Investment trusts continue to deliver

Global equity investors had a mixed year in 2015, with varying performances across global markets. The Japanese market produced the strongest returns, with the Topix up 12% in yen terms, while European equities saw decent returns in 2015, up 9% in euro terms. After a strong year in 2014 the US market had a quiet year in 2015, with returns of just 1% in dollar terms. The difficult period for Asian and emerging markets continued in 2015, down 6% and 5% respectively in local currency terms. The price of oil fell 32% last year in sterling terms, compared with a 47% decrease in 2014, and it closed the year at US$36 a barrel.

Investors in the UK market saw modest returns for the second year running, with the FTSE All-Share Index up just 1% on a total return basis. The year actually started brightly as a result of optimistic hopes for economic growth and the UK market was up 9% in the first five months and the FTSE 100 Index exceeded 7,000 for the first time.

However, a series of global macroeconomic concerns weighed heavily on the market from the summer onwards, not least evidence of a Chinese economic slowdown. In the last seven months of the year, the FTSE All-Share Index fell 8%, with a substantial increase in market volatility.

Investment trusts in 2015

2015 was another good year for investment trusts both in absolute and relative terms. The vast majority of investment trust sectors delivered positive NAV returns and outperformed the FTSE All-Share Index, with only seven in negative territory. The best performer was Japan – Smaller Companies (+28%) followed by European – Smaller Companies (+27%) and Japan (+23%). The worst performer last year was Commodities (-19%) followed by Emerging Markets – Global (-14%) and Asia Pacific Income (-5%).

The investment trust sector average discount (excluding private equity, direct property and fund of hedge funds) ended last year at 4.7%, compared with 5.7% 12 months earlier. Since the end of 1989, the long run average discount for the investment trust sector has been 9.7%, although since 2005 the sector has tended to trade at a narrower level. This reflects the prevalence of buybacks since April 1999 (when tax rules changed), corporate activity, and strong outperformance.

The majority of sub-sectors saw their discounts narrow in 2015. UK Small Cap saw the greatest discount tightening, as the sector was re-rated in the final quarter of the year. Europe and Japan were also re-rated reflecting strong performances from these regions last year. Global Growth also saw its discount tighten as Alliance Trust initiated a significant buyback programme, while Scottish Mortgage Investment Trust continues to trade at a premium. In contrast, UK Property saw the greatest de-rating last year as NAVs rose and premiums eroded. Amongst equity sectors the US saw the greatest discount widening, reflecting a quieter period of performance.

Outlook for 2016

The stock market has had a difficult start to 2016, against a backdrop of increasing geopolitical tension in the Middle East and dramatic falls in the Chinese market. Some commentators have warned that this year could see a repeat of 2008. While equities do not appear to offer value by historical standards, neither are they particularly expensive and, in the case of Asian and emerging market equities, valuations are reasonable. Consequently, while this year may see a set-back in equities, we still believe that they remain attractive on a long-term view. The trick, as always, is to back the companies that can prosper in a rapidly changing environment and that is why, in our opinion, it is crucial to select the right active investment manager.

Outperformance of closed-ended funds

Investment trusts have a strong record of outperforming open-ended funds over the long-term. When the nine most comparable sectors for investment trusts and open-ended funds are examined over a ten year period, investment trusts are ahead in each category. We believe there are four main reasons for this. Discounts of investment trusts have narrowed over the long-term, while a number have used modest levels of gearing to increase returns. In addition, management fees have historically been lower for investment trusts than the equivalent open-ended funds.

This advantage is no longer as marked following a review by the regulator in 2013. However, investment trust boards, which are independent, have responded to more competitive pricing by negotiating lower fees with their respective investment managers. This trend was a feature of last year and we would expect it to continue this year. The other factor that we believe assists the performance of investment trusts is that the structure allows longer term investment decisions to be made. Fund managers, who are responsible for both open-ended funds and investment trusts, will often make the point that it is easier to manage a captive pool of capital rather than having to deal with the inevitable liquidity calls on an open-ended fund.

Another advantage that investment trusts have over their open-ended equivalents is the ability to use revenue reserves or, with shareholder permission, use capital to support or even continue to grow their dividends. This was used across the sector to good effect six years ago following the financial crisis, when many banks ceased paying dividends, and when BP suspended its dividend in the wake of the Deepwater Horizon disaster. This ability to provide greater dividend certainty has seen investment trusts in the UK Equity Income sector being consistently highly rated. A number of investment trusts also have impressive records of dividend growth, such as Murray Income Trust, which has seen 42 years of consecutive dividend increases.

Value opportunities

We believe that investment trusts are attractive vehicles for contrarian investors who are looking for value opportunities. While the overall discount on the investment trust sector is at historically high levels, pockets of value exist. Unsurprisingly, these can be found in out-of-favour asset classes that, invariably, have suffered from periods of disappointing returns. The best examples of this at present are: Asia, where Edinburgh Dragon Trust* and Aberdeen Asian Smaller Companies Investment Trust invest; emerging markets; and Private Equity, where investment trusts include Aberdeen Private Equity Fund. It is difficult to predict with certainty when sentiment to areas such as emerging markets will improve. However, for investors who can take a long-term view and tolerate potential volatility, it can pay to be contrarian.

Good examples of this in recent times are Japan and Europe. Both sectors were significantly out-of-favour in 2012, following periods of indifferent performance.

Consequently, investment trusts investing in these regions were available on double-digit discounts. Following Abenomics in Japan and Mario Draghi’s ‘whatever it takes’ speech in Europe, both were re-rated and investment trusts in these sectors are now trading on premiums. The effect of discounts narrowing and a period of strong performance can lead to significant outperformance.

Summary

The investment trust sector has seen a substantial evolution in the last eight years as the advantages of the closed-end fund structure have been put to good use to meet investors’ growing income requirement.

There have been over 70 IPOs since the start of 2011, of which 80% can be categorised as ‘Alternative’ asset classes, often with an income target. This wave of issuance has refreshed the sector and, together with existing trusts that provide in-demand equity income mandates, accounts for the historically low average discount level.

We believe that the closed-ended fund structure has a significant advantage in providing access to both illiquid asset classes and yield orientated strategies. In addition, the structure allows longer-term investment decision making that, in our opinion, often leads to stronger returns. Consequently, we believe that the investment trust sector is well poised to meet investors’ demands in 2016.

* Denotes a corporate broking client of Winterflood Securities

Winterflood Securities Ltd is authorised and regulated by the Financial Conduct Authority. This article contains information of a general nature and does not address the circumstances of any particular individual or entity. Nothing in this document constitutes or shall be implied to constitute advice, including legal, tax, financial and/or other professional advice, and nor does this article constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. The investments and investment services described in this material may not be suitable for all people. Before entering into an agreement in respect of an investment referred to in this material, you should consult your own investment advisers as to its suitability for you and should understand that statements regarding future prospects may not be realised.

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