Investment Trusts: Time to trust or flee?

Thursday, 08 October 2009 03:43

The high level of public debt has led many to speculate that this government - or the next - will have to inflate their way out of it, which will once again be bad news for savers.

Traditionally, investing in equities has been the way to beat inflation, but the financial crisis sent many people running from the suddenly volatile and risky world of stocks and shares.

But with the FTSE 100 showing signs of a recovery and the spectre of inflation rearing its head, is now the time to head back into the stock market?

Investment trusts - which pools investors' cash to buy a range of stocks, overseen by a professional fund manager - are a good way of investing in equities while spreading your risk over different stocks and sectors.

The trust is registered as a public limited company, and investors buy shares as with any publicly listed company.

Sarah Routledge looks at the advantages and risks of investing in the stock market through investment trusts.

Job Curtis, fund manager for Henderson's The City of London Investment Trust, explains an important difference between open-ended investment companies (OEICs) is the ability to smooth returns.

"What we've been doing in the boom years is hold back as much dividend as we could, so we could build up a big revenue reserve," says Job.

Foreign & Colonial Investments (F&C) launched the first investment trust in 1868 and is still going strong with over 100,000 investors.

Simon Cordery, head of investor relations for F&C, explains a closed-ended investment trust has advantages over other collective investments, such as an open ended investment companies (OEICs).

"They share all the positive attributes of collective investments, you're invested in a pool of companies that gives you diversification and spreads your risk. But the key difference is you are buying into a publicly listed company. That gives you added safeguards.

"Not only do you get the regulation under the FSA, but also under the Companies Act and under rules publicly listed companies must follow to protect shareholders."

Mr Curtis says a steady income is important to the investors in the fund, and consequently he invests in blue-chip multinationals on the FTSE 100 who have been consistently paying out dividends.

Another advantage of an investment trust is a board of directors who oversee the performance of the fund manager, Mr Cordery adds.

"Their job is to ensure the fund is being run according to its mandate. It is an important backstop that you don't get with OEICs.

"For example, if shareholders feel the fund is underperforming and they are not happy, they can bring this up to the board and the directors can sack the manager.

"And this does happen."

The directors also set the performance benchmark for the fund manager.

Often this benchmark is tied to the performance of the FTSE All Share, but the City of London board has recently changed this.

"I have to beat the sector before I get a performance fee," explains Mr Curtis.

This means the fund will have to outperform its rivals before the board will consider the fund manager has done a good job.

Another advantage with closed-ended funds such as an investment trust is the shares are sold onto another buyer when you want to redeem your capital, so the fund manager does not have to sell the underlying assets as in an open-ended fund.

"In a downturn, a unit trust fund manager will be hit with a flurry of redemptions and they will be forced to sell the underlying assets at the worst possible price. But in a closed-end fund, there is no need to sell the underlying assets, so these types of funds tend to do better in a falling market.

"The other thing is investment trusts can do is borrow money to invest. It can leverage its fund in exactly the same way a company like Marks & Spencer can do. Gearing does come with a risk, however, but it is normally manageable.

"The other risk is the fund manager is responsible for the net asset value (NAV) but the stock market generates the value of the holding to the shareholder.

"Investment trusts often trade at a discount to the NAV. Broadly, this is to do with supply and demand - when people get nervous about their investments, they think of investment trusts as safe havens and feel more comfortable owning these.

So the share price rises as demand increases, and the discount narrows.

"As markets recover, the discounts widen again."

Investment trusts do not generally go bust, although some will underperform to the point where they could be wound up and investors are given their cash back.

The fund management company could go under, but the board of directors has ultimate control over the assets and would just replace the fund manager.

The unique structure of investment trusts mean fund managers have to react quickly to events in the market to keep the board, and the investors, happy.

Mr Curtis explains how his strategy has changed since the financial crisis hit last year.

"As a result of Lehman's, governments underwent unprecedented financial easing, interest rates were cut to near zero and government deficits grew.

"I think this was the right response and otherwise the world might have gone into depression. And I really think we are starting to see an economic recovery.

"In the UK, we've seen better news with house prices stabilising and retail sales improving. But there is still too much consumer debt around and as a result, economic growth will be weaker.

"So my strategy has been to focus on multinationals that get much of their profit from overseas, as well as companies that export."

Companies that Mr Curtis expects will continue to issue dividends include HSBC, BHP Billiton and pharmaceutical including AstraZeneca.

For long-term growth, Mr Curtis also points toward Tesco as a UK company with plenty of potential.

"There is a big opportunity for Tesco in personal banking in the UK, and they've got big opportunities to grow in Asia and eastern Europe," he adds.

However, Mr Curtis is not optimistic about the banking sector in the UK and sold most of his holdings except Barclays, which he believes made a good move in buying up part of Lehman Brothers and refusing government cash to stay independent.

The merger between Lloyds and HBOS was a "flawed vision" and Mr Curtis said he voted against it at the shareholder meeting.

"The only way Lloyds Banking can make its money back is to take advantage of its position as the UK's biggest bank and I just don't think the Competition Commission will let them get away with abusing the market."

Investment Trusts with the highest Overall Morningstar Rating

Source: Morningstar
One-year performance calculated net of basic rate tax income on reinvested basis

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