1. How investor demand and market forces are shaping investment trust offerings
2. Why the closed end structures allow for high conviction investing
3. How net redemptions can impact negatively on an open-ended fund
KIERAN: I would say that illiquid securities, and however you define them, are ideal in an investment trust. And where they probably don’t, where investment trusts don’t add any value, it’s in normal liquid securities, unless you are high conviction holders of certain securities. So at the moment you’re seeing great value in investment trusts in stuff like loans, which is a big spread out there for loans, for any kind of illiquid alternative interest or income securities like catastrophe bonds, and then you’ve got everything else that goes even more illiquid than those kind of securities.
So forestry, any agricultural play should really be in a kind of illiquid structure, or in a permanent capital structure like an investment trust. You can’t obviously have forests held within an open-ended vehicle (a) because most of those open-ended vehicles want to be under the UCITS directive. So they’re the, when we look at what kind of investment trust we want to allocate to, it’s really a case of well what’s inside the investment trust, and is that a worthwhile home? Is the investment trust a good home for those assets? So it’s really about illiquidity of the underlying holdings.
PRESENTER: And James Carthew, having said that, there are quite a lot of conventional investment trusts, that’s where most retail investors would look to first. Where do those do particularly well against open-ended competitors?
JAMES: It’s really all about being able to take a long-term view. So because you don’t have to worry about money flowing in and out the fund, the manager can sit back and look at the portfolio in for over a three, four, five-year time horizon, which is much harder to do I think in an open-ended structure. And then you’ve also got the benefit of gearing. So they can borrow money to enhance returns as well, which is much easier if you’ve got a fixed pool of money to deal with.
PRESENTER: Well we’re going to bring up a chart now that shows the comparative returns at sector level between some of the main open-ended up and closed-end fund sectors. So if we can have a little bit of a chat through that. James, talking about that, you can see there these great, in most areas over 10 years, investment trusts have obviously beaten their OEIC equivalents. That’s on shareholder not in NAV terms. But a couple of areas they haven’t: global emerging markets, property and North America smaller companies – any particular reasons for that?
JAMES: So you’ve got quite small sample sizes with some of them. So if we talk about North American smaller companies for example. You’ve got one fund in there which I’m not sure it’s in the right sector because it’s got a lot of UK holdings, and that’s affected its returns relative to the other funds in that sector. But you’ve only got a handful of funds. And so if you’ve got one fund that doesn’t perform very well that drags the whole thing down, so if that affects it. Global emerging, it’s a tricky thing to try and pin down as to why the funds have done worse. But I suppose the law of averages says that it’s going to work out that way for some sectors sometimes. But it might be that you’ve just got a poorer set of managers in there, but difficult to tell.
PRESENTER: But overall as you look at that chart, would you say that backs up this idea that investment trusts long term in the round are a better vehicle than an open-ended fund?
JAMES: I think so in the long term. And that’s really what we’re talking about. Because over the long term you get rid of the effects of discount moves and that sort of thing that people tend to associate with choice and underperformance in trusts.
PRESENTER: And Kieran, just coming back there, you were saying earlier how attractive the closed-end structure is in some, alternative income for example. But what about in this mainstream space, what does an investment trust need to do in the more mainstream sectors to get you as a fund buyer interested in it?
KIERAN: Well I think James is quite right. I think you want to see, there’s an element, there’s an advantage to having a fixed pool of capital that means you can take a long-term view. It also means that you can actually build up some very large positions in companies that you think are operating very strongly but are cheap. So if you look at, I mean there’s Simon Knott who runs discretionary open-ended funds, MI Discretionary, but also runs Rights & Issues Investment Trust. And you can see that in the open-ended vehicle he has a 5% position in a company called Scapa. But in the closed-ended vehicle that’s a 15% position. So he’s able to take high conviction on companies that he has a lot of confidence in, and over I think we went back to 2000 when we were looking at the two different structures. And the investment trusts outperformed about 2½% more than the open-ended fund. So that’s the key advantage we see, is that it allows managers to take a long-term view, but also to take a higher position in a conviction position.
PRESENTER: But given that, why do so many discretionary fund managers have so much open-ended paper - or so many open-ended funds inside their portfolios for clients?
KIERAN: Well I think there’s two points we’d say. The one point is it’s very cost effective to manage a business. We’ll call it a business, a discretionary management business, if you have your underlying clients all model based. So by that it means that you might have 20 positions, so let’s be simple 20 funds 5% each. And you get clients coming to you every day, or leaving you actually. You could have redemptions from clients. It’s very easy just to hit the button and say buy all those 20 securities, and you don’t have to worry about stuff like volume, 30-day average volume is what we’d look at on position sizing basis. You just hit the buy, you just invest the money or you redeem the money, and there is little or no movement on an earmarked basis from when you actually allocate the capital or withdraw it.
Now, the other point is that - so that’s great if you want to have a streamlined cost effective business. The second I’d say push factor to that direction is the regulator. So the regulator is making it more and more difficult from a paper trail to show movements in and out of positions. So you might actually want to offer bespoke portfolio management to clients, but you’d always have to document everything you do. So every purchase you make has to be documented - every sale. So it becomes a lot easier just to say OK well we’re going to operate to fund managers who are going to make that call, and that’s going to be one part of recording that purchase or say that allocation. And you don’t have to worry about timing or making what we would say is valuable allocations on behalf of your client. But with that comes a huge level of compliance overhead.
PRESENTER: And James, just going back to this point about managers running portfolios with conviction. Is the market good at making investment trust managers run high conviction portfolios, or is there quite a lot of stuff that could be open-ended and it’s just a hangover for historical reasons?
JAMES: I’ve been working in the sector for a very long time, and there’s been a drift all the way through for more conviction in portfolios to get rid of the sort of me too funds. And so if you just think about the global generalist sector for instance, when I started there was a lot of people saying that there’s no reason for any of that to exist at all. But the funds have just constantly reinvented themselves.
PRESENTER: So when you say global, these are things like, what, F&C investment trust?
JAMES: Yes exactly, so the classic is the biggest fund in the sector which it Scottish Mortgage, which has completely ripped up what it did before, and now runs a high conviction global portfolio in some big tech type names. And even that, it’s not quite exciting for it so it’s moved to investing more and more in private equity as well, which it can do because of the closed-end structure. So it’s that reinvention is happening I think because people are saying we don’t want a boring me too index looking fund.
PRESENTER: But given the rise of tracker funds anyway, isn’t that going to force open-ended funds to do exactly the same thing as well, because they’ve got to justify what they’re doing?
JAMES: But as we talked about the liquidity thing. There’s only so far they can go in terms of this sort of high conviction portfolios because they need to be able to trade in and out of things to fund redemptions.
PRESENTER: So what happens with an open-ended fund Kieran, if there’s a run on it, the money can go out? What can that do to performance?
KIERAN: We hope, we’ve got an open-ended fund so we hope there’s no one.
PRESENTER: Sure but.
KIERAN: But I guess it means you have to sell, generally speaking it’s a fire sale. I mean open-ended funds under the UCITS directive will have a gate applied to it, so no more than 10% every day that you are open for business so to speak. So if you have a daily trading fund, if more than 10% is redeemed then you say hold on, we’re just going to start liquidating. And then the next day there’s more than 10% again, it’s the same issue that goes on. But it leads you actually just have to sell what you can, there is no discrimination and ultimately your administrator on the fund is looking at the risk management and saying OK well we’ve got these redemptions, you’re going to have to just fire sale everything.
So that’s the, that is a concern. I mean you make sure, we make sure that we have, when we buy a security it’s the average 30-day volume, so we can get in and out very quickly without having to move the market.
KIERAN: So that’s the concern is that if you get a, in an open-ended vehicle you have to worry about that redemption versus your liquidity. Whereas a closed-ended vehicle you have to worry about the discount, obviously the premium and discounts, but other than that you can actually continue holding companies that you think have good value. Because actually when you get that redemptions the liquidity is probably going to be in the one that you have conviction in, and the one that isn’t performing very well you’re going to have to just say well we’re going to have to redeem that, even though it’s well below your actual market value or the value that you ascribe to it.
JAMES: I mean I think actually this is when a closed-end fund might actually make quite a lot of money. Because you’ve got the open end fund managers running round like headless chickens trying to raise cash, and you’ve got the closed-end managers sitting there and they can borrow money if they think it’s actually too cheap. And they can pick up stuff at bargain prices. So that can be a real opportunity for them.
PRESENTER: And I suppose going back to this point about long term, when you, and we’ve got a table coming up now which has got, from the AIC just showing how some of the longer serving investment trust managers are. But again there does seem to be people like Peter Spiller, Simon Knott, Matthew Oakeshott, these guys have been on funds for, not just for years but for decades. Why does the investment trust space encourage this long management?
JAMES: I think if you talk to fund managers most of them will say that they’re fun funds to run – because of the little wrinkles that you can do with them to make them a bit more interesting, and because you can take a long-term view. And actually one of the things that I always think is quite powerful is having a board of directors, which closed-end funds do and open-ended funds don’t. So you’ve got somebody to go and bounce ideas off and challenge you, and much more than you would just internally.
PRESENTER: And Kieran, I suppose the other way of approaching this is why do managers on open-ended funds not stick around for longer?
KIERAN: Well if you look at the open end universe it’s brand names all over the place: Schroder and whatnot. So a lot of that churn of management is a manager probably thinking you know what, I can get better economics elsewhere. I’ll spin out, set myself up. Or he’ll be poached from somebody else. Or its strategies just go and die. I mean sometimes there’s so much money put into a strategy that all the alpha is gone and then returns fall, and the manager in the end has made a rod for his own back through good performance in the good times, and then the underperformance is leading everyone to question his performance and how he’s allocating the capital. But I think that’s the main driver.
PRESENTER: And so given these advantages of investment trusts, if there was one in one of the more mainstream sectors that did have a high active share, a really punchy way of running money that you liked with a long-term manager, is that the sort of thing that you could justify putting in your portfolios?
KIERAN: Oh absolutely yeah. It’s ideally in areas in which we don’t feel we’ve got any, so we have a large allocation in Vietnam, in Japan. My Vietnamese is as good as my Japanese, it’s zero. So we’d always like to find a manager either through an open-ended structure or an investment trust in which we can allocate good companies. It’s people who have alignment of what value is, what operations you want your companies, your underlying companies to be achieving, and then just having the patients through the natural ebbs and flows of the market not to lose faith in their investment allocation techniques. So that’s the key thing that we’d look for in allocating to investment trusts, or open-ended vehicles.
PRESENTER: And how does the use of gearing affect what you think of an investment trust, how much risk if you like that’s putting into your overall portfolios?
KIERAN: I wouldn’t see it as any, I wouldn’t see it as risky if they borrowed 10% of their NAV or 20% of their NAV. But I wouldn’t want it to always stay at 20%. I would see it a bit like what James was saying there, a tactical decision to say OK well we’ve got permanent capital, we can raise an extra 10% almost of capital to go and buy these depressed assets – but you want to see them paying that back. Because then it becomes a gearing, that’s a bad gearing is when you just say OK well we can always have 20%, let’s go 20% more or 30% or 40%, whatever the metrics you want. I think I wouldn’t want the returns coming from gearing really, but that opportunity that you have means it’s a really attractive investment vehicle. But I’d like to see them paying that back. It’s a bit like Buffett, he’ll always have cash on hand but through 2008 to 2009 he was issuing paper all over the place just to get more capital in. But then he would pay that back.
PRESENTER: But James, it’s a real skill to know when to borrow. I mean I’ve never, I’ve hardly ever met a fund manager who was depressed on his own market. They’re always, they always want to back themselves.
JAMES: Market timing is a very difficult thing to get right. And I think most people that think they can do it they were just lucky. If you know your companies and you know what you think your companies should be worth, then you can say well actually this is trading at 10 times, and I know it’s going to make profit of X in five years’ time. So you can be confident that way. If the stocks you like are trading inexpensively then probably now is a good time to go out and borrow some money and buy some more of them.
KIERAN: And there’s actually some, there’s great opportunities created by the infrastructure behind the markets as well. So you see at the moment there’s a complete selloff in some mining companies, just because there’s a rebalance coming on in one of the major ETFs. So you’ve got to be able to take advantage of that. Whereas an open-ended manager, at best he can sell out of some things and buy into the companies that are affected by it. But the permanent capital vehicle can just go and issue, borrow some more money and go and. Because it’s that point, it’s like well it’s half price now, and there’s been no update from the company. They’re still operating quite strongly. I mean that’s when you need to be able to say OK that’s when you buy back in. That’s when you say OK we’re going to increase our position in that, because there is no operational change.
So if it was good enough a month and a half ago before rebalancing of an index that ran through the order book, that’s the ideal time to pick up some more – which the open-ended manager can do it, but it’s not as easy, it’s not as efficient for him to do that.
PRESENTER: But given we hear so much about investment trusts buying back shares, issuing new ones, are they really as closed-ended as we’re implying at this conversation, are they becoming quasi open-ended vehicles?
JAMES: There are a handful of investment companies now that try and maintain a zero discount. And I think the line between them and an open-ended fund is now quite narrow really. I mean they’ve got the right to suspend that if they want to in fast markets and things, but it does create a similarity there. For the others they do, there’s this big caveat in discount control mechanisms that if markets are running away in the wrong direction then we will suspend things. And I think that’s the power of the structure, and the boards shouldn’t be afraid to stand back and say no this is not the right time to be doing it. So I think that’s a slightly controversial view in some areas.
PRESENTER: All right. I suppose the other, you’ve talked about NAV and share price, but this is a period where the markets are up a lot, the NAVs and share prices are pretty tight on investment trusts at the moment. What would you say to someone who says well that’s a really good reason not to get into them? This is a time you don’t want to be, because you’re more likely to go to a discount than a premium.
JAMES: Yes, markets have been climbing this wall of worry for a long time now, a very long time. And people have been calling the end of the bull market for years as well.
KIERAN: Six years I think.
JAMES: Yes, again we go back to that market timing issue. You just cannot tell when it’s going to turn. It feels to me like everything’s quite toppy but yeah don’t know.
PRESENTER: But even given the structures that underpin investment trusts now, attitudes towards buybacks, do you have a, it’s almost unfair to ask people to make big predictions but if the markets did fall a lot you wouldn’t expect to see investment trust discounts stay wide in the long term.
JAMES: They will widen. It would be wrong to say that that won’t happen. But if you’re investing for the long term it’s not a thing you should be really worried about because they should snap back again. There are very few investment companies now which don’t care about their discount. Because if you don’t care about your discount somebody will come along and snap you up and liquidate you.
PRESENTER: Take care of you.
JAMES: Exactly, which is this great renewable thing that happens in the, there’s some companies in the industry as well. So the poorly performing funds, funds that are unpopular, doing things that people don’t really want any more, they just get liquidated.
PRESENTER: And Kieran, we talked about, a little bit about, referred to blending open and closed-ended funds in a portfolio, how do you go about doing, can you talk us through how you do that at your shop?
KIERAN: So we look at it, because we run bespoke managed accounts, and we run the fund. There’s probably about 10% that’s in investment trusts, there’s 30 or 40% in open-ended companies, and then there’s just direct stocks and other vehicles. And the key determinate isn’t really about the liquidity, actually, because we make sure that even when we find investment trusts that they’re relatively liquid. So that’s the, we wouldn’t go into a very illiquid investment trust, because then it would be very difficult to get out of it. A bit like a lobster pot or whatever it’s called. So those would be the, it’s really about liquidity. But I think the one key to any capital allocation decision is the price you’re paying for it. And it’s not about whether the investment trust is actually trading on a discount or premium, because the primary key is to look through the investment trust and see what the company’s allocating to.
So when we’re looking at, in Vietnam we’d love to buy, and there’s some very liquid Vietnamese investment trusts out there. And they’re trading at a discount of sometimes 20%. Then when you look at them and see what they’re allocating to, the companies aren’t operating strongly. They’re not growing their cashflow. They’re not cheap on the basis of that cashflow. So if you actually went into it and said OK well we’ll have a little bit in investment trusts, and the ones at a steep discount, you end up putting the cart before the horse. Whereas no matter what you buy whether it’s through an investment trust, through an open-ended or direct to the companies themselves, we would say the primary concern is the price you pay for anything. And we’d have a quality on top of that and say well the company’s got to be operating strong and have good returns to shareholders, return on equity.
PRESENTER: But do you ever play, I take here what you say but do you ever play the discount game where if you see a manager who runs an open and closed-ended fund, the closed-end is on a walloping great discount and you think well I’d certainly buy that now?
KIERAN: We’ve never had the opportunity to be honest, because (a) we’re both into investment trusts, open-ended and direct stocks. But you’re quite right, if I had one that was an open-ended and I saw the discount. Like Terry Smith’s -
PRESENTER: Emerging market.
KIERAN: - emerging market. And I think he buys expensive companies, but he buys quality companies I’ll take my hat off to him for that. But if there was a big washout in the market and we wanted to get some emerging market experience, I’d have, you wouldn’t really need to go and have a look in at the companies there because you know they’re all quality. And you’re just going to say well they were expensive, now they’re cheaper.
PRESENTER: In terms of the amount of due diligence you have to put into buying a closed-ended fund for the portfolio, is it much higher than for an open-ended equivalent?
KIERAN: The major difference is the liquidity. So we want to see what we’re allocated to from underlying, and you can get all that information. You don’t get it as readily because you get the annual reports really where all the juicy stuff is for an investment trust. But you go and meet the manager, you find out what his rationale, why he’s holding certain securities. And then it’s really just a case, so when you’re comfortable with the underlying and the manager, which his pretty much the same thing to be honest. Then you just have to say OK how much of this can I buy without getting myself in too much of a bother if. And it might not, because you’re banking on the manager on that, so you don’t think there’s going to be any style change. There could be, but the major risk is that OK what if liquidity dries up here? And then you have to sell your fore seller into an illiquid security, which is not a good place to be.
PRESENTER: Well, James, how if you’re an adviser can you find out a bit more about how liquid investment trusts are, because performance numbers are quite easy to get your hands on?
JAMES: Actually you can get stats on how many shares change hands every day and that sort of thing quite easily. I mean our website does that. So they are available. Most of the market information screens, they’ve got the information on there.
KIERAN: You don’t have to pay for the Bloomberg terminal that’s for sure.
PRESENTER: OK. I wanted to move on, we’ve got about 10 minutes left, just to some of the potential scenarios of how you can use investment trusts in portfolios. I suppose a classic one is, we’ve always seen is school fees planning, and I asked the IAC, they came up with a figure recently for me. They said if you put £50 a month into the average investment company over 18 years up to the end of May you’d generate a pot of £32,166, which would be lovely. And then you hand it all over to your child who blows it at university. But what, in terms of using investment trusts as regular savings vehicles, how effective can that be, and is that more effective than doing it in open-ended funds, James?
JAMES: It’s quite easy to do because there are lots of schemes around that let you save regularly, investment companies. Unit sizes are a slight issue, because you need to factor in some dealing charges. And obviously there’s an element of fixed costs that you’re doing. But that sort of applies to open-ended funds too. Because you’re dripping money in all the time you do end up buying at the bottom of the market quite often. So that’s a good way of saving, again it doesn’t matter whether it’s open or closed. I can’t see anything particularly different about say different investment companies rather than open-ended funds when it comes to regular saving.
PRESENTER: But this is the power of compounding and pound cost averaging.
JAMES: Yes exactly.
JAMES: It all works for you yes, and you need to have the dividends reinvested as well.
KIERAN: And you are actually, if you’re, say if it’s open-ended or investment trust you’re buying in the low of the market but you’re also, those will be trading at a discount as well at that moment. So that’s the only advantage I can possibly, I’d probably be agreeing with James. It’s minimal but if it is it would be on the basis of you’d pick up the discounts.
JAMES: Yes, if you were making your own decisions. Instead of the money just being debited out of your bank account every month and going into the fund, normally when we’re in this sort of headless chicken scenario and everybody’s really panicking, you’d probably go oh I don’t want to buy anything then. But that’s definitely the time you want to be.
PRESENTER: That’s when your £50 buys more.
JAMES: Regular thing of just going chip, chip, chip.
KIERAN: But I think you also, I mean OK I’ve gone back to it, you want to know what you’re buying as well. So you actually want to just do your due diligence now almost before you, and then make sure it’s good, that you don’t need to worry about when the market’s falling what has this guy been buying? Because you don’t want to have to be double guessing or second guessing, because everything’s going to look bad. You’re going to be looking at like good managers who are 50% off, and you want to have the conviction that these guys know what they’re doing.
JAMES: But we’re talking about long-term saving as well. So you need to have, think about a fund that’s still going to be around and relevant in 10-15 years’ time. And you probably don’t want to put all your eggs in Japan or Vietnam or something just because it’s exciting now.
JAMES: But it’s much better to think about having a spread of stuff. So this is where the global funds come into their own I think. I think they’re quite good vehicles for long-term savings.
PRESENTER: But given they’re becoming quite, given they’re becoming unique, that sounds contradiction, but I mean given what you were saying earlier about the use of private equity becoming quite punchy, does that mean they’re becoming less relevant as a solid long-term savings vehicle?
JAMES: Scottish Mortgage is sort of coming towards the extreme of that high conviction thing. And I think because of the nature of what it’s doing, there’ll be times when it doesn’t work. That hasn’t happened for quite a long time, which is why it’s expanding. I mean it’s just raking in money at the moment.
PRESENTER: But even the F&C Investment Trust I think has got a private equity sleeve in it, that’s.
JAMES: Yes, but that’s enormously more diversified. I mean that’s more of the really old school stuff, it’s probably got hundreds of holdings and all sorts of fingers in lots of different pies as well. So yeah, that’s the other end of the scope.
PRESENTER: All right, and I suppose the other scenario where people talk a lot about investment trusts is around income. Again Kieran, I mean you’re putting income portfolios together, how attractive or otherwise is the closed-end structure for that?
KIERAN: Well they jump at you from a, when you’re analysing OK if a client comes in and says I want to have some income. From the equity space you can buy companies that have got strong dividends, well covered by cashflow from operations. So it’s not the equity part that concerns us. It’s how on earth you get a real rate of return from your fixed income allocation. Now some people would find, you could have a property equivalent. The problem I have with that is interest rates back up if and when, and it’s probably more if, when than if. That property will pretty much, that property allocation will just look like a long bond. So I don’t think you really want to be swapping a fixed interest allocation for property. But in the fixed interest you have to go alternative income at this stage.
PRESENTER: So for you these are alternative fixed income vehicles that you’re using.
KIERAN: We can’t play corporate bonds, we can’t play, we don’t want to play high yield, because you’re not getting compensated for it, and we can’t play govies. So actually with some clients we just have to tell them to hold cash outside of the portfolio in their own name, because it’s just, it’s not cost effective, because we’ll be charging a management fee on cash like. So a lot of managers will just go OK we’ll just buy some gilts. They still get their management fee, they’ve got an allocation to something that’s cash like substitute, but it’s not the optimal solution for a private client, or for an institution by that matter.
PRESENTER: And what about on the equity side James, because you hear quite a lot from the investment trust industry about how the income story for investment trusts is a very attractive one for investors. Does it make a difference compared to open-ended funds?
JAMES: We’ve got a huge range of equity income funds in the closed-end space; quite a lot of which are replicated in the open-ended world as well. But it was one of the trends early in the 2000s to launch more regional income funds, emerging markets income. Actually there’s just been a new launch in that space now, Jupiter have just done one. So there are all sorts of equity income funds out there. One of the things that you can do with investment companies is that you can smooth the dividends. So they’ve got the ability to hold back some income and put it in revenue reserve, and then dig into that in the bad times. So if somebody’s actually relying on the income coming in, it’s much more likely that the investment company will maintain or increase its dividend. And so you’ve got a whole raft of investment companies that have increased their dividend for 50 years now, or 40 years, so really good solid long-term track records.
So that’s quite important. And then one of the other innovations that we’ve had much more recently is the ability to pay dividends out of capital as well. That really depends, I mean sometimes it work, sometimes it doesn’t. But if a manager’s earning pretty steady capital-type returns, and being able to distribute part of that, it’s quite attractive. So you can actually get yield out of things like private equity now, which you couldn’t do before.
PRESENTER: Well just to bring this to a close then, given let’s say a little bit of extra complexity round an investment trust, are they worth it Kieran?
KIERAN: In the large yes. I think they offer, for small retail, not small but retail clients, even if you’ve got a million you can still allocate very well into that space. As an institutional fund manager it’s a problem for us. We can’t play that, but that’s just the nature of the game. We can play things that the billion dollar guys can’t play, and they can play things that Warren Buffett can’t play. They’re really good for small, either small offices or just private individuals, they’re great.
JAMES: Yes I agree.
PRESENTER: All right, we have to leave it there. Gentlemen, thank you both very much indeed.
KIERAN: Thank you.
JAMES: Thank you.