 12.1 per cent against 15 per cent for the open-ended Investment Association (IA) North American Smaller Companies sector. Both were behind the Russell 2000 index's return of 16 per cent.

Looking at the longer term, investment trusts outperformed their open-ended equivalents in nine out of 16 sub-sectors over three years, 12 out of 16 over five years, and 13 out of 16 over 10 years, according to Winterflood.

An important point to make here is that these are just averages. There are many investment trusts with poor performance records and many open-ended funds with great performance records. 

Reasons for investment trusts’ average outperformance include their managers’ ability to take a long-term investment view and wait for assets with long-run potential to come to fruition, because they do not have to meet investor redemptions. If you want to take your money out of an investment trust you have to sell your shares to another investor on the secondary market. 

The other main reason for trust outperformance is gearing – the ability to take on debt to invest more – which is beneficial when the prices of assets are going up.

Another reason for better returns from investment trusts historically has been lower charges. But since January 2013, following the Retail Distribution Review, commission payments to independent financial advisers by open-ended funds were banned, and funds introduced cheaper share classes that didn’t pay commission or offered private investors cheaper share classes previously only available to institutional investors.

This means that most open-ended funds now have an ongoing charge below 1 per cent, in contrast to 1.6 per cent for their older share classes. And reports last year by Tilney Group and Canaccord Genuity found that open-ended funds are now on average cheaper than investment trusts.

Tilney Group also found that, over three years, the open-ended funds covered by its research delivered higher returns than the comparable trusts on a total return basis 60.5 per cent of the time, although over five years returns on the trusts were ahead 63.9 per cent of the time.

Even if taking a long-term view and gearing helps a trust’s returns, if it has high fees then the end investors will lose a good chunk of this return. And while there is no guarantee that using these strategies will boost a trust’s returns, costs are a certainty, so it is still important to try to get the exposure you need in a cost-effective way. There has to be a very good reason for paying more for an investment trust or any higher charging fund.

But the good news for investors is that while investment trusts are on average more expensive, you do not buy an average but rather individual trusts and funds, and some of the cheapest active funds happen to be investment trusts.

For example, top-performing Global investment trust Scottish Mortgage (SMT) has an ongoing charge of only 0.44 per cent and Monks (MNKS), a slightly less racy Global trust that also has a good performance record, has an ongoing charge of 0.59 per cent.

Income stalwart City of London Investment Trust (CTY), which has raised its dividend every year for 50 years, has an ongoing charge of 0.42 per cent. And Edinburgh Investment Trust (EDIN), run by highly regarded manager Mark Barnett, which offers a yield of 3.5 per cent, has an ongoing charge of 0.6 per cent. 

In fact, many mainstream equities trusts in sectors such as Global and UK Equity Income – the types of funds you might have as a core holding in your portfolio – are reasonably priced. 17 out of the 23 trusts in the AIC Global sector have ongoing charges of less than 1 per cent, as do 15 out the 24 trusts in the AIC UK Equity Income sector.

Average investment trust charges tend to get pushed up by ones focused on esoteric assets, which often include a performance fee. But performance fees are less common among mainstream trusts and virtually unheard of among open-ended funds, with the exception of those in the IA Targeted Absolute Return sector.

This underscores an important point: if you invest in funds, in particular investment trusts, you can’t be lazy. Surveys of average performance and average charges do not account for those of individual funds or investment trusts. You need to carefully analyse each investment trust and assess it on its individual merits, in other words be a discerning investor. And if you are, you are likely to be well rewarded.

Discounts

Since the start of 1990 the long-run average discount for investment trusts has been 9.3 per cent, according to Winterflood. However, in the past 10 years, the average has been tighter at 7.2 per cent due to a number of factors, including buyback programmes, the adoption of discount control mechanisms and demand for funds offering greater dividend certainty through the use of revenue reserves if necessary.

Discount tightening has also been a feature of 2017, with Winterflood reporting that the average investment trust discount at the end of September was 3.5 per cent, compared with 4.1 per cent at the end of last year.

"The dynamics of the sector are constantly changing and activity in the past few years has led to the likelihood of narrower discounts," says Peter Walls, manager of fund of investment trusts Unicorn Mastertrust (GB0031218018). "These include fee reductions, which a number of trusts have made to compete with open-ended funds and passive funds, the growing realisation that share buybacks are important, and buyback activity if markets have a setback. Rising markets also tend to be correlated with narrowing discounts, while the number of trusts distributing income from capital is also gradually growing, and in some cases this has helped their ratings."

For example, in September last year International Biotechnology Trust (IBT) introduced an annual dividend equivalent to 4 per cent of its NAV on the last day of its previous financial year, and uses its capital reserve to fund this. Before announcing the changes in September last year the trust frequently traded at a double-digit discount to NAV, but since then it has substantially tightened so that it now trades on a discount of around 2 per cent.

Invesco Perpetual UK Smaller Companies (IPU) amended its policy in 2015 to pay higher dividends, which can be partially taken from capital. It now trades on a discount to NAV of around 6 per cent and has typically been at single-digit levels since mid 2015, before which it was generally wider than 10 per cent.

F&C Private Equity (FPEO), meanwhile, amended its policy in 2012 to enable it to pay a higher dividend partially funded from capital, and is one of only four trusts out of 24 in the Private Equity sector trading on a premium to NAV. 14 of the trusts in this sector are on double-digit discounts to NAV.

Private Equity remains one of the investment trust sectors on a wider average discount at 14.5 per cent as at 6 November, along with UK Smaller Companies on 12.2 per cent and Commodities & Natural Resources on 14.6 per cent.

Land of the setting sun?

A stand-out performer, not just in the Japan sector, but across the closed-ended world has been Baillie Gifford Japan Trust (BGFD) which, for example, over five years has made a share price return of 311 per cent and NAV return of 247 per cent. 

The trust's strong returns have been partly due to lead manager Sarah Whitley, who has run it since 1991, alongside open-ended funds including Baillie Gifford Japanese (GB0006011133), which also has a strong performance record. Between 30 September 1991 and 31 August 2017 Baillie Gifford Japan Trust’s NAV increased 545 per cent compared to the Topix index’s return in sterling terms of 156 per cent, according to the trust’s board.

However, in September it was announced that Ms Whitley will retire from Baillie Gifford at the end of April next year. When a manager steps down from a fund its investors should take note – especially when the manager has an outstanding record, as the fund might not do so well going ahead.

Baillie Gifford has appointed Matthew Brett as lead manager of Baillie Gifford Japan Trust and Praveen Kumar as deputy portfolio manager. The trust’s board says that Ms Whitley will work with Mr Brett and Mr Kumar up until she leaves to ensure a smooth transition.

Mr Brett is fairly experienced having joined Baillie Gifford in 2003. Since June 2008 he has been co-manager of Baillie Gifford Japanese alongside Ms Whitley, as well as attending the trust’s board meetings. He is also co-manager of Baillie Gifford Japanese Income Growth (GB00BYZJQG71) and part of the investment team that runs Baillie Gifford Global Select (GB00BYNK7G95).

Research company FE Trustnet says that Mr Brett has "overall, performed better than his peer group composite. Over a long track record, the manager has outperformed the peer group more often than not. Good stockpicking has had a material positive impact on results, which have not been particularly exposed to falling markets".

He is well ahead of his peer group composite over one, three, five and seven years.

Mr Kumar joined Baillie Gifford in 2008 and took over the management of Baillie Gifford Shin Nippon (BGS) and Baillie Gifford Japanese Smaller Companies Fund (GB0006014921) in December 2015.

Analysts have mixed views on whether the trust can continue to do well. "Sarah Whitley has been managing Baillie Gifford Japan for 26 years and over that period she has delivered very strong absolute and relative returns for shareholders,” say analysts at Winterflood. “However, the approach has undoubtedly been team-based, with investment ideas generated from a number of sources including other areas of the firm. We rate Matthew Brett and Baillie Gifford’s wider Japan team highly and would not expect the investment approach to change materially as a result of Sarah Whitley’s retirement."

Analysts at Numis say: "Sarah Whitley's track record during her 37 years at Baillie Gifford is impressive, but investors should not be concerned by her retirement. There is an emphasis on a team-based approach to idea-generation, and crucially there will be no change in approach. Her replacement as leader of the Baillie Gifford Japan team is Donald Farquharson, who has 29 years' experience. We believe the trust remains an attractive core holding for exposure to Japan. Reflecting the strong long-term performance record the trust has typically traded on a premium in recent years. However, there could be some pressure on the size of this premium following the announcement [of Ms Whitley's retirement]."

Baillie Gifford Japan Trust is trading on a premium to NAV of around 7 per cent.

Anthony Stern, analyst at Stifel, says: "While the change is being managed carefully, there is clearly the risk that the trust's future performance will not match its strong track record under the departing manager, and there is also the possibility that long-term backers of Sarah Whitley may seek to exit the trust. The trust could be exposed to a discount de-rating should this materialise. Sarah Whitley has been a key portfolio manager in the team for many years and her experience as well as decision making is a significant loss."

As a result of Ms Whitley's forthcoming departure Mr Stern suggests switching into Fidelity Japanese Values (FJV).

Investors should never make snap decisions on whether to keep or sell a fund following news of a manager change, especially in a case like this when it is a number of months away and the fund is managed by a team rather than one individual. But if you are a shareholder it will be important to monitor this trust, especially after the end of April next year, looking at details including performance, premium/discount to NAV, and portfolio composition. Baillie Gifford Japan Trust is one of our IC Top 100 Funds so we will provide regular updates on it.

Read all the features in our Investment Trust special:

Asia Trusts are the secret to bargain growth

Asia Pacific ex-Japan investment trusts offer growth at a discount

Two portfolios for income

We check in with our two investment trust income portfolios to see which one has paid the most, which has performed the best and what changes have been made. 

Around the world in eight investment trusts

It’s time to grab your passport and your carpet bag and build a geographically diversified portfolio with Algy Hall.

Investment trusts: Professional picks 2017

Four professional investors set out their picks for growth, income, wealth preservation and diversification.

‘No deal’ upside

John Baron explains why the UK market looks good value regardless of a trade deal with the EU

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