Reading the comments on the last piece it seems that some people felt that my concerns about ITs weren’t relevant and that I was being unduly negative. I certainly haven’t changed my opinion in the last few weeks and many of the things I find problematic about investment trusts remain an issue for me.
However, I do think there are some advantages to investment trusts that can be put to good use to enhance a portfolio with some careful consideration.
First up, and probably most important to me, is the stability of the asset base. Investment trusts aren’t subject to asset inflows and outflows like open-ended funds.
Once they have raised the desired level of funds, this is fixed. Thus supply and demand is reflected in the share price of the trust and has no impact on the money being invested by the fund manager.
This means the fund manager is free to pursue a long-term strategy without being forced to sell holdings if people want to cash out, or find somewhere to invest new money when it comes in.
This is especially beneficial when the fund invests in illiquid instruments. It is fairly common to see successful small cap funds have to start including more medium-sized companies, because they have too much money to just focus on the smaller ones, despite this being the reason for their success.
Harry Nimmo’s Standard Life UK Smaller Companies and Giles Hargreave’s Marlborough Special Sits immediately spring to mind.
Additionally, investments in property are not easily traded – selling an office block takes time, as does buying one, and it isn’t uncommon to see property funds sitting on big piles of cash just in case people want to withdraw their money, or until they can find another property to buy.
Cash drags on performance and thus investment trusts have an advantage, as well as suiting high-conviction stock strategies.
In my own analysis, property and other areas where long-term stability is key, such as infrastructure, look to be the most promising areas where an investment trust seems favourable.
Another plus is that investment companies are not bound by the same rules as open-ended retail funds and have far greater freedom in investment strategy.
This means they offer greater access to things like hedge funds, private equity and venture capital that as an individual investor you wouldn’t otherwise have access to.
Admittedly this could be a double-edged sword as the regulator restricts most of these complex investment types for a reason; however, for the adequately informed, these alternative asset classes offer great diversification.
A few per cent in private equity or funds of hedge funds could be a worthwhile addition.
This is probably where my professional interest differs from the average investor, as I’m not sure there is much unfulfilled demand for hedge funds among retail investors.
But as I’ve stated before, it is my belief that diversification is the key to a successful portfolio, and more options is definitely a good thing.
Another freedom not afforded to open-ended funds is the use of gearing. This is where the trust borrows additional capital to invest alongside what it has received from investors, thus amplifying returns.
This can be an advantage in rising markets but lead to greater losses in falling ones, increasing overall volatility.
Carefully managed, however, gearing can offer significant benefits, even at lower risk levels.
If you are in the market for a high risk, aggressive equity investment, then you will find more on offer from a highly geared trust than an open-ended fund that has its market exposure restricted to 100 per cent.
If you look at funds and trusts run by the same manager with a similar mandate, trusts tend to outperform over the long-term for this very reason.
The closed-ended version of Nimmo’s Standard Life small cap portfolio is a good example.
Performance of fund vs trust over 10yrs
Source: FE Analytics
Gearing can also be used to effectively boost the yield paid to income investors.
The final advantage is also what I highlighted as the biggest disadvantage last time: discount volatility.
As I pointed out last time, the price an investor pays is the price of the share listed on the exchange, which is different to the underlying value of the trust’s assets.
This difference fluctuates at random and can have a significant impact on performance; it is easily my biggest headache when trying to perform quant analysis.
Despite this however, it also presents an opportunity to buy on the "cheap". Much additional returns can be gained if you call the direction of the discount correctly, and often the trading range is relatively consistent, although this can easily go wrong and end up a negative.
That then, is my view of what the advantages to investment trusts are.
I still feel the additional uncertainty and volatility coming from the discount makes them an unfavourable choice in most cases, but they do offer some significant advantages in the right situation.
If you can buy a listed version of your preferred fund at a record discount and at a lower cost, then the upside probably justifies the additional volatility.
If you want to reach hard-to-access specialty asset classes, again a trust can do a job there.
Their quirkiness will probably see them remain something of a niche investment rather than breaking into the mainstream, and in my mind I think the balance between pros and cons would mean they work best as a way to subtly change the characteristics of a portfolio rather than make up the core.
So, while I’m not a complete convert, I’ll definitely be looking out for opportunities in investment trusts from now on.