Ghosts in the machine

Gearing has seen many investment trusts suffer steeper falls than other investment funds. Sonia Speedy checks out which sectors have stood up best to the downturn

Investment trusts have taken a battering in the current economic storm – particularly those that are highly geared. But which sectors are faring better than others, and is now the time to start reconsidering these investment vehicles or risk missing out on some serious upswing once the economic tide changes? Opinions are mixed.

Like most investment products, the recession has taken its toll on the UK investment trust industry. Figures from the Association of Investment Companies (AIC) reveal that the industry had total assets worth £94.6 billion as of March 31, 2008. This included 320 investment companies, or a total of 443 with Venture Capital Trusts (VCTs) added into the equation.

But by the same time this year, more than £20 billion had been wiped off the total value, leaving it at only £73.9 billion and the number of investment companies had fallen to 315, or 439 including VCTs.

The only conventional investment company sector to show positive returns in the last year was biotechnology/life sciences, thanks to its defensive qualities, which, as of March 31, had posted an 18.8 per cent gain. In the VCT space the environmental sector saw a positive return of four per cent over the same period.

But elsewhere investment trusts have been feeling the economic malaise. The private equity sector returned just £34.71 before charges for every £100 invested in the year to March 31, while financials returned £42.71 on the same basis. The UK growth and income sector fared better, but still only returned £70.54, while global growth and income returned £79.58.

JPMorgan Asset Management investment trusts’ head of sales and marketing James Saunders Watson says the core long-only investment trusts have generally fared better than others during the downturn, particularly those with an income focus.

Because they are companies rather than regulated funds, investment trusts can reserve up to 15 per cent a year for a rainy day.

“A number of the more mature trusts have significant levels of revenue reserves which the boards are able to draw on to smooth the dividend payments if there is a shortfall in the income from their investments,” he says.

F&C Investments head of investment trusts Mike Woodward concurs, suggesting that tried and trusted stalwarts of the investment trust scene like the Foreign and Colonial Investment Trust and the Alliance Trust have not seen discounts “blow out”.

“We haven’t really seen great swathes of individuals selling out of the more traditional vehicles. They have run scared of the alternatives such as private equity, but the traditionals have weathered the storm,” he says.

The sectors that have been the most “challenged” were those exposed to alternatives, such as private equity, hedge funds and real estate, Saunders Watson reiterates.

Hargreaves Lansdown head of research Mark Dampier goes so far as to describe some investment trusts – such as those in the hedge fund sector – as having “fallen out of bed”.

While many managers have reduced gearing levels within their investment trusts, a degree of gearing still exists and therefore these products tended to fall more than open-ended funds, he says.

Woodward points to property trusts as a good example of the effect gearing can have, saying that a lot of heavily geared investment trusts in this sector were “killed”, when the property market turned. “The three property vehicles we run have not been terribly highly geared and so have not suffered quite as much, but they’ve still had a geared fall into the market,” Woodward says.

The flip side however, is that once the property market bottoms out and valuations begin to rise again, the same gearing that has damaged returns could help rocket gains ahead. “The property sector is quite a good case study of how too much gearing can kill you on the way down, but if you survive in a position then on the way up you ought to outpace the opposition because you get a geared return,” Woodward adds.

Across the investment trust sphere discounts have widened sharply during the recession, with property once again a good example, Woodward says. “As asset values were falling and gearing was playing havoc, people were bailing out of them. Therefore the discounts went from next to nothing to really very substantial numbers – 40, 50, 60 per cent and beyond,” he says.

However, in advance of a change in direction in the property market, discounts on investment trusts in this sector have begun to narrow, Woodward says.

Private equity is suggested as potentially the next sector to move this way. “It too is being killed, as asset values have fallen as gearing takes effect, and again discounts have gone out to silly numbers. So, if and when private equity recovers, one would hope to see the mirror image of all that happening,” Woodward says.

As well as helping to improve returns when assets values rise, narrowing discounts also help provide a cushion against any potential further decline in asset value, he adds.

Saunders Watson points to a further benefit of investment trusts: “Being invested in real assets they should also give investors protection against the potential damage from inflation as the authorities introduce measures to kick start the economy,” Saunders Watson says.

Alistair Darling’s second Budget in April brought at least some small measure of good news for the investment trust industry, with the introduction of a new tax framework for investment trust companies set to come into play from September 1 this year. This will enable investment trusts to invest more tax-efficiently in bonds and put them on a more level playing field with other investment products.

On a less positive note, EU Commission proposals to regulate all alternative investment fund managers – which will include nearly all AIC member companies – are seen as a major threat.

Regardless of any potential advantages investment trusts may have going forward, many IFAs continue to steer clear of them. The risks associated with gearing and a lack of liquidity are the most commonly cited reasons for this.

Informed Choice joint managing director Martin Bamford is one such IFA and says he does not recommend investment trusts because of the gearing risks and because of the lack of availability of these products on most platforms.

He says IFAs who do not recommend investment trusts are often accused of doing so because of the lack of commission, but points out that this is not the case for his, which is fee-based.

Towry Law certified financial planner Patrick Connolly expresses similar sentiments. “We manage our client money on a discretionary basis and we need to buy and sell in large proportions. With closed-ended funds if you buy you need to find a seller; if you sell you need to find a buyer. With open-ended funds you don’t have that issue, you simply create or get rid of units,” he says.

While getting the market timing right can be difficult, Saunders Watson maintains that investors ought to be considering investment trusts.

“We believe that there are good examples of value emerging and investors seeking income should seriously consider investment trusts as an alternative to cash on deposit – if they are prepared to accept some volatility in the capital value,” he says.

Despite not recommending investment trusts, Bamford can still see their potential. “If you can afford to take that longer term view and you understand the associated risks with investment trusts, then absolutely, it could be seen as a good time to invest. I guess it comes down to issues of access and availability,” he says.

But for Dampier the cons still generally outweigh the pros. “At the end of the day I think they’re niche vehicles for private clients,” he says.

Commercial property oversold?

Yellowtail Financial Planning principal Dennis Hall is one adviser currently looking more closely at investment trusts as a way of adding value to client portfolios. Hall has a client base of medium to long term investors and generally focuses on a buy and hold strategy. He is positive about the prospects for investment trusts in the medium term.

“If you’re going to go into the market anyway, if you think the time is right for a particular sector and you happen to be able to get those assets at a discount through an investment trust; and you’ve got a reasonable time horizon – then I think you’d be foolish to ignore them,” he says.

Hall particularly likes the commercial property sector, believing there are significant discounts to Net Asset Value (NAV) available, although he is wary of those companies with heavy borrowing. He is also a fan of private equity.

“Like all things there are certain sectors of the market that have been oversold and in investment trusts that will equate to wider discounts, which I think is a great opportunity for investors to buy things at below NAV if they’re prepared to hang on and hold on,” Hall says.

He favours companies such as HgCapital Trust, the F&C Commercial Property Trust and the Alliance Trust.

“I do think that investment trusts are poised to take a bigger share of the market than they have in recent years. They’ve got a great story to tell and they should be banging the drum.”