Investors should beware greater downside risk when buying investment trusts over their open-ended peers, according to Paul Craig, manager of Old Mutual’s Cirilium range of fund of funds.
Investment trusts have a several key differences to open-ended funds. While the latter has daily liquidity, investors can buy into trust or sell them immediately so long as there’s a contrasting market participant.
Importantly, this relates to another of trusts’ key features: they can move between premiums and discounts versus their net asset value (NAV) depending on the demand for their shares.
Also, investment trusts have the ability to borrow cash, or use gearing, in order to leverage investments and make greater returns if the market goes up. Of course, this means their losses can be higher in down markets.
Because of their structure and these features, trusts tend to outperform the wider market and their open-ended counterparts over the longer term.
Not only do investment trust managers have a sealed pool of assets which allows them to take longer term bets, but they can gear-up in a rising market and if demand rises for their shares their discounts to NAV can narrow, which boosts potential returns for shareholders.
It is no surprise therefore to see that in the six years since the FTSE All Share bottomed out in 2009, the average trust in the IT UK All Companies sector has returned more than the average fund in the IA UK All Companies sector.
Performance of sectors and index since 3 March 2009
Source: FE Analytics
Craig, who runs Old Mutual’s Cirilium range, which includes Old Mutual Cirilium Balanced, Old Mutual Cirilium Dynamic, Old Mutual Cirilium Moderate Old Mutual Cirilium Strategic Income and Old Mutual Cirilium Conservative, has been a big fan of using trusts for precisely these reasons.
However, he says the maturity of the current market makes trusts considerably less desirable now due to a greater chance of downside risk, amplifying the danger of holding trusts.
“We don't really want to hold closed-ended funds because we don't want to be geared to the market. Also discounts are narrow; they are actually the narrowest they have ever been in my 25-year career,” he said.
“Early on we were focusing more on closed-ended funds because that is where we saw the opportunities. However we are six years in [a bull market] and we have seen tremendous returns from equities and I still feel it offers the best prospective return. What we have done is to reduce the risk of seeing drawdown by reducing exposure to closed-ended funds.”
“I am not expecting discounts to widen dramatically but if returns are expected to be lower then we don't want to give any of that potential return away through even a marginal increase in the discount.”
A recent FE Trustnet study found Old Mutual Cirilium Dynamic, the range’s most aggressive offering, was the second highest returning portfolio among all of the multi-asset funds in Investment Association universe since the collapse of the Lehman Brothers bank.
Old Mutual Cirilium Dynamic has been managed by Craig since June 2008. Until recently it was called Henderson Cirilium Dynamic having been – along with the other portfolios in the Cirilium range – sold to Old Mutual Global Investors in 2014.
The only portfolio to beat it in the multi-asset space was Peter Walls’ £25m Unicorn Mastertrust, which heavily bought investment trusts on wide discounts during this period.
Not only did both funds outperform the FTSE All Share over this period but they did so with lower annualised volatility and better risk-adjusted returns.
Performance of funds and index since Lehman’s collapse
Source: FE Analytics
Craig said: “Shortly after the financial crisis, when we took over the funds, closed-ended funds offered a greater prospective return than open-ended funds. Discounts were very wide and many were geared.”
“If you had an open-ended portfolio and a closed-ended portfolio and there was no difference between the portfolios and they were both trading at net asset value then you would never buy a closed-ended fund.”
“But when you can buy the same portfolio at a wide discount and be geared into a recovery then clearly we utilised closed-ended. We have been aggressively reducing exposure to closed-end funds to the point now where there is now only about 25 per cent in closed ended funds.”
However, the manager still clearly backs some trusts and says he occasionally will also hold ETFs to bolster a theme in the portfolio.
“We look at all varieties of products and ways of gaining exposure to build a multi-asset, multi-manager portfolio. What we are using closed funds for now is really the gamut that it gives us things such as listed private equity.”
He recently told FE Trustnet that he had increased exposure to one such vehicle recently due to a narrowing its discount in addition to its portfolio’s strengths.
Craig added to the US-based HarbourVest Global Private Equity investment trust, which is portfolio of different private equity funds and trusts. It has returned just over 100 per cent since listing in the UK in 2010.
Performance of trust since 2010
Source: FE Analytics