Investment trusts enjoyed a stellar 2017, with 61 investment trusts and companies up at least 30 per cent in share price terms. Buoyed by strong returns from global equity markets, the representative FTSE Equity Investment Instruments index delivered a return of 18.4 per cent over the year, well ahead of the 11.9 per cent return from the FTSE 100 index.
Demand for investment trusts has reached an all-time high. In December the typical trust’s share price was trading on a discount to the value of its underlying assets of just 2.4 per cent, against 3.8 per cent at the start of 2017 – lower than at any time in the past two decades.
Performance in 2018 will, ultimately, be determined by the returns delivered by trusts' underlying assets. Another strong year from global markets is likely to narrow discounts still further, while any deterioration of investment sentiment would have the opposite effect; but the bigger picture is the underlying themes now set to drive portfolio performance in the year ahead.
The end of the bull run?
Question number one for many investors is whether the extended bull market in global equities will run out of steam over the year ahead. The positive case is that the economic backdrop is encouraging, with the International Monetary Fund predicting the best year for global growth since 2010.
Against that, share prices in many markets – notably the US – are stretched on most traditional valuation yardsticks. The widely followed Shiller cyclically adjusted price to earnings ratio, for example, puts US equities on ratings not seen since the height of the dotcom bubble almost 20 years ago.
‘Concern is certainly building,’ warns James Carthew, an investment trust analyst at Quoted Data. ‘The greatest support to valuations comes from low interest rates, and any significant increase in rates would have a negative effect on many asset classes, though with global growth still fragile, central banks are likely to be cautious.
‘But political risk could be more problematic: Germany needs a government, Trump may be damaged by the Mueller investigation, Brexit rumbles on, there are tensions in Korea, the Middle East and Venezuela – the list goes on.’
For cautious investors leaning towards a bearish view of 2018, Carthew’s suggestion is one of the more defensive funds from the flexible investment sector, with Personal Assets and Ruffer his preferred options, along with Seneca Global Income & Growth for those happy with more exposure to non-traditional asset classes. These trusts have a broad mandate to diversify, including into very liquid assets such as cash during periods of stress.
Alternatively, for investors more concerned about missing out on the final leg of the bull run, Carthew picks out three funds with large allocations to technology stocks, which have driven returns in many markets over the past year. He likes Scottish Mortgage and Allianz Technology, which both have significant allocations to the US, as well as Pacific Horizon, which offers exposure to the technology industries of Asia.
Impact of the monetary policy divergence
was the year in which a decade of co-ordinated central bank interventions to support the global economy finally began to unwind: the US and the UK now appear to be on a path towards tighter monetary policy, raising interest rates and unwinding their programmes of quantitative easing, while the eurozone and Japan, in particular, remain in looser mode.
Given the way years of monetary policy stimulus have flooded financial markets with capital, this divergence will inevitably have an impact on investment returns. Many analysts are especially nervous about bond markets, given the enormous flows of capital into government and corporate debt in recent times, but equity markets have also been buoyed and may now sink back without the support of policymakers.
‘Inflation and central bank policy should remain firmly on investors’ watch lists during 2018 and beyond,’ says Gordon Smith, an investment trust analyst at Killik & Co. His suggestion is to focus on the developing inflationary story that has prompted the US Federal Reserve and the Bank of England to move back towards tighter policy.
‘If inflation does move higher, the attraction of sustainable and progressive dividends backed by long-term and predictable cashflows with explicit inflation linkage will prove attractive within portfolios,’ Smith argues.
He picks out Civitas Social Housing, a specialist fund that buys up supported housing assets where rents effectively come from local or central government, and are therefore underpinned by the creditworthiness of the state. This is a fund that may be of particular appeal to income-seekers, given the built-in protection of yield, though it could form part of a total return strategy too.
Alternatively, Smith’s defensive bet is Personal Assets Trust, where manager Sebastian Lyon has taken steps to prepare for the impact of a tougher monetary policy environment in key markets, shifting out of equities and favouring index-linked bonds over other fixed-income assets.
In search of value opportunities
If markets lose momentum in 2018, at least in aggregate, there will still be areas that offer value. As the tide goes out – one feature of the year just gone was the remarkable lack of volatility across a range of correlated asset classes – we’ll get to find out who wasn’t wearing any swimming trunks, as Warren Buffett so famously put it.
In which case, the aim for investors must be to identify the investment trusts that didn’t go into the water naked. ‘Despite the concerns we have for equity market indices in general, we believe there will be opportunities for active managers to add value,’ says Charles Cade, head of investment companies research at Numis Securities. ‘Ideally, given those concerns, we also favour funds with an active discount control policy or those where we believe the downside to the discount is limited.’
The search for value may take different forms. Cade picks out Fidelity Special Values as one possibility, with manager Alex Wright arguing the case for his trust on the grounds that the portfolio currently trades on lower valuations than the market as a whole.
‘His approach has a strong contrarian flavour with a focus on unloved stocks where the downside is limited and there is a catalyst for change,’ Cade says. ‘Wright remains positive that selecting cheap companies with improving fundamentals, should allow “a good chance” of outperforming the market in coming years, and the board has committed to protecting a single-fi gure discount through share buybacks.’
Another option, suggests Killik’s Smith, could be to turn away from developed markets, with emerging market equities generally trading on less stretched multiples. ‘Despite strong market returns in Asia, longterm valuation measures remain attractive relative to the US,’ Smith argues. ‘We like Schroder Asian Total Return: the portfolio remains focused on consumer areas, while the hedging strategy reduces systemic risk.'
Embracing new asset classes
Closed-ended funds offer a useful structure for investors seeking exposure to alternative assets – particularly illiquid holdings that would sit uncomfortably for an open-ended fund manager expected to deal with inflows and outflows of cash. And given the anxiety of many investors about valuations of conventional assets, 2018 may be a year in which alternatives prove to be an important theme.
For the purists, that might mean specialist funds in niche sectors, such as Smith’s pick of Civitas Social Housing. Sectors including private equity, debt and infrastructure all saw increasing demand over 2017, though more UK-focused funds in the latter group have suffered following the pledge by the Labour Party to end private finance initiatives if and when it returns to government.
Another option is to look for a fund with exposure to alternatives as well as mainstream assets. At Numis, Charles Cade picks out two possibilities. ‘Caledonia Investments has substantial cash resources that reflect the management’s cautious approach to equity markets, but in addition the fund has substantial exposure to unquoted assets, which will not move directly in line with quoted markets,’ Cade says. Its leading unquoted holdings include Seven Investment Management and Gala Bingo.
For income-seekers – or total return for those who reinvest – Cade’s pick is Aberdeen Diversified Income & Growth. ‘This is a fund with a chequered history, but it moved to Aberdeen Asset Management early in 2017 and the transition to a multi asset approach has gone smoothly,’ he says.
‘It seeks to achieve returns of Libor plus 5.5 per cent a year after fees over rolling five year periods, with investments in a portfolio that is genuinely diversified by asset class, in contrast to many ‘multi-asset’ funds – for instance, the portfolio includes infrastructure, insurance-linked securities, property and private equity.’
Still looking for yield
The Bank of England’s decision to raise interest rates from 0.25 to 0.5 per cent hardly represents a breaking of the dam for investors struggling with the income drought – and while further increases are expected during 2018, we remain a long way from normalised monetary policy conditions. In this context, yield will yet again be a crucial investment theme over the year ahead, says Carthew of Quoted Data, and closed-ended funds are a good place to go looking.
‘Investment companies offer a much wider choice of investment strategies to the income-seeking investor than open-ended funds,’ Carthew says. ‘2017 saw the launch of funds in entirely new asset classes such as biopharma credit, considerable expansion of funds with exposure to specialist areas of the property market, and new equity income funds such as Jupiter Emerging & Frontier Income; we would expect to see many of these funds expand in 2018.’
More cautious investors may prefer to opt for a fund with a consistent record of paying dividends but a strong emphasis on downside risk management. At Winterflood Securities, investment company analyst Kieran Drake picks out RIT Capital Partners. ‘The aim of the fund is to capture greater participation in up markets than down markets, with the rationale that this will lead to both long-term outperformance and capital preservation,’ Drake argues. ‘The fund is currently trading on a premium and so there is some risk of premium and discount volatility, though it has traded on a premium for extended periods in the past.’
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