A first-half home run for investment trusts

Anyone who predicted the market crash of the first quarter, in which the FTSE All-share index fell by 35% in five weeks, would also likely have predicted that investment trusts would under-perform, due to widening discounts to net asset value (NAV – the value of the underlying portfolio) and the debt employed to enhance returns in rising markets (also known as gearing).

Those were certainly negative factors on the way down. The average discount widened from 2% to 22%, before narrowing to 11% on April 3rd.

Yet by then, with the All-share index still down 29% year to date, the investment companies sector was already 7% ahead. And that lead continued to grow.

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At the end of June, the All-share index was still down 17.5% – but the investment companies sector was down just 3.5%, 14% ahead, helped by the sector average discount falling to 6.7%.

Not bad at all.

A strong first-half performance for investment companies

Against the MSCI World index, which rose by 0.5% in the first half, the overall performance of the investment trust sector looks less impressive than against the FTSE All-share.

But this ignores the heavy geographic bias of the sector, which has a higher exposure to the UK markets (which comprise just 4% of the MSCI All Countries index) than to the US (58%).

When each sub-sector is compared against its respective index, investment companies outperformed across most areas, often by significant margins, though the disparity with rivals was often huge. For example, Scottish Mortgage, the sector’s £12.6bn giant, returned 43%, while Witan lost 15%.

Meanwhile, few UK specialists did well, not helped by the underperformance of smaller and mid-cap companies. But technology and healthcare specialists had an outstanding six months.

Alternative income funds accounted for 39% of the sector at the start of the year and would have been defensive on the way down, notwithstanding widening discounts, but they didn’t hold the sector back on the way up.

Meanwhile, open-ended funds continued, on average, to underperform, encouraging the relentless shift of investors from active to passive funds.

So what is the explanation for the investment trust sector’s extraordinary performance – and is it set to continue or just a flash in the pan?

Investment companies tend to beat open-ended funds

A considerable body of research shows that investment companies nearly always outperform their open-ended equivalents over all time periods, even when the funds have the same manager investing in the same area of the market.

Since the long-term trend of markets is upwards, the use of debt to enhance performance has usually helped; and discounts have steadily narrowed.

More importantly, it is easier to manage a fixed pool of money than a constantly changing one, with new investors flooding in at market highs and out at their lows. But those factors do not explain the first half of 2020.

The stock selection of most investment trust managers must have been considerably better for closed-end funds than open-ended ones – but why? How did so many managers avoid the value traps that so many others fell into?

The answer may lie in the focus of investment trust managers on performance, egged on by their non-executive directors, peer pressure, brokers, investors (especially direct ones) and the financial media. The pressure on open-ended fund managers is far less and performance may not even be their prime consideration.

Many fund management companies are more focused on their own growth and profitability than on their clients’ performance, and good performance does not sell itself. Their strategy is to avoid losing clients as much as it is to gain them.

Clients are lost when performance falls into the fourth quartile of comparable funds and this dictates avoiding what is seen as “risk” - too wide a departure from a benchmark weighting, paying up for growth and standing out from the crowd.

But in avoiding this fourth quartile, fund managers are also denying themselves a chance of being in the first quartile. Pottering along in the second quartile is seen as ideal but, in practice, that usually means trailing behind the benchmark.

The sales force is then set to work spinning an explanation of how the “risk-adjusted” performance was better than it looks and dull performance reflected a “sensibly cautious” approach.

There are plenty of open-ended fund managers who do not share this culture at all – notably Baillie Gifford, JO Hambro, Polar Capital and Fundsmith. These are firms that prefer to grow organically than by acquisition, who put talented managers in the limelight rather than hide them in teams, and understand that though performance does not sell itself, it’s better for sales than poor performance.

A culture of performance

Still, the culture of performance is deeply embedded in investment companies, not least by the risk that the directors will move the management contract elsewhere if performance is persistently poor.

This is what may happen at Temple Bar, one of the sector’s casualties in 2020, though there is a severe risk that the Board is throwing in the towel just when investing for recovery is seeing the best market conditions for a decade.

The funds once managed at Invesco by Neil Woodford are also on the move, and a number of alternative income funds have struggled badly, notably in parts of the property and debt sectors. As always, market turbulence has exposed weak investment strategies at the same time as it has proved the resilience of strong ones.

The strong overall performance can only increase the long-term confidence of investors in the sector. There have been no new issues in recent months but issuance by existing trusts has been solid – more than £400m even in March and subsequently rising – and buy-back activity has fallen.

The average discount is now 6.7% and investment companies have protected investors from dividend cuts by digging into their revenue reserves or paying out of capital. Performance was excellent in the stable market conditions of last year, was even better in relative terms in the volatility of 2020, and looks set to continue strongly as economies and markets return to normal.

In short, the renaissance of investment companies still has a long way to go.