Two funds to reward patient investors

Early-stage companies and micro-cap stocks can deliver spectacular returns but the risksare high and you must be willing to lock away your money for many years.

While I frequently discuss new listed funds in these pages, I'm relatively cautious about buying into their initial public offerings (IPOs). I usually prefer to wait for the fund to list and see how performance stacks up and then take the plunge. But this week I'm breaking some of my rules and committing to invest in two heavily publicised funds just about to kick off their stockmarket lives.

The investment trusts in question areNeil Woodford's Patient Capital Trust and Miton's UK MicroCap Trust, managed by Gervais Williams and Martin Turner. These two funds are very different in scale the Woodford fund looks as though it might be about to raise £800m, while the Miton offering may be lucky to get up to £100m. But I think both deserve a place at the core of your portfolio.

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Their managers aren't new names, but they are trying to do something rare: capture the "illiquidity premium" that comes with investing in small, risky and illiquid stocks.

The best of both worlds

The bad news is that there are only so many of these great companies out there, especially those trading at a reasonable price. So Woodford plans to combine these with investments in "early stage and early growth companies". These may be listed stocks or private companies, but the key trait they share is that they have global growth potential based on some form of intellectual property.

London-listed Allied Minds is an example of how this has worked in the past. Woodford has long been an investor in firms which back technology companies that are spun out of universities.

Allied Minds is one of those and its share price has more than doubled since listing on the UK market back in the summer of 2014. The firm focuses on spinning out great academic research from US institutions, including major universities and defence research establishments in effect, it's a giant portfolio of early growth businesses.

So Patient Capital Trust is intended to be a fund that combines boring old blue-chip names say, big tobacco and consumer businesses alongside a long list ofAllied Minds. Obviously, it's not certain if £800m can be sensibly deployed to either bucket, but my guess is that if anyone can pull it off, Woodford can.

The strategy for Miton's UK MicroCap Trust is similar to the second, riskier leg of the Woodford approach. The fund will invest in very small, listed businesses on the UK market, especially on Aim.

The average market cap for its holdings will be the sub-£150m level, which makes this a true micro-cap fund, rather than a small-cap fund that occasionally invests in tiny businesses. In my experience, Aim-listed businesses are variable in quality. But if anyone knows how to find the Asos of tomorrow, it's Gervais Williams at Miton.

So why should we expect these funds to earn better returns by investing in these very small and often risky companies? In simple terms, because this is what investing for the long term should be about but frequently isn't. Over the last few decades we've seen massive growth in the amount of savings deployed into global financial markets. But this has been accompanied by tougher regulation.

The authorities are terrified that big investors, such as pension funds, will be in trouble if they invest in anything that isn't liquid (ie, something that they can't easily sell whenever they want). Hence large investors have to put their money into securities such as UK government bonds and large-cap stocks. Illiquid securities are to be feared and avoided, rather than viewed as an opportunity.

Yet copious amounts of academic research show that the smaller the business, the greater the potential for long-term capital growth. And the shortage of investors who can accept the liquidity constraints that come with investing in this kind of business means that such stocks canoffer relatively good potential returns.

I estimate that if normal equities generate a premium of 3.5% per year more than inflation over the long term, then small-cap and private-business investing should be able to generate in excess of 5% real returns per year, if not much more.

Investors will need to sit tight

At that time, trusts like these will trade at a discount to the value of their assets. Investors will complain, and opportunistic activist investors will become vocal. But I, for one, will be sitting tight, mocking the short-sightedness of those who prize liquidity above all, and hoping that both funds provide me with the long-term double-digit returns thatI expect to earn.