Investment trusts come back into fashion

 28 October 2016

It is no coincidence that as part of his fightback against the asset management "system", Daniel Godfrey - the ousted chief executive of the UK's asset management trade body - will launch an investment trust.

Once maligned and dismissed as a nerdy, old-fashioned way to invest, the world's oldest collective investment vehicles have undergone a reinvention as vehicles for esoteric and disruptive new asset classes.

The sector has morphed from a collection of mainstream equity income funds - such as Foreign & Colonial, founded in 1868 - to a hunting ground for private investors desperately seeking returns and exposure to niche asset classes in a world where income is hard to come by.

Because of the way investment trusts work, they are able to offer liquidity to investors ploughing their money into fundamentally illiquid asset classes. The funds list on a stock exchange and offer shares to investors at IPO. Once the fund has raised its capital by selling shares, it can buy assets without having to worry about whether it can sell them in a hurry - investors wanting to leave the fund can do so by selling their shares on the stock exchange, just as they would with an equity holding. The only caveat is the share price may plunge well below the value of the fund's assets - something that has made them a target for activist investors in recent years.

Nevertheless, investment trusts are shaking off their unfashionable image to emerge as the hipsters of the investment world - and their ability to target niche asset classes is particularly prized. However, the new direction also brings increased risks which investors need to be aware of.

Years of quantitative easing and the prospect of rising inflation have boosted the appeal of infrastructure and property, and investment trusts have provided a liquid wrapper for these sectors. Numis, the broker, estimates that 80 per cent of investment trust share issuances in the three years have been in alternative asset classes - including property, private equity, infrastructure, asset-backed leasing and peer-to-peer lending.

That said, it is not plain sailing for investment trusts. Even star manager Neil Woodford shelved further fundraising plans for his Patient Capital Trust in March. The board of the trust, which focuses on early-stage investment in growth companies in sectors such as biotech and technology, blamed "continuing uncertainty prevailing in markets". This was a reversal of plans announced in January, when the trust said it was looking at further share issuance.

"Investor demand has been muted and where there has been some, it's been for income," says Simon Elliott, investment trust analyst at Winterflood, the broker.

Income hunger should, in theory, be good news for investment trusts. While open-ended income funds battle against dividend cuts on FTSE 100 stocks, investment trusts are in a good position to keep paying out dividends above and beyond what they earn. Unlike open-ended funds, trusts are not obliged to distribute all of the dividends they earn from the stocks in their portfolio, meaning they can hold cash back for rainy days to increase dividends even when times are tough.

The Association of Investment Companies - a trade body for trusts and something of an evangelist for the sector - recently compiled a list of 19 funds that had increased their dividend every year for 20 years. They were all either global or UK equity income funds.

"There are some large and long-established funds with good attractive fees, strong track records and experienced managers who've been around a long time," says Ewan Lovett-Turner, investment trust analyst at broker Numis. "You have the benefit of a revenue reserve which means dividends are very safe."

This ability to create dividends out of spare cash is one of the things boosting the popularity of asset classes that are not typically considered yield generators - such as private equity. Listed private equity funds were popular among retail investors until the 2008 financial crisis, at which point they were largely deserted and their share prices dropped well below their net asset values. But the trusts have spent the best part of a decade trying to win back small investors, who they view as more loyal than institutional players.

In a bid to make themselves more appealing, many have manufactured dividends out of capital returns, even though the unlisted companies the funds invest in typically do not offer dividends. For example, F&C Private Equity aims to return 4 per cent of its net assets every year to shareholders via a dividend, while Apax Global Alpha returns 5 per cent. Princess Private Equity and NB Private Equity generate dividends of between 4.4 and 8 per cent.

Other asset classes - like alternative debt - naturally produce income and so the funds have no need to manufacture dividends. However, in the case of peer-to-peer loans, the liquidity wrapper offered by the trust entices in investors who may otherwise have been put off by committing to several years via an online platform.

In its purest form, peer-to-peer lending involves matching borrowers with those who are prepared to lend their savings to interest paying borrowers. The connection is made through a website that arranges the loan without taking any balance sheet risk - it is this innovation that sets the peer-to-peer companies apart from traditional high-street banks.

Although questions about the quality of the underlying credit-writing remain, the asset class has so far delivered good returns to those investing directly in the loans, -- its total return over 3 years has been of 15.86 per cent, according to the Liberum Altfi Index. For investors who are prepared to stomach the risks, the remaining catch is the illiquidity - but this is where investment trusts have stepped in. While no asset manager has invested in peer-to-peer loans directly, plenty have bought shares in the investment trusts. Asset managers including BlackRock, Invesco Perpetual, BNY Mellon and Baillie Gifford have all bought shares in the handful of investment trusts buying peer-to-peer loans. Following the mantra of when in doubt, make sure you can get out, putting an equity wrapper on a debt instrument allows this.

Another criticism of peer-to-peer lenders is that - for the most part - they do not actually do any lending. Some argue that without so-called "skin in the game", the lenders are not incentivised to make sure the loan is good. One of the investment trusts has found a solution to this problem. Victory Park Capital has said it will move away from lending directly to the end borrower and more towards "balance sheet lending". This means it lends money to the peer-to-peer company, which then itself lends the money onwards. "You're ensuring the lender to eats their own cooking," says one fund manager.

For retail investors, however, there are some downsides to these trusts. The returns at present are not stellar. The subsector is one of only two to see negative performance in the third quarter of 2016, with its net asset value declining by 0.4 per cent, although its share price return has been about 4 per cent over the same period. The fees they charge are also relatively high. One of the P2P trusts, P2PGI, is backed by hedge fund Marshall Wace and has a series of hefty performance fees in place.

The UK's Retail Distribution Review in 2013 banned open-ended funds from paying commission to financial advisers and wealth managers. Investment trusts, which never paid commission in the first place, suddenly found themselves being taken far more seriously by advisers.

But this change has been a double-edged sword for the funds - although they are now more likely to be looked at by financial advisers, they also have to work harder to compete on cost. Historically, not paying commissions meant that the costs passed on to the investor were smaller than those charged by open-ended funds. RDR has changed that.

"It's one of the great shibboleths of the industry that trusts have lower costs than open-ended funds, but that is a little bit of a hang on from the past," says Jason Hollands, wealth manager at Tilney BestInvest. "Not all boards have moved on to see that competitive advantage is not a given."

Fund houses will often run two versions of the same investment strategy - one open-ended fund and one investment trust. Recent research by Tilney took 47 strategies and compared the costs of the open-ended fund and its investment trust cousin. It found that in just over 50 per cent of cases, the open-ended fund was cheaper.

The fees charged by investment trusts can be high in esoteric asset classes, with some charging "performance fees" for outperforming their benchmark, especially in more hedge fund like strategies. Listed private equity funds and venture capital trusts (VCTs), in particular, have higher fees than other trusts investing in other asset classes.

"That is a part of the industry that is inherently labour intensive per square foot of assets," says Mr Hollands. "Once you're invested in a small unlisted business you're in the deep end. You're likely to put one of your members on the board of the company and you're very involved with the business," he says. For VCTs, annual costs could range from 1.5 to 3 per cent, according to Tilney.

Investors should also beware of investment trusts pursuing a fund of funds approach. These funds are typically more expensive as they charge two layers of fees - the one for the fund's management company being on top of charges levied by the underlying funds. These costs are not always reflected in the fund's OCF (ongoing charge figure) quoted to investors.

However, the discount mechanism means many trusts can be picked up for bargain prices. While you might expect the fund managers to not mind too much about their share price given that it doesn't affect the amount of capital they have to manage, many see it as a point of pride.

"It matters because investors [who bought shares] at IPO have lost money," says one manager, whose fund was trading at a discount. Mr Lovett-Turner, at Numis, says listed private equity funds were an area the broker had been "highlighting as cheap for quite a while".

Other subsectors - such as infrastructure - are trading on enormous premiums to net asset value. Infrastructure has long been a popular choice among professional stock pickers in volatile markets. Infrastructure companies often have their loans underwritten by the government, and invest in everything from schools and hospitals to roads and sewers. Their relative safety has seen them trading on a hefty premium of 16 per cent to net asset value on average recently, however.

For all the liquidity advantages of investment trusts, the share price mechanism means investors can be in for a bumpy ride. It is possible to sell out - but that doesn't mean you won't lose money if the value of your shares suddenly collapses. That volatility is often much greater than the volatility of the underlying asset class, meaning investment trusts are not for the faint hearted.

Multi-asset

Multi-asset strategies covering shares, bonds and derivatives have traditionally been scarce in the investment trust sector - but then BlackRock Income Strategies came along. The fund, formerly known as British Assets, was managed by F&C until its board decided to switch to BlackRock's multi-asset team - and take its name - about 18 months ago. However, hopes that its policy of investing in shares, bonds and derivatives would provide returns that significantly beat inflation have fallen short in current market conditions. Following declines in the share price and a widening discount to net asset value, the trust's board announced a so-called "manager beauty parade" several weeks ago - effectively putting BlackRock on notice.

"It's unusual to have a beauty parade so soon after appointing a new manager," says Mr Elliott of Winterflood. "This is a trail blazer that hasn't worked out - but clearly there is a place for multi-asset."

Mr Lovett-Turner of Numis agrees: "There aren't many funds with this specific mandate and it is quite an appealing strategy for investors." He added that the structure of the investment trust could give managers "more flexibility" when distributing their gains.

Property

Real estate investment trusts (Reits) are a good illustration of the liquidity advantages that a listed structure can provide.

In the aftermath of the Brexit vote, open-ended property trusts paid the price for promising investors daily liquidity -- but when it came to it, the cash was not there. In normal market conditions, investors wishing to exit funds could have their money back within a day. But buildings take months to sell - and if large numbers herd for the exit, problems occur.

Many open-ended property fund managers were forced to suspend trading on the funds until they could sell enough buildings to get investors' cash back. Although all have managed to deal with redemptions and reopen again, Mike Prew, an analyst at investment bank Jefferies, says that open-ended funds had been selling "snake oil".

"Open-ended funds only work on the way up when they source real estate and manage the cash drag," he says, referring to the effect of cash on fund returns.

"On the way down the promise of liquidity in an illiquid asset class failed in 2007 and is failing again only eight years post Lehman Bros' collapse."

The way listed Reits are structured mean that investors looking to exit did not have this problem. Yes, shares in the sector took a beating and investors may have lost money, but the companies did not have to sell assets in a hurry, and investors could always trade out.

Venture capital trusts

VCTs have grown in popularity in recent years thanks to their tax benefits.

The vehicles, which invest in early stage companies, offer income tax relief of up to 30 per cent of the cost of shares while gains are exempt from capital gains tax (CGT). Taxpayers can claim these breaks on anything up to a £200,000 investment.

The funds raised more than £457m in the 2014-15 tax year, making it the third highest year for fundraising since records began in 1995, according to data from the Association of Investment Companies.

A reduction of annual and lifetime allowances on what can be saved into a pension prompted savers who were already using their full Isa allowance to consider VCTs.

This April, the lifetime allowance - the amount of money that can be built up in a pension pot while still receiving tax relief - fell from £1.25m to £1m, with savings in excess of the new cap being hit by a tax penalty.

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