Investment trusts rediscover their roots with a 21st century twist

view original post

Investment trusts seem to be coming full circle. For most of the 20th century, they gradually moved away from their origins as entrepreneurial schemes investing in specific targets, often in Britain’s colonies, to running generalist equity portfolios. Today, they are raising record sums to fund a new wave of innovation in a period of rapid technological change.

Recent trends show investment trusts returning to their specialist roots. Among the 11 trusts to be launched this year, HydrogenOne Capital Growth specialises in hydrocarbon stocks to help promote opportunities in clean fuel and Seraphim Space Investment Trust is designed to fund space entrepreneurship, while Cordiant Digital Infrastructure and Digital 9 Infrastructure are the first two investment trusts with dedicated exposure to the infrastructure of the digital economy.

“The reason why investment trusts get involved in these private companies and assets is because there is no other suitable vehicle to access these exciting asset classes,” says Daniel Lockyer, senior fund manager at Hawksmoor Investment Management. “These trusts can provide a vehicle for investors to get exposure to sectors that are impossible [to access or] inappropriate within open-ended funds.”

For investors it’s an echo of the past: the three largest global investment trusts have specialised origins: F&C Investment Trust, formerly Foreign & Colonial, which dates back to 1868, initially invested in overseas government bonds and Alliance Trust was an early backer of mortgages for North American railroads and Texan oilfields. Scottish Mortgage Investment Trust, another supercentenarian, was set up to lend money to rubber planters in Malaya.

Unlike open-ended funds, investment trusts are closed-ended collective investment schemes, which means investors buy and sell shares on the stock exchange rather than from a fund manager directly. Managers have more freedom to invest in illiquid stocks, as they do not have to sell the underlying holdings when investors want their money back.

Investment trusts can therefore trade at a premium to their asset value when demand for the trust is high, or a discount when it is not — a factor which typically leads to higher volatility in a trust’s share price than the underlying value of its assets.

The ability of investment trusts to access private assets has led to them raising more money in initial public offerings and secondary fund raisings this year than at any point in their 153-year history, according to data from the Association of Investment Companies, the industry body for trusts.

Of the £12bn raised so far this year, over three-quarters has been invested in some form of private asset. Renewable energy infrastructure trusts, popular for the income they pay, have attracted investment of more than £2.5bn across four fund launches and 11 trusts which raised extra capital to help meet demand for greater investment in clean energy. The first two digital infrastructure trusts, meanwhile, have already raised more than £1.3bn between them.

Property investment trusts — known as real estate investment trusts (or Reits) — have raised £2.21bn so far this year with logistics and healthcare property assets in high demand following the pandemic. But not all will get off the ground: neither UK Residential Reit and Responsible Housing Reit — the two Reits that tried to launch this year — gained sufficient funding. Among social housing Reits in particular, concerns have grown over the ability of tenants — typically housing associations — to meet the terms of their long-term lease agreements.

Private equity has also seen a spate of funding as investors have turned to the sector in hope of high growth. Three trusts — Seraphim Space, Petershill Partners and Literacy Capital — were launched in 2021 to invest in unlisted companies and almost £900m has been raised towards private companies by more established trusts via secondary issuances.

“Many companies, especially those with strong growth prospects, are choosing to stay private for longer and seek funding from investors, such as Chrysalis, Baillie Gifford and other private equity specialists,” says Lockyer.

An image of Singapore’s Changi Airport, taken from an ICEYE satellite. ICEYE is a portfolio company of the Seraphim Space trust © ICEYE

Going for growth

Even investment trusts that major in listed companies are increasingly turning to the private sector, making use of the flexibility of their closed-ended structure.

“Private companies tend to outperform publicly listed companies primarily because they can focus on the long-term growth of their businesses outside the gaze and pressure of the public markets that are increasingly obsessed with short-term results,” Lockyer says.

Scottish Mortgage, which delivered annualised share price returns of 29.2 per cent for the decade to November 5 2021, according to Morningstar data, has led the pack. Around a fifth of the portfolio is now in private companies, up from 4 per cent six years ago.

Commenting on Scottish Mortgage’s results this week, Numis underlined the fund’s record on investing in companies that later went public. “These are a key source of new ideas for the fund and many transition to being listed over time, with 44 per cent of the portfolio being unquoted at the time of investment.”

Other trusts have been following suit. Pacific Horizon Investment Trust, in the Baillie Gifford stable, which invests in Asia but excludes Japan, is raising the proportion of assets it can invest in unlisted holdings from 10 to 15 per cent and has invested in three private Indian companies over the past year. Fidelity China Special Situations also sought shareholder approval to increase the amount it can invest in unquoted companies from 10 to 15 per cent this year.

“In recent years, we’ve seen many mainstream investment companies increasing their allocations to unquoted companies, or changing their investment policies to allow them to do so,” says Nick Britton, AIC head of intermediary communications.

“Companies are staying private for longer so this gives investment companies the opportunity to capture some of the rapid growth that can come at an earlier stage of a company’s development.” 

But investing in unlisted companies comes with risks. These trusts are often minority shareholders investing alongside established private equity investors. When something goes wrong they may have little power to change things and holdings may be difficult to sell.

In recent years a handful of investment trusts have been set up specifically to invest in private companies and own them through flotation. Baillie Gifford’s Schiehallion Trust, which is listed on the Specialist Funds Segment of the London Stock Exchange but is available to private investors on several platforms, is the largest example.

It has raised more than £500m in secondary fundraising this year and has a market capitalisation of £1.27bn, according to Hargreaves Lansdown — a fast pace of growth for a trust set up in 2019. But buyers should take note: it traded on a premium to net assets of 36 per cent on November 8, meaning the assets in the trust would have to increase in value by one-third to match what you paid for them.

Chrysalis Investments, set up in November 2018, has a similar aim of targeting later stage private companies with long-term potential, but has a UK bias and is listed on the London Stock Exchange’s main market. Its share price grew by 139 per cent from its launch to November 8 this year, according to FactSet data. But the recent share price collapse of The Hut Group — previously 8 per cent of Chrysalis’s portfolio — sent Chrysalis shares down 15 per cent in the first two weeks of October as the trust’s premium collapsed.

“The portfolios tend to be fairly concentrated and that presents some risk,” says James Carthew, head of investment company research at research firm QuotedData. “If portfolio companies can’t IPO — because markets are weak, for example — they may need to seek additional private funding.”

Woodford Patient Capital Trust provides a cautionary tale, having raised £800m in 2015 to invest in high-growth listed and unlisted companies, mainly in the UK. When Neil Woodford’s open-ended fund was suspended and his company, Woodford Investment Management, collapsed, the share price of Woodford Patient Capital Trust plummeted and the value of many of the unlisted holdings had to be written down.

Performance has picked up recently following a management change and a rebranding to Schroder UK Public Private Trust in October 2019, but its assets were £403m on November 8, according to Winterflood — around half the value at its launch date.

Fund profile: Chrysalis

Manager: Jupiter Asset Management, Richard Watts and Nick Williamson

Market cap: £1.33bn (Nov 8)

Launch date: 2018

Manager fee: 0.5% of NAV, performance fee 20% of the amount by which the adjusted NAV exceeds the higher of the performance hurdle (8% annual compounding) or high water mark.

Fund profile: Buys late-stage private equity companies and aims to own them through flotation. Managers believe there is a gap in the market because seed, angel and venture capital investors have finite investment periods and are often looking for liquidity before a company wants to list. Rob Morgan, chief analyst at Charles Stanley, says: “The ‘lumpiness’ of the portfolio is an issue, with Klarna currently representing almost a third, but for a high-octane position at the fringes of a growth portfolio it is interesting.” Charges, including a high performance fee, were 8.1 per cent for the year to end of September 2020, according to the AIC website.

There are also sector specific investment trusts chasing high growth. Augmentum Fintech, set up in 2018, has a concentrated portfolio of around 15 unlisted fintech companies, while Seraphim Space is targeting punchy returns of 20 per cent a year via 20 to 50 privately financed space tech businesses, once fully invested.

Investors are bullish. Seraphim Space traded on a 26 per cent premium on November 8, while Augmentum Fintech’s premium shot up from 34 to 44 per cent following media reports that Abrdn is in talks to buy investment platform Interactive Investor, the trust’s largest holding. However, Augmentum Fintech’s share price has still comfortably underperformed its broader technology peers, Allianz Technology Trust and Polar Capital Global Technology Trust, over the past three years.

Given the high premiums commanded by several private equity growth capital trusts, better value might be found in the more traditional, diversified private equity funds, according to Rob Morgan, chief analyst at Charles Stanley. The weighted average discount of the five private equity funds-of-funds was 17.7 per cent on November 8, despite sector average NAV growth of 38 per cent over the past 12 months.

Many private equity investment trusts calculate net asset values once a quarter, which is why the share price and NAV can be far removed from one another. Valuation uplifts in companies can take time to feed through into the NAV, which may leave trusts appearing to trade at a very large premium or discount — a problem not suffered by listed equity funds.

The income story

Despite equity-focused investment trusts recording their first fall in dividends this year for over a decade, investment trusts have broadly managed to shield their shareholders from the huge drop in dividends their open-ended counterparts suffered after the pandemic struck last year.

According to fund group Link’s dividend report, total payouts for equity investment trusts in the first half of 2021 were 3.1 per cent lower than in the first half of 2020. This comes on the heels of a 12 per cent fall in global equity dividend payouts last year.

Unlike open-ended equity income funds, investment trusts can keep up to 15 per cent of the income they receive from holdings each year in a revenue reserve, to supplement income payments in difficult times. Most trusts also have the ability to pay dividends out of capital profits.

Direct investors in UK equities, the highest yielding of any major stock market, were worse hit as payouts fell by over 40 per cent between April 2020 and March 2021, according to Link. UK equity income trusts, meanwhile, managed to increase total payouts last year and saw only a 9 per cent fall in the first half this year compared with the same period in 2020.

But there are significant differences of opinion in the trust sector over the role that dividends should play. Three UK equity income trusts — Troy Income & Growth, Edinburgh Investment Trust and Temple Bar — have cut their dividends since the outbreak of the pandemic, arguing that reductions may ensure a more stable course of rising dividends over time.

Mick Gilligan, head of fund research at wealth manager Killik and Co, says some investors prefer capital gain to income for tax reasons. “Following that logic through, some of these investors believe that dividends and tax leakage should be minimised where possible.”

On the other side are those who like sustainable dividends, assuming a reasonable level of revenue reserves. “Many income seekers like the hassle-free regular and increasing payment profile of a dividend hero rather than having to assess when and by how much to take capital profits to supplement any income,” he says.

Fortunately for the trusts that maintained their dividends, payouts in underlying holdings have rebounded strongly this year. UK dividends were up 89 per cent in the third quarter this year compared with the same period last year according to Link, largely driven by the mining sector, which has benefited from soaring commodity prices.

The dividend recovery is already clear in investment trust reports. Dividend cover, the extent to which dividends paid out by a trust were paid by dividend payments from underlying holdings in the trust, has made a strong recovery among trusts that have most recently reported this year — as shown in the table below.

“The sector has weathered the initial onslaught, and the majority of companies have still got meaningful revenue reserves in case of need,” says Alan Brierley, director of investment companies research at Investec.

For the longer term, the jury is still out on whether UK equity income trusts will be able to or should maintain continual growth in dividends. The sector currently pays an average yield of 4.0 per cent, according to Winterflood data, and targeting high yields inevitably narrows the pool of companies managers can invest in. Many are in low-growth, old economy sectors such as oil and tobacco.

Fund profile: Law Debenture

Manager: Janus Henderson (James Henderson and Laura Foll)

Market cap: £956m (Nov 8)

AIC ongoing charge: 0.57%

Launch date: 1889

Approach: Achieve long term capital growth in real terms and steadily increasing income

Key points: Law Debenture is unusual as it combines an investment trust with a professional services business, which makes up 16 per cent of the NAV and has provided the trust with more than a third of its income over the past decade. The equity portfolio is managed with a growth and contrarian focus with the 80 per cent invested in the UK. On November 8, the trust had a yield of 3.6 per cent, traded on a discount of 3.9 per cent and had the best five-year share price total return in the UK equity income sector, according to Winterflood data.

Link expects extractive industries, including the oil sector, to account for more than one-third of UK dividends this year. As Brierley noted in a recent analyst report: “The UK is uncomfortably reliant on two volatile and highly cyclical sectors for income.” 

Carthew says: “It does not make sense to focus on high risk, high yielding stocks just to maintain a dividend record.”

The giant awakes

The investment trust sector, once something of a sleeping giant, has become much more entrepreneurial in recent years. The closed-end structure is finding a new lease of life especially in evolving industries at the same time as many investment trusts are cutting their fees. According to the Association of Investment Companies, 21 investment trusts have reduced their base fee so far this year, with 32 trimming fees last year and 39 in 2019.

When compared with their open-ended siblings, Jason Hollands, managing director at Tilney Smith & Williamson, says: “In some cases trusts will be more competitive on fees, in others the open-ended fund might have the edge”.

The investment trust sector appears in rude health, but some analysts warn investors to remain cautious. “The volume of new investment trust issues has been building all year and seems particularly high right now,” says Gilligan. “Quite often, the longer we are into an IPO cycle, the lower the quality of the offering becomes.”