Rob Murphy, managing director of Financials at Edison Group, examines the trends and opportunities in investment trusts in 2021
Despite economic uncertainty in the last year, the structural features of investment trusts/companies (‘Trusts’) have meant they have been an attractive option for investors. These features include the fact that they are permanent capital vehicles with independent boards, have the ability to smooth dividends through reserves and can employ (modest) gearing to boost returns.
Arguably, these features explain the fact that investment companies have tended to outperform their open-ended counterparts over time. As a result, they should continue to provide investors with excellent opportunities in the year ahead.
Similarly, there are a number of themes which have grown in prominence in recent years which will continue to drive interest into Trusts long into 2021. These include the rapid rise of alternative strategies owning less-liquid assets as diverse as economic and social infrastructure, renewable energy projects, music royalties, digital infrastructure, venture capital, private equity and debt. Many of these investment themes reflect investors’ desire to generate attractive income and returns in a low interest rate environment and are often strongly aligned with an ESG-focused approach to investing. As for much of the investment industry, fees have also been declining through the benefits of competition and scale.
Structural features and dividend growth
Notably, Trusts are permanent capital vehicles or ‘closed-ended’, meaning that the capital raised is permanent and stays in the fund, with shares trading in the market to provide liquidity. This means that even in distressed periods when some investors might panic and sell their shares, investment trust managers do not have to sell underlying assets at unfavourable prices to meet investor redemptions.
This feature provides investors with the opportunity to invest in traditional liquid investments like UK or global equities as well as illiquid assets that investors can’t access easily through investment vehicles like ETFs or unit trusts. Such less-liquid assets include growth areas like economic and social infrastructure, renewable energy, music royalties, digital infrastructure and private equity.
Trusts also come with their own independent board of directors. This means they have a legal obligation to safeguard shareholders’ interests. Additionally, by buying shares in an investment trust, and therefore becoming a company shareholder, investors can vote on issues such as the appointment of directors or changes to the investment policy. Clearly, this provides investors with an opportunity to access these vehicles without the concern of excessive fee taking.
Further attractive elements include the robustness of dividends paid by investment trusts. Trusts can retain up to 15% of their income in any year. This can provide extra income in the future and help make their payments consistent. This has been seen recently with 11 trusts increasing their dividends for more than 45 consecutive years: City of London, Bankers, Alliance Trust, Caledonia Investments, BMO Global Smaller Cos, F&C, Brunner, JP Morgan Claverhouse, Murray Income, Scottish American, and Witan. Research by platform Interactive Investor found just 20% of trusts have cut or suspended dividends in 2020 – a period in which around half of all UK companies have cut pay-outs. This strong history of robust and regular dividend payments being much less impacted by the pandemic means investors can have more confidence in receiving a steady stream of income.
Outperforming their peers and reduced fees
When it comes to short-term performance compared to open-ended funds, investment trust share prices are more volatile than open-ended fund NAVs as the share price can diverge from the underlying NAV. This can make Trusts feel more risky to hold during periods of market volatility in the short-term, but over the longer-term share prices follow NAVs and if the portfolio performs well the shares will perform well. Moreover, in the event of a sell-off, an excessive discount can offer a compelling opportunity to acquire shares significantly below fair value.
Research by Interactive Investor and others has shown that Trusts outperform their open-ended counterparts such as ETFs over 10 and 20yr periods. This is mainly a result of the attractive investment trust structure.
Managers of Trusts do not need to sell assets at fire sale prices during market downturns when open-ended managers may receive a deluge of redemptions. The hidden costs during normal market conditions of constant ongoing subscriptions and redemptions in the form of dealing charges and market impact are never explicitly quantified in open-ended funds but are nevertheless real. Boards have acted in shareholders’ interests and changed manager where performance has not been as expected or merged with other trusts. The ability to gear performance in Trusts also has a beneficial impact over the long-term, provided the underlying investments are sound.
Despite the superior net performance there has been continued downward pressure on fees for Trusts, as with the broader asset management industry. The increasing scale and competition in the industry means that fees will be a constant point of battle between Trusts which are actively managed and passive funds long into the future. However, fees should never be the primary decision variable in choosing an investment as it is the net return over the long-term which matters.
The rise of ESG investing
Demand for investment products with strong ESG elements has been a growing trend over the last decade, with the pandemic highlighting investors’ focus on the theme. This has been one of the fastest growing areas for Trusts in recent years and we expect this growth to continue into 2021.
Like the open-ended fund sector there has been a rise in specialist Trusts which have an ESG lens. These include renewable energy companies like Foresight Solar Fund, Greencoat UK Wind, Gresham House Energy Storage, JLEN Environmental Assets, PremierMiton Global Renewables and US Solar Fund. Others with a slightly different focus include Impax Environmental Markets, which invests in a range of mostly listed companies with significant exposure to sustainable activities and SDCL Energy Efficiency Income, which focuses on assets that improve the efficiency of energy usage. Given the huge amount of capital required to build out many of these industries we expect continued growth in the sector in coming years.
A resilient option for investors
Overall, with the structural benefits Trusts offer, their outperformance compared to open-ended peers and access to ESG compliant strategies, the sector is well-positioned to provide investors with attractive income and growth from an increasingly diverse set of investment opportunities.
This article was first published in the June 2021 issue of Professional Paraplanner.