What does 2013 hold for investment trusts?
Investment trusts and investment companies are too often ignored by private investors. It's usually for one of two reasons, or both. They are not as 'visible' as funds - most financial advisers do not recommend them to clients and most trusts do not market themselves as aggressively as funds.
But the presence of discounts or premiums - when a trust's share price is either lower or higher than its underlying asset value - is also a factor. The shares of all but a handful of trusts trade in this way, with most trading at discounts to net asset value, or NAV.
But it can be argued that investors who buy trusts for the long term should put the issue of discounts out of their minds. That's because investment trusts, on average, outperform funds, and often by a significant margin, on both share price and NAV.
Alan Brierley, director of investment companies at stockbroker Canaccord Genuity, encapsulates the reasons. "Lower total expense ratios, the ability to focus on managing money rather than be distracted by managing inflows/redemptions, the ability of income funds to use revenue reserves to smooth dividend payouts, the potential for NAV enhancements through gearing, buybacks and share issuance give trusts strong competitive advantages."
Brierley revels in pointing out the performance disparities and regularly highlights them in annual comparisons. The most recent, to the end of 2011, analysed average performance of funds and trusts over 10 years in popular, comparable sectors. It made uncomfortable reading for fund fans but was a compelling story for trust aficionados, as well as for those who ignore them.
The widest disparity was between global growth trusts and funds. On an annualised basis, trusts outperformed by an average 4.4%; in the Global Growth & Income sectors it was 4%; 3.9% extra each year among Asia Pacific ex-Japan trusts; 3.7% in Global Emerging Markets; and 2.2% in Europe ex-UK.
Trusts that focus on mainstream UK Shares and UK Equity Income outperformed by a still-healthy 2.2% and 1.9% respectively. Only in Japan did trusts underperform funds - by 0.4% a year.
Not only that, trusts on average beat the relevant benchmarks except in North America and Japan, whereas funds on average failed to beat any of them. The figures for trusts are based on NAV total return, not the share price total return that investors care most about. But that brings me back to the issue of discounts: they should not be of much concern to the longer-term investor.
Trust discounts are a reflection of investor opinion: either the trust or its sector is out of favour.
If the individual trust is underperforming, its board of directors will be pressured by shareholders to fix it via share buybacks, changing the investment manager, or a corporate action such as wind-up or takeover.
If it's the sector that is underperforming, then 10 years is an adequate period for market sentiment to turn, something that also applies to both funds and trusts.
The structural advantages that investment trusts have over funds should, over time and with a fair wind, outweigh concerns about trust discounts widening. The caveat is when investors back trusts quoted on significant premiums.
Here the danger is that the trust's strategy or the sector loses favour with investors. That will likely hit popular income-focused trusts currently trading on significant premiums when expectations of interest rate rises start to gain traction.
And what of the financial advisers who have traditionally eschewed trusts?
Come January they are more likely to consider recommending them to clients, because the commission bias that swayed them towards funds will be outlawed on any new recommendations they make.
They might also be more inclined to take note of Brierley's annual performance comparison when he updates them early next year. That's something I am anticipating with relish.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
Net asset value
A company’s net asset value (NAV) is the total value of its assets minus the total value of its liabilities. NAV is most closely associated with investment trusts and is useful for valuing shares in investment trust companies where the value of the company comes from the assets it holds rather than the profit stream generated by the business. Frequently, the NAV is divided by the number of shares in issue to give the net asset value per share.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Investors who borrow money they use for investment and use the securities they buy as collateral for the loan are said to be “gearing up” the portfolio (in the US, gearing is referred to as “leveraging”) and widely used by investment trusts. The greater the gearing as a proportion of the overall portfolio, the greater the potential for profit or loss. If markets rise in value, the investor can pay back the loan and retain the profit but if markets fall, the investor may not be able to cover the borrowing and interest costs, and will make a loss. Also used to describe the ratio of a company’s borrowing in relation to its market capitalisation and the gearing ratio measures the extent to which a company is funded by debt. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.