Star manager James Anderson (pictured) is seeking to increase the mandate of the Scottish Mortgage investment trust to allow up to a quarter of the £3.4bn portfolio to be invested in unquoted smaller companies. 
This follows a trend that began two years ago when Scottish Mortgage’s board approved 5 per cent exposure to unquoted firms but last year this was doubled to 10 per cent. Now the board will vote in June whether to up this to 25 per cent.
The Scottish Mortgage portfolio has been managed by James Anderson since 2000 since which, according to our data, it has gained 262.7 per cent, vastly more than its sector average and index. It is also top decile over three, five and 10 years in the IT Global sector.
Performance of trust, sector and index since April 2000
Source: FE Analytics
Its strong returns have been driven by such stock market darlings as Amazon, Tesla Motors, Illumina, Google and Facebook.
Anderson was joined by Tom Slater in 2009, who is now co-manager. The two mangers use a largely thematic approach to their portfolio, which ignores quantitative methods of picking stocks more popular with many funds and trusts.
The trust is prone to greater volatility than both the index and its peers and 2015 was a difficult year for the strategy, with the portfolio down 16.39 per cent since June.
The trend for demand to unlisted equity is also highlighted by the much vaunted launch last year of Woodford Patient Capital which another star manager – Neil Woodford – brought about due to a belief there is a huge untapped opportunity in smaller firms in desperate need of ‘patient’ capital.
However, a year after its launch, it has underwhelmed many investors despite keeping ahead of the FTSE All Share index, its sector average and Scottish Mortgage to boot.
Performance of trust, sector and index since launch
Source: FE Analytics
Unlisted investments in Scottish Mortgage have been around for many years but Anderson and Slater believe there is a pressing need for greater proportional exposure to a “shift in the balance within the capital markets between the providers and consumers of capital’.
In short: many companies now need less cash at the early stage of their growth before they list on a stock exchange. Anderson says this is particularly the case in for technology-heavy firms.
“In order to maintain the breadth of their investment opportunities, the managers have sought to utilise the flexibility of the closed ended capital structure of Scottish Mortgage to invest in a number of private companies, in the belief that this will provide them with a greater opportunity to continue to deliver long term returns for shareholders in the future,” a spokesman for Baillie Gifford said.
It is a significant shift for Scottish Mortgage, says Cantor Fitzgerald's Charles Tan, who thinks the move is positive for investors.
“The structure of investment trusts lends itself well to less liquid holdings. Why put in highly liquid securities into a closed ended vehicle when those kinds of securities naturally belong in an open-ended fund. On balance it should be quite a good thing,” Tan said.
“If you take a look at technology firms, which is the most relevant given the tech-heavy leaning of Scottish Mortgage, the trend you are seeing is the hottest firms are coming to market later and later.”
“Uber for example is at a $50bn valuation and if it were any other company it would probably have listed by now. It seems like the best ones are holding on longer and longer.”
“However, lots of stuff does go wrong that you don't hear about. There has been talk of a valuations bubble and how there are so many unicorns out there in the tech space but not all of them are justified in their valuation.”
A unicorn in this context refers to a company valued at more than $1bn.
Ben Willis, head of research at Whitechurch Securities, used to hold Scottish Mortgage in several more aggressive growth portfolios but he sold it when it moved to a premium last year. Willis says he is not overly concerned by the increase to unquoted names.
“It makes it difficult to hold within model portfolios [when its premium/discount moves around]. The trust had c. 10 per cent exposure already and it has always been managed on a high conviction basis.”
“If Anderson and Slater feel that there are significant opportunities in this area, then shareholders are likely to be happy to back them given the returns the trust has generated over the medium to long-term.”
Stiffel’s Iain Scouller says the managers are trying to further differentiate the trust from the rest of the global trust’s peer group, but that investors should pay heed to a potential for greater discount risk.
“If they get access to some good deals that perform well – all well and good. [However] they need to be careful not to put too much in unquoteds in case it scares investors and impacts the discount rating – it is worth noting that the UK listed Private Equity funds are typically on 20 per cent to 25 per cent discounts.”
Winterflood’s Innes Urquhart says the proposal to increase the potential exposure to unquoted holdings reflects the difficulty that growth managers have in accessing disruptive companies solely through public markets. This should be noted by investors, he says.
“In our opinion, increased exposure to unquoted investments makes Scottish Mortgage a fundamentally higher risk proposition.”
“However, we also believe that it increases the fund’s return potential and we continue to recommend the fund within our model portfolio as a high growth vehicle that should perform well in positive markets.
“In addition we believe that discount risk is alleviated to an extent by the board’s willingness to use buybacks to reduce discount volatility.”
Scottish Mortgage has an OCF of 0.51 per cent. The trust is 13 per cent geared and is currently on a premium of 2.3 per cent.
