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Why you should own investment trusts after the next crash

21 April 2016

A recent report from Investment Trust Intelligence shows by just how a great a margin closed-ended funds outperform their open-ended rivals over the longer term and, more specifically, during a strong recovery market.

By Alex Paget,

News Editor, FE Trustnet

Investors have historically been greatly rewarded by backing investment trusts rather than open-ended funds over the longer term and especially during the aftermath of a severe market crash, according to Investment Trust Intelligence.

Concerns have mounted regarding the outlook for risk assets, with many suggesting that a severe correction may be on the horizon for equity markets.

Indeed, though woes surrounding China have recently dissipated, global economic growth is still subdued, valuations are by no means cheap and political risk – in the form of a potential Brexit and the US presidential election – is on the rise.

The authors of Investment Trust Intelligence, which is a quarterly report published by Kepler Partners, agree that the chances of a significant correction in global equities have increased dramatically recently as central bank policies have so far failed to kick-start the economy while the debt burden which caused the global financial crisis is still ever-present.

“With questions hanging over the ability of the United States to sustain its economic momentum, and an outside chance that the world’s most powerful country might end up under the stewardship of a swivel-eyed billionaire whose penis has become the subject of televised political debate, the likelihood that equities will beat a retreat of some magnitude is viewed by many as a matter of when, not if,” the report said.

Though that may be enough to cause some to sell their holdings and hoard cash, the report also highlighted just how much money can be made from equities over the longer term if investors keep skin in the game and not sell into a global crash.

According to FE Analytics, for example, the FTSE All Share has made 1,459.27 per cent over the past 30 years – a period that includes the 1987 crash, the tech bubble bursting and the global financial crisis.

The chart below also illustrates how, over that time period, the crash of 1987 – which was viewed at the time as the one of the most painful and severe market falls ever – is little more than a mere blip on a long-term graph.

Performance of index since January 1986

 

Source: FE Analytics

The report added: “Of more interest to us is not what to do to prepare for a crash, but what is the best position to be in for the climb which we are sure will follow in its tracks, as it did after Black Monday, the tech bubble and the great financial crisis before it.”

As a result, Investment Trust Intelligence has produced research on the performance of trusts versus funds during periods of strongly recovering markets over the longer term.

It notes that managers of investment trusts have a number of clear structural advantages over those who run traditional OEICs and unit trusts in such an environment.

“With no need to worry about redemptions, they are never forced to sell their holdings at a time which does not make sense from an investment point of view.”

“The same principle – that lack of a straitjacket forcing them to remain liquid – means they can invest in smaller companies than their open ended counterparts and gearing accelerates upside significantly when used wisely, with impressive effects over the long term.”

“Perhaps most importantly, the impact of the discount, usually at its widest when the market is in the doldrums, will often narrow when the recovery begins to take hold, boosting shareholder returns very significantly.”

“The extent to which these theoretical advantages actually work in trusts’ favour when one considers the real performance numbers since the last time the market bottomed is startling.”


 

For the research, Investment Trust Intelligence looked at the total returns of funds and trusts in the six largest equity-only IA and AIC peer groups – the global, UK all companies, UK equity income, Europe, Japan and Asia Pacific ex Japan sectors – after the three largest crashes of the past 30 years and showed that investors have historically been rewarded for backing trusts after a market crash.

FE data also backs up their results. While the data is too patchy when looking back to when markets rebounded after the 1987 crash in the November of that year, it shows that trusts have – on average – massively outperformed funds since markets bottomed in 2003 and in 2009.

Total return performance of sectors (in %) after the last two major market crashes

 

Source: FE Analytics *average outperformance of trusts is shown in percentage points, not per cent

As the table above shows, apart from in the Asia Pacific ex Japan space since 2003, trusts have outperformed funds in all of the major equity peer groups over the periods in question. Since 2003, trusts have outperformed – on average – by 74.77 percentage points and since 2008 crisis that figure stands at 59.05 percentage points.

The report also highlights that, when combining the respective fund and trust sectors together since the last two major market corrections, 75 per cent of the time the best performer has been a closed-ended fund.

The exceptions have been in Japan since 2009, as Legg Mason IF Japan Equity has been the best performer; in the global sector since 2003, as Skagen KonTiki has been the best performer; and in the UK All Companies space since 2003, as Franklin UK Mid Cap has been the best performer.

“This analysis is not meant to prove that investment trusts are ‘better’ than their open ended counterparts, and we do not propose that at all,” the report stated.

“However, what we do believe is that at certain times the structural differences between these two types of fund can have immense implications and now, with equity markets waiting for an excuse to tank, is one of those times”.

“The past, we are told, is no guide to the future, but what these figures conclusively show is that, generally speaking, the impact of gearing and a closing discount adds a significant boost to the performance of a trust in share price terms.”

Current and previous average discounts (in %)

 

Source: The AIC

“Discounts continue to move out across the board in the face of miserable sentiment and we think that when the next correction comes – at which point those discounts will be wider still – the figures that we have uncovered convey a clear message.”

Of course, a fair counter argument to the results of the report is that it only shows the outperformance of trusts after a painful bear market – therefore suggesting investors need to get their market timing right to reap the rewards.

Indeed, the consensual view is that closed-ended funds tend to underperform relative to open-ended portfolios during corrections as their structural benefits in a rising market (gearing, discount volatility) often work against investors from a total return point of view when investor sentiment declines.


 

However, according to FE Analytics, investors have largely been better off backing trusts over funds even if their market timing has been completely off.

For example, we looked at the 12 sectors again from a total return point of view since January 2000 (when the tech bubble started to burst) and in October 2007 (when the market began to fall in the build up to the global financial crisis).

Again, apart from in the UK equity income space since the beginning of the global financial crisis, trusts across all the major sectors have on average outperformed funds over both periods.

Total return performance of sectors (in %) since the start of last two major market crashes

 

Source: FE Analytics *average outperformance of trusts is shown in percentage points, not per cent

According to FE Analytics, trusts have outperformed funds by 19.55 percentage since the beginning of the most recent crisis and have outperformed by 74.47 percentage points since markets began to fall as a result of the collapse of the tech sector.

“We believe it shows the advantage that investment trusts have, bought when their shares are cheaper than the assets they represent, for those who believe that equity markets will, eventually, recover,” Investment Trust Intelligence added.
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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.