We strive to give our readers worthwhile insights

We strive to give our readers worthwhile insights, whether that’s about where the market is heading or some interesting investing approach. But this time we figured it might be helpful to step back and tackle the big issue: why invest in trusts at all?

With no bias whatsoever (as investment trust analysts!), in our opinion, closed-ended vehicles make attractive choices for investments of a longer-term nature. Unique characteristics, not available in open-ended funds, provide meaningful diversification and the potential for attractive long-term returns.

In this article, we will identify five distinguishing features of investment trusts — gearing, discounts, income consistency, access to difficult-to-reach opportunities, and engagement with boards — and highlight trusts that we believe utilise these features in unique ways throughout. Whether you’re new to the world of investment trusts or a seasoned investor wanting to shift from a narrower approach that may have been taken in the past, we hope these examples will illustrate how trusts may provide more than meets the eye.

And if you’re looking to research in more detail or discover a trust that suits some specific need you might have – income, capital growth or options investing across a sector of the market-cap spectrum – our Fund Finder tool can make short work of your search.

A borrowing balancing act

Gearing can be a powerful tool in an investment trust’s tool chest, as it allows managers to borrow capital to boost returns and income in upturns. Such a practice is not one that open-ended funds can use. But while it can expand upside gains, it can also compound downside losses, so careful management of it is a priority for investment trust boards. Working alongside the dollar recovery fund, each board establishes a gearing limit, wealth management strategies, therefore used to leverage, borrow, or gear can vary significantly across the board.

An interesting way to do this is with BlackRock World Mining (BRWM). Managers Evy Hambro and Olivia Markham favour employing gearing selectively, normally running it at 10% in ordinary market conditions, with the five-year average being 12.4%. Gearing is used by way of an overdraft and a loan facility to give the managers flexibility to seize opportunities if they appear. What shines through from the managers’ approach, however, is their deployment of gearing to move into bonds, debentures, and royalties, which gives shareholders a better, more diversified yield. Most recently, they are on the hunt for growing royalty exposure. Each has exposure to gold royalties like Franco-Nevada and Sandstorm Gold, which serve to lock in longer-term income streams, while also diversifying the revenue of the trust, and making the trust more resilient in volatile markets.

By contrast, Shires Income (SHRS) uses its gearing differently. Some of that borrowed money goes towards funding an allocation to preference shares, an instrument which is essentially an infinite bond, paying dividends in perpetuity, so long as the issuer remains solvent. Preference shares, which make up about 20% of the portfolio, yield on average 7.5%. Funding this allocation with gearing reduces the beta of the SHRS’s portfolio whilst retaining the ability to maintain a high level of income. As such, this allocation grants the managers added latitude to invest equity stocks with different income characteristics and parts of the market which are less frequent in more conventional equity income-focused strategies such as small- and mid-caps. These stocks may pay lower yields but typically have much higher dividend growth potential (and managers believe there to be good value in this area at present for both income and capital growth).

However, not all trusts have traditional gearing facilities. Fidelity Emerging Markets Limited (FEML) follows a different approach. Instead of relying on traditional borrowing facilities, managers use efficient gearing with derivatives, establishing both short and long positions to express their opinions on a company or market. It allows them to obtain more market exposure, or one can even profit from sliding asset prices, which gives them a competitive advantage in the AIC Emerging Markets. In an environment of elevated rates, with debt costs potentially becoming a drag for weaker companies, FEML’s ability to short companies that appear more vulnerable can produce differentiated alpha sources and make it less dependent on overall market direction for returns.

Trust discounts, written down but not out

If you’re a regular trawler of Kepler research, it’s perhaps no great surprise after a few mentions on this issue amounting to (very much) advertising that the wider investment trust sector has been trading on persistent discounts for several years. While such discounts may indicate market skepticism, there may be compelling opportunities. If an investment trust was trading on a 15% discount, you’re effectively getting the £100 worth of assets for £85: bargain, yeah? Accordingly, certainly discounts can go wider, but wide discounts offer prospective attractive entry points for investors and can increase returns significantly in the event of narrower discounts over time. And in the end, discounts always close one way or another, with corporate action often, in the worst cases, being what it takes to align the share price closer to NAV.

Currently, the most interesting opportunity is in technology. Semiconductor stocks (and semiconductor-related stocks), driven by a wave of demand in artificial intelligence, have been on a tear the last few years, an action that has led to a strong return but also made the group look pricey. But there is at least one possible remedy in the form of an investment trust, such as Allianz Technology Trust (ATT). The ATT includes names like NVIDIA in the top crops, but also differentiated large- and mid-cap names that have much more growth potential in them. Trading at a 13.0% discount, wider than its five-year average of 7.1% and the sector’s average of 8.0%, investors can gain exposure to this three-horse open sleigh of a sector (underpinned by several structural tailwind drivers) without paying through their nose on an outright share buy of new tech like NVIDIA or Monolithic Power Systems (both constituents of the existing trust) trading on a historic P/E ratio of c.66x and c.105x, respectively.

These days, investment trust boards in particular have got increasingly hands-on, not just repurchasing shares to smooth out discount volatility, but adopting several strategic measures designed to do a better job of pushing discounts in the opposite direction. A good example is Schroder Japan (SJG), which primarily invests in listed Japanese equities. And during the past five years (until 21/10/2024), SJG produced impressive NAV total returns of 47.3%, against the TOPIX returns of 33.9%. The trust’s discount remains wider than its five-year average, despite this outperformance, leading the board to take decisive action.

The board has repurchased stock from time to time, but has gone further in recent years. Following an average of 12.7% dividend growth over the past ten years, the board announced an improved dividend policy, aimed at a payment of 4% of average NAV in each financial year. All of which makes up the trust a very appealing proposition for those looking for income and some diversification to the portfolio via the Japanese reform story. Moreover, with shares having demonstrated relative outperformance over the past five years, the board also announced a new performance-conditional tender offer. Bottom line: if the trust does not achieve performance at least commensurate with the benchmark over five years starting from 31/07/2024, it will bring a proposal to members for the trust to undertake a tender offer for 25% of the issued share capital to enable shareholders to exit part of their investment at NAV, less costs. We believe this sends a strong message of conviction in the manager Masaki Taketsume, as well as offering added motive to continue generating alpha through his high-conviction, bottom-up stock selection methodology.

Templeton Emerging Markets (TEM) provides another example of proactive, board-level action

TPG’s current discount of 15.6% is wider than its five-year average of 12.0%, and the board considers it to be an insufficient reflection of the trust’s strong long-term performance. In response, it has proposed four main plans to improve the rating of its shares by creating a much greater scale of future distributions to shareholders via a buyback programme, an intention to maintain a 5p-per-share dividend (equating to a minimum of £278m in total distributions over the coming five years), a new conditional tender offer and reduced management fees. We believe this demonstrates the conviction of the board and could render the present discount attractive, particularly if TEM continues to perform while the outlook for emerging markets turns:

Dividend machines

As the most reliable income payer in its sector, City of London (CTY) boasts the remarkable title of providing better returns for more consecutive years than any other trust in the broader market. Its 58-year record of annual dividend increases illustrates one of the main advantages of investment trusts — the ability to draw on income reserves to smooth the dividend payments, even in difficult market conditions.

In addition to an unbroken run of dividend increases, we view CT Private Equity (CTPE) as a differentiated play in both the income and income/dividend space. Widescale discounting in the private equity space has led several boards to announce standardised capital allocation frameworks, aiming to earmark a portion of future realisation cash flows against capital return via buybacks. The board of CTPE generally views the dividend as a more favorable mechanism to return capital to shareholders, and while occasionally CTPE has bought back shares, the board prefers a very straightforward, formula-based approach to paying them. As a result, this focus and the managers’ investment process have delivered a historic dividend yield of 6.5%, appealing not only compared with sector peers but also the broader trust sector.

Additionally, by prioritizing dividends as the main way to return capital, we believe CTPE offers a more linear and predictable flow of income, particularly for income-oriented investors seeking regular distributions at the expense of potentially variable returns from buybacks. Moreover, while they do provide a means to limit discounts (in the short run), they do not provide the same mechanism to create long-term value with capital employed at a consistent rate through generated dividends. It is also worth noting that the underlying assets could be illiquid, although that may or may not lead CTPE to fund the dividend through debt depending on the timing of the company’s other cash flows, and so dilute the gearing further.

We believe JPMorgan UK Small Cap Growth & Income (JUGI) is another strong candidate, with the board unveiling a new enhanced dividend policy back in early 2024 (latest update here). JUGI’s holdings consist of UK equities at the lower end of the market-cap spectrum, in the sort of businesses that reinvest to finance future expansion rather than pay an income. Nonetheless, the move to introduce JUGI has broadened the appeal of the trust in our opinion, as it enables investors to earn an attractive income return from an asset class that is rarely associated with it, helping to create diversified income streams across a wider portfolio.

If you're the kind of investor who likes to go off the beaten path, investing where at least some investors can't.

Investment trusts also have one huge advantage because they can offer access to opportunities that simply would be difficult or even impossible for individual investors to achieve on their own. They are usually in private companies, niche sectors, and physical assets such as property and infrastructure, which by their nature deliver diversification and returns that are different from mainstream equity markets.

Just look at BH Macro (BHMG). One of the greatest hedge fund managers of all time in cumulative lifetime gains, Brevan Howard is known for its successful strategy of producing high, asymmetric returns (strong performance when market conditions are not great). The secret of the trust’s strategy is that the capital allocated to invest in the majority goes to approximately 10–15 senior traders, all experts in their field, who will all trade the market in completely different ways. This results in a well-diversified portfolio with exposure to global fixed-income and FX markets, as well as peripheral exposure to equity, credit, commodities, and digital assets, with NAV returns being historically uncorrelated to both equities and bonds. The resulting diversified exposure, and the skill with which it is managed, make for an extremely differentiated investment opportunity — one that an individual investor could never replicate on their own — and is what makes BHMG an attractive solution for those looking for hedge fund-like strategies, and markets, typically unavailable to the average retail portfolio.

Another significant example is CTPE, making its second appearance. Its differentiated approach guides it away from finding itself focused only on the ‘mega-deals’ that usually dominate the news. Instead, it uses hybrid investing, meaning less permanent money is committed to lower mid-market managers, which are similar to the UK’s small-cap universe, while co-investments make up more than 40% of the portfolio. The managers prefer this space as there is less competition for deals, but also point out that they still have the means to identify opportunities in objects with real organic growth potential. Participating in CTPE reduces risk through diversification, as it has exposure to more than 500 underlying companies (led by 50 or so different private equity management groups) – a coverage not easily achieved for retail investors, in our opinion.

A further excellent case study in accessing hard-to-reach parts of the market can be found in the renewable energy infrastructure space

These kinds of trusts are clearly providing access to otherwise hard-to-reach markets, but also fulfilling an invaluable role for portfolio diversification. This low correlation to traditional equity markets (illustrated below) positions them as a potential source of differentiated alpha. Not only are these trusts negatively correlated to the MSCI World Index, but they are also showing low correlation in their respective sectors. They’ve got different profiles for return, different approaches to income, and different exposures to sources of risk and return. Hence they can potentially fill a very significant role as part of any wider portfolio or overall exposure to market alpha.