Investment trusts are widely assumed to be investment vehicles investing in listed equities. However, at the start of this year, “alternative assets” accounted for 39% of the £165bn sector. And the proportion continues to grow steadily – the sector accounted for more than 70% of share issuance in 2019.
The “alternatives” umbrella covers funds invested in areas such as infrastructure, property, renewable energy, bonds, debt and specialist finance, as well the older established areas of private equity and hedge funds.
These are expected to produce returns very different to those of listed equities and so help diversify a portfolio (hence the “alternatives” label).
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They invest primarily in unlisted or highly illiquid assets which are not suitable for an open-ended fund – assets which are generally very cash generative.
Below, we’ll take a look at what the sector has to offer.
The growing demand for alternative assets
The reason for the upsurge in interest in “alternative” funds is the decline of the balanced fund model of investment. This sought to balance the high, but volatile, returns from equities with low-risk bonds to achieve steadier, if lower, overall returns.
However, as yields on government bonds fell to levels which are at best very low and increasingly often negative, bonds came to represent what investment guru James Grant describes as “return-free risk.”
Moreover, the inverse correlation of their performance with equities could no longer be relied upon – hence the search for an asset class which would provide diversification, positive real (ie, after inflation) returns, and income, to compliment lower yielding growth-orientated equities.
Ironically, many investment trusts, such as Scottish Mortgage, started out by investing in debt rather than equities, but the variety of investment propositions offered is now greater than ever. Within these, there are many funds of proven merit; a number that have failed to deliver on their promises; and others for which it is too early to say.
Investors need to choose with care, basing their analysis first and foremost on understanding where the returns are coming from, how risky they are, and how repeatable.
Hedge funds and private equity
That has been the problem with the listed hedge funds, a group which first appeared some 20 years ago and expanded rapidly following the 2000-2003 bear market, which most hedge funds negotiated far better than equity funds.
A number of managers sought to make their funds, which were previously available only to the very wealthy, open to ordinary investors – but returns soon declined.
This was inevitable: the investment strategies involved relied entirely on a given manager’s ability to exploit a limited field of opportunity. As the field became more crowded with both money and new managers, the opportunity to outperform faded.
Hubris turned to nemesis, so the few of these funds that remain have shrunk considerably. Notable among these are the two Brevan Howard funds and Pershing Square, which have navigated the virus melt-down exceptionally well.
Listed hedge funds rarely offer income and nor, until recently, did many in the £15bn listed private equity sector. Six of these, including 3i, Harbourvest, HGT and Standard Life European have five-year returns above 100%, yet nearly all appear to trade on double digit discounts to net asset value ( though these have not been updated for the Covid-19 sell-off and recession).
The “funds of funds” investing in unlisted private equity funds – such as Pantheon, Harbourvest and Standard Life European – usually trade on discounts, despite five year returns averaging 91%, as the visibility of the underlying portfolio is not good.
About half of the funds, including 3i and HGT, now pay dividends, though these are paid largely out of capital. 3i, accounting for half the sector, and HGT are among the direct investors, buying controlling stakes in companies either themselves, or alongside sister funds.
Two promising new funds, Schiehallion and Merian Chrysalis have recently joined the sector as has the rump of Woodford’s Patient Capital, under the banner of Schroders.
Investing in infrastructure
Infrastructure funds were first launched nearly 15 years ago, initially to invest in PFI (Private Finance Initiative) projects, mainly in the UK. The sector has been a regular issuer of equity and has performed well, despite a hiccup in the run-up to the last election.
The six funds with a combined market value above £11bn have increasingly invested outside the UK and in projects with some revenue uncertainty, as opposed to the index-linked income streams of PFI.
Since the funds invest in the equity portion of often highly-leveraged projects, there is, in theory, considerable risk, but good management has ensured consistent annual returns of 8.8% and above, financing an average dividend yield of 5.1%.
Returns in the £8bn renewable energy sector in the last three years have been nearly as good and yields slightly higher, but the funds are vulnerable to falling energy prices while new projects no longer attract subsidies. This makes them riskier which is not reflected in share prices, but once investor over-enthusiasm has subsided, they will be attractive again.
Bond and debt funds – skating on thin ice
Bonds and debt funds account for £6.7bn of market value, but the funds are more numerous and, on average, relatively small. An increasing number are struggling, and few trade above their issue price, while average returns over one year are firmly negative. Five funds have recently cut their dividends, and the too-good-to-be-true yield of over 7% on a further 23 indicates that investors suspect there will be more cuts.
Those tempted to buy should work backwards from the yield: a fund yielding, say, 6%, and with an expense ratio of 1%, needs to generate a return of over 7% from its investment portfolio, against a yield of under 1% from ten-year gilts.
To manage this, either the manager has to be investing in the equivalent of junk bonds; or leveraging up lower returns with cheap debt, which will increase the risk by magnifying valuation swings. There may be examples where, due to illiquidity, the specialist nature of the asset class or the skill of the manager, the portfolio yield is out of line with the risk – but, for the most part, the reality is that investors in bond and debt funds are skating on thin ice.
Investing in property
Finally, alternatives include the £14bn property income fund sector. These funds invest in higher-yielding property, often leveraged with debt, to give investors a yield generally in the range of 4-6%.
The properties owned will usually be rented on long leases, but there are often opportunities to add value from lease modifications, changes to the tenants and rental increases when lease terms expire. Development, if any, will play a small role in the companies’ activities, unlike in mainstream property companies so, at first sight, the portfolio looks like a cash machine.
However, properties need to be maintained, repaired and modified if obsolescence is to be avoided. There is no guarantee even then that properties or even the land they occupy will hold their value – as owners of shopping centres are now finding out. There is plenty of value in the sector, but not necessarily in the funds trading on discounts to asset value.
In short, seekers of income in the alternative funds sector need to beware. High yields often come with high risks and investors must look out for what John Patullo of Henderson calls “fool’s yield.” In a world of low bond yields, the high yields offered by many of these funds may be a mirage; the problems being suffered by many in the Great Virus Crisis show them to be riskier than they first appeared.
Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
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