This year’s investment trust tips suffered a baptism of fire when stock markets around the world plunged during the first fortnight in August. The worst of the setback was over before the tips appeared on the website, let alone when the September edition landed on subscribers’ door mats. So anyone who liked our ideas should have been able to buy at substantially lower prices than those listed in the tables, as we take 1 August as our starting point.

Despite some strong recoveries in October, many of our selections still look relatively woeful. In many cases they have suffered from having too much in smaller companies, too much direct exposure to emerging markets, and too much of a value orientation.

Here are the various rationales behind trust strategies: smaller companies have significantly outperformed larger companies over extended periods; emerging markets (where the International Monetary Fund is forecasting 6.4 per cent growth over the next year) provide a more helpful economic environment than the over-indebted West (where the forecast growth rate is only 1.6 per cent); and value investing has been out of fashion for far longer than is normal.

We continue to hope that these three traits will prove their worth over time, but in the short run they have been badly out of tune with market sentiment.

Fortunately, Ruffer Investment Company’s mix of ‘fear and greed’ investments helped it steer a relatively steady course through the market turmoil. The geared ordinary shares of Jupiter Second Split Trust also did well over the quarter, though this was entirely due to a sharp tightening in the discount, which has subsequently widened out again.

The Jupiter trust is managed by the ultra-bearish Philip Gibbs, so it should be no surprise that the net asset value (NAV) of its geared ordinary shares – which are highly sensitive to any changes in its underlying portfolio – fell during the October rally, having been comparatively resilient in the earlier setback.

Edinburgh Investment Trust (EIT) was one of the few other bright spots in absolute share price terms and was chosen by Alan Brierley, head of investment company research at stockbroker Collins Stewart. The trust is managed by Invesco Perpetual’s Neil Woodford, whose conviction that high-yielding multinationals such as GlaxoSmithKline, AstraZeneca and British American Tobacco offer exceptional value has finally found favour with the market.

Woodford’s colleague Mark Barnett follows a similar policy at Perpetual Income & Growth Investment Trust (PIGIT), which was selected by Simon Elliott, head of research at Winterflood Securities. However, Barnett prefers a less concentrated approach than Woodford, with his top three holdings accounting for only 18 per cent of his portfolio as against 33 per cent at EIT.

Barnett also has more exposure to medium-sized companies, which has served his trust well in the past but is out of tune with the market’s current obsession with liquidity. As a result PIGIT’s quarterly returns were a little less resilient than EIT’s and its share price has not been pushed up to such a demanding – and potentially dangerous – premium.

The worst falls in the UK market were among smaller companies. Throgmorton Trust was one of the more resilient smaller company trusts at the NAV level, as we had hoped, because it can hold long as well as short positions. However, its share price was badly hit by a widening discount to NAV, as was also the case with Aberforth Smaller Companies, but with greater justification. Its NAV per share suffered a 15 per cent collapse in August alone.

Aberforth’s managers are bitterly disappointed by its poor performance. The trust entered the summer downturn with its holdings on an average price/earnings ratio of 20 per cent below the Hoare Govett Smaller Company index benchmark, an average yield about 20 per cent higher, and strong balance sheets. The Aberforth team is convinced that the trust’s holdings are now exceptionally undervalued and are backing their belief with above-average gearing of 13 per cent.

James Henderson, who manages Lowland Investment Company, also favours a value-oriented approach and has far more in medium-sized and smaller companies than any other trust in the UK growth and income sector. This has contributed to Lowland’s exceptionally strong long-term record, but can lead to above-average volatility, as was uncomfortably apparent in the last quarter. However, Henderson is not trimming his sails. On the contrary he has complied with his board’s advice to raise Lowland’s gearing to 15 per cent.

‘It is very difficult to call markets on a top-down basis, so I am driven by valuations,’ he says. ‘If I can buy shares when they are relatively cheap and sell when they are expensive I will add value over time. At the moment I am spoiled for choice as a lot of companies are doing very well and will pay increased dividends and this is not reflected in their share prices.’

Henderson adds: ‘The Lowland board has been keen to gear the trust up, as we can borrow at less than 2 per cent, and invest for a yield of 4 per cent or more. So I have been buying across the spectrum. My larger company portfolio has held up relatively well thanks to holdings in household names such as Diageo and Unilever, and I have added Rio Tinto for the first time because of all the cash it seems likely to generate over the next few years. I have also been topping up a number of my smaller company holdings.’

Lowland recently increased its interim dividend by 5 per cent and hopes to follow this up with an increase in the final one.

Hansa Trust is also expect to lift its dividend this year, as last year’s payout was hit by the timing of distributions from Ocean Wilsons, which accounts for over 40 per cent of its portfolio. The trust’s portfolio performed in line with the market over August and September, but lagged a bit during the October recovery, and a widening discount added to the share price setback.

Ocean Wilsons was among the October disappointments, because its deep involvement in Brazilian maritime activities didn’t see it benefit from the 14 per cent bounce in the MSCI Latin American index.

Like Lowland, Hansa was also hurt by its exposure to smaller companies. ‘Investors sold down everything in the early stages of the correction, but then returned to larger companies in October, and particularly to those with exposure to emerging markets,’ says Hansa manager John Alexander, adding that smaller companies have not enjoyed the same recovery.

The 12 per cent October recovery in the Chinese stock market, as measured by the MSCI China index provided some relief to several of our selections, including Templeton Emerging Markets Investment Trust and Henderson TR Pacific Trust.

The former has a quarter of its portfolio in China and Hong Kong, and the latter has 43 per cent – including an exceptionally high 36 per cent in mainland-quoted shares.
Henderson’s Andrew Beal admits the high China exposure has been a headwind for the trust over the past 18 months, but barring an international recession he expects the Chinese economy to make reasonable progress over the next year. He adds that he can find better-priced growth companies in China than in more mature Asian economies such as Singapore.

Beal’s Asian selections are heavily skewed towards domestic consumption and in China this includes an array of internet companies, such as Baidu, CTrip and Tencent. It also includes Sands China, with its Macau casinos, and second-home developer Agile Property, which Beal thinks has been unfairly tarred with the same brush as more run-of-the-mill housing companies.

‘September was a brutal month, in China in particular, but we took the opportunity to top up a number of our holdings and to buy into Zhuzhuo CSR Times Electric, which more than doubled in October,’ he says.

Scottish Mortgage Trust (SMT) subscribes to the view that China will avoid a hard landing by rebalancing its economy away from export-led growth to a more domestic orientation. China accounts for over 14 per cent of its portfolio compared to 11 per cent in UK.

Manager James Anderson’s belief in the superior growth outlook for developing economies meant SMT was hard-hit by the summer flight into supposedly safer ‘risk off’ asset classes. But he is sticking to his bias away from the developed and indebted West. ‘Since July [equity markets] have reacted with intense nervousness to day-to-day developments in the eurozone and to the challenges of dealing with the implications of a Greek debt default. This nervousness has been self-feeding and little attention has been paid to more promising and positive news flow especially at company level,’ Anderson complains.

‘While conditions in developed markets may continue to be tough and achieving growth overall here may be a struggle, many individual companies are likely to continue to do well. Powerful longer-term positive influences, notably the rapid growth of developing countries and the rapid pace of technological advance across many fields, remain in place.’

Like a number of our other selections, SMT benefits from low costs and boasts exceptionally robust longer term returns. Investors should not be unduly perturbed by its travails over the last quarter.

See the December issue of Money Observer to check how our 2011 investment trust tips are performing after three months.