The relentless growth of passive (or index) funds – invested according to the composition of an index without regard to the quality, value or prospects of their constituent companies – has put active investors into a spin.
The problem is that most active investors aren’t very good at picking winners. As a result, on average, active funds underperform their indices. Much of this is due to the costs of active management, although it is often forgotten that the costs of passive funds – while low – are not zero, so transaction costs mean that many passive funds also mildly underperform.
Still, research group Kepler points out that over half of US shares are now held passively; over 90% of settled trades are between passive participants; and over 100% of gross equity cash-flows in the US are into passive investment vehicles. That’s an extraordinary shift, with some interesting implications.
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How investment trusts can profit from the passive revolution
As Jack Bogle, founder of Vanguard, the global leader in passive funds, once said: “if everybody indexed, the only word you could use is chaos, catastrophe… the markets would fail.” This puts a heavy responsibility on the managers of active funds to perform, on their employers to keep costs and charges down, and on investors – whether professional or private – to pick good funds.
As this year has decisively shown, the simplest route to outperformance has been via investment trusts. In the year-to-date, the FTSE equity instruments index has outperformed the All Share index by nearly 24%. Some of that can be explained by the allocation of many trusts to outperforming markets, particularly the US. Yet even taking that into account, trusts in nearly every sector have outperformed their benchmarks on average, despite the average discount of the share price to net asset value (NAV - the value of the investment trust’s underlying portfolio) widening to 3.5%.
Investment trusts have no reason to fear the competition from passive funds but, as Christopher Brown of JP Morgan Cazenove shows, they are in a good position to benefit.
There are only two investment trusts in the FTSE 100 index – Scottish Mortgage, the FTSE 100’s best performer this year, and 3i. But three more – Pershing Square, F&C and HICL – are close behind. Indeed, Pershing is joining the FTSE 100 in next week’s index reshuffle. The latter three, plus 74 other trusts, are in the FTSE 250 index. Thirteen of them (including Pershing) have a market value of over £2bn and so could, subject to good performance and share issuance, reach the FTSE 100 in the next few years.
In the last four years, Brown notes, investment companies, having accounted for roughly 2-3% of the All Share index for most of the last 30 years, have climbed from 4% to 7%. Yet this excludes 3i and many REITs (Real Estate Investment Trusts), which are mysteriously not classified as investment trusts. As money flows into All Share index funds, passive funds must buy these 79 trusts, putting upward pressure on prices and facilitating share issuance.
As Brown continues, most active UK investors use the All Share index as their primary benchmark, and that includes investment companies. Many institutional investors “don't buy” investment companies, often because of “fees.” This ignores the fact that commercial companies have overheads. This neglect of investment companies would not only exclude important areas of the market, such as renewable energy, music and infrastructure from a manager’s portfolio, but also threatens underperformance, as the intact All Share index has outperformed the same index excluding investment companies by 2% in the last four years.
The sector is also a way for investors with a UK mandate to obtain exposure to overseas markets, a point that Worldwide Healthcare Trust has been making in its presentations since launch 25 years ago. UK fund managers who have not invested in the FTSE 100’s best performer Scottish Mortgage Trust (up 89% this year while the FTSE 100 is down 17%), will be tearing their hair out.
Why investment trusts look set to keep beating their open-ended rivals
Virtuous circles do not go on forever but this one may have barely begun. Strong performance draws in private investors, wealth managers and multi-asset funds. In turn, this narrows discounts (as demand for the shares rises) and enables the issuance of new shares. As shares are issued and money flows in, index funds have to buy. Active managers, who often hate buying funds run by other managers, are under performance pressure to tag along.
As trusts expand, fees are cut – Scottish Mortgage’s costs are now competitive with passive funds – which also helps performance. Most managers will say that share issuance is at worst neutral for performance, at best positive, while if a trust’s shares fall to a discount, the Directors can add value by buying them in.
With the added advantage of being able to use gearing (i.e. borrowing to invest) to enhance performance, there is very little chance that trusts won’t continue to perform better than comparable open-ended unit trusts, “oeics” or “Sicavs” as they have in the past. This promises a bright future which can only be enhanced by the success of the “alternative” sector. This provides private investors and those unable to make multi-year commitments with access to illiquid assets which are not suitable for open-ended funds with daily, weekly or monthly dealing.
Investors have learned expensive lessons from open-ended funds investing directly in private equity and property. But investment trusts, including “real estate investment trusts” (Reits), with similar tax advantages, are ideally suited. If there is a rush for the exit in an investment trust, the seller in a hurry may have to accept a large discount to asset value – but the trust will not have to sell assets at distressed prices to meet redemptions.
Without investment trusts, the infrastructure sector, including renewable energy, would have been closed to private investors and all but the largest professional ones. The trust structure has also given investors access to large swathes of the fixed-interest market which offers generous yields for poor liquidity without being especially risky.
Not all innovation using trusts has worked out well; catastrophe insurance has been catastrophic for investors and aircraft leasing has struggled badly, but music royalty companies show promise and new ideas for packaging assets or cash-flow are sure to follow. This is not only good for investors but provides an important source of finance for corners of the economy - like renewable energy - that might otherwise struggle to raise capital.
The renaissance of the investment trust sector is no flash-in-the-pan but an enduring investment success set to provide capital for economic growth and attractive returns for investors for years to come. Many private investors have known this for a long time – but even the professional investors are now having to take notice of this extraordinary British success story.
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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