These reactions are not limited to the investing public, however; having spent most of my career looking at open-ended funds, I too have developed a bit of a bias against their closed-ended cousins. This is not uncommon in analysts as, despite the many similarities, the two structures have significant differences that often lead to the two being analysed by different teams.
Investors, by comparison, frequently view trusts and funds as equals, especially when they share a manager.
With the popularity of trusts starting to increase, especially among FE Trustnet readers, I thought it would be a good time to look at them in a bit more detail.
Over the course of the year I’m going to be developing a research methodology to help identify good investment trusts.
Before I start, however, it is probably a good idea to lay all my preconceptions on the table and outline what I consider to be the main problems that hold back investment trusts and keep their popularity well below UTs and OEICs.
My wariness of trusts can broadly be summed up by three main complaints:
Firstly, there is not enough transparency. In order to be able to make an informed investment decision, I want to be able to get a clear picture of what the fund manager is doing with the money in his care: what is he investing in, what are his reasons for doing so and so on.
With open-ended funds, this information is relatively easy to come by – even the smallest fund will produce a factsheet, usually monthly, that will give a breakdown of the regions and sectors the fund is invested in, a list of the top holdings in the portfolio and a brief explanation of what the fund is trying to do.
While this information is available for some trusts, there are many that fall far short. Often all you will be able to find is a copy of the annual report, which is less conducive for effective analysis.
The reason for this lack of transparency, I suspect, is linked to my second complaint. Once the initial offering phase is complete, the trust has the assets it wants and doesn’t have to worry about inflows.
While this has previously been regarded as a positive, it also means that the interests of those running the trust are not always aligned with investors’.
In an open-ended structure, changes in assets under management (AUM) directly impact on the earnings of the fund group, thus winning and retaining clients is a key part of their business, so engaging and communicating with investors and potential investors is critical.
As such, AUM are often factored into the remuneration of fund managers.
In a closed-ended fund, once the initial offer period is over, the AUM are fixed. The manager is focused on the performance of the net assets, while investors experience the performance of the share price. There is naturally a disconnect here.
Some investment trusts do actively try and manage the relationship between NAV and price through discount control mechanisms (DCMs), such as Sebastian Lyon’s Personal Assets Trust.
As the graph shows below, the difference between the share price and NAV has been relatively small over the last three years. In fact, the share price has actually performed better.
Performance of trust’s NAV and share price over 3yrs
Source: FE Analytics
However, most trusts do not use a DCM, and those that do are not always that effective.
Here is an example of a trust that has seen a bigger difference in the performance of its NAV and share price:
Performance of trust’s NAV and share price over 3yrs
Source: FE Analytics
This links me nicely to my third complaint: the performance of listed shares is not solely based on the performance of the trust, and changes to the discount or premium can be the biggest driver of performance.
This is probably the biggest problem, in my opinion. The performance of the share is not perfectly linked to the performance of the fund manager like it is with an open-ended fund.
Even if a fund manager does an excellent job and makes a 15 per cent return on his assets, there is no guarantee I will make 15 per cent on my investment.
Any number of factors, from the popularity of the trust to the performance of the market it is listed on can conspire to ensure you experience something very different.
These three points add to the complexity of analysing an investment trust. While I’m pretty confident I will be able to get my head around the fund managers’ strategy and their ability to carry it off, I need to add in loads of additional work on capital structures, credit quality, interest coverage, debt covenants, smoothing policy and share buybacks; plus market analysis and timing considerations to figure out how the share might react.
This work multiplies significantly for split caps, which have multiple share-types available.
Identifying a good trust has very little to do with identifying a good investment.
Finally, while not a complaint per se, a common plus-point used in the defence of investment trusts is that by purchasing listed shares, you are not losing a chunk of your capital in fees.
This certainly has some appeal as fees can have a significant impact on a portfolio, however I’m not sure this is as straightforward as it seems.
While there may be no explicit management fees, you can be sure that the fund manager is not working for free. Management fees are applied to the assets under management.
If you believe that the price of your trust's shares is determined by the performance of the net asset value of the trust, you implicitly feel the effect of management fees, not through a direct deduction but in the reduced performance of the assets.
I’m sure by now investment-trust fans are foaming at the mouth, and I’d like to point out that I didn’t specifically set out to write a hatchet piece.
There are many excellent investment trusts out there and I will be looking at them in close detail in future articles; however, in my opinion, there is an awful lot more that needs considering before you can confidently predict which ones they are.
Given I sell a research service, retail investors don’t have the same requirement to cover the bases as comprehensively as I need to; however, all of the factors that cause me anxiety should be carefully considered by retail investors, too.
Investment trusts have long been neglected by the bulk of retail investors and financial advisers, and the above list of gripes is part of the reason why.
Recent rule-changes for advisers might have rekindled hope that investment trusts will make their way back into the mainstream and challenge the dominance of open-ended funds, but until the problems above are addressed I predict they will stay on the fringes.
In Rob Gleeson’s next blog, he will look at the advantages of investment trusts, and highlight which sectors are most suited to a closed-ended structure.