Contents

About the author

Acknowledgements
Foreword
Introduction: The changing landscape of investing
1 What are investment trusts?
Structure and differences
Net asset value (NAV)
Discounts and premiums
Price and size
Range and reach
2 Better performance and cheaper fees
Better performance
Beware unit trust tables
The strange case of ‘mirror funds’
The effect of cheaper fees on performance
Lesson from America
The TER and more
Performance fees and Warren Buffett
3 The opportunities and risks of discounts
Opportunities and risks
Factors affecting discounts
How to judge value
The risks of investment trusts
Discount control mechanisms
4 Other pros and cons of investment trusts
Investment trusts are better understood
Gearing
Directors and shareholders
The long term and alternative assets
Size and marketability
Dividends
Capital changes
Enhanced flexibility
5 Useful investing miscellany
Directors’ and managers’ shareholdings
The report and accounts
Doing the splits
ETFs and trackers
Portfolio turnover
Different investment styles
6 Deciding investment objectives
Saving and investing
Risk tolerances: time and volatility
Currency considerations
Income requirements
Choosing a benchmark
The route to market
7 Successful investing
Getting started
Why it is important to stay invested
Diversification
Reinvesting dividends
 Regular rebalancing
Reaching investment goals
8 Other investment secrets
Sentiment versus fundamentals
Keep it simple and cheap
Multi-manager funds
Hedge funds
Structured products
Ignore forecasts
The magic of compound interest
9 The Investors Chronicle portfolios
The rationale
Investment philosophy
Investment strategy
Balancing competing factors
A recent column
References
Index
To Thalia, Poppy and Leone,
with my love
And to those who have helped me,
with my thanks
About the author

John Baron is best known to readers of the FT’s Investors Chronicle

magazine for having successfully run two live investment trust portfolios as
measured by their appropriate APCIMS Growth and Income benchmarks. His
popular monthly column explaining portfolio changes is closely followed. It
aims to help investors – private and professional – with their investments.
John has used investment trusts in both a private and professional capacity
for over 30 years. Upon leaving the Army, he entered the City as a fund
manager running a range of portfolios for private clients and charities. He
was a Director of Henderson Private Clients, and then a Director of
Rothschild Asset Management having been approached to run its private
client core UK equity portfolio.
Upon entering politics, John has sat on the other side of the fence helping
charities monitor their fund managers. He remains a member of the Chartered
Institute for Securities & Management.
His message is that investment is best kept simple to succeed. Complexity
adds cost, risks confusion and usually hinders performance. This philosophy
runs through this short but revealing book about the City’s best-kept secret.
Acknowledgements

We are grateful to the following for permission to reproduce copyright

material:
Figure 2.1 from Moore, E. (2012), ‘It’s an open and closed case for fund
investors’, The Financial Times, 25–26 February © The Financial Times
Limited. All rights reserved; Figure 2.2 from Walters, L. (2011), ‘Fund
performance tables hide bad records’, Investors Chronicle, 19–25 August,
using data from Lipper; Figure 5.2 from Barnes, D. (2011), ‘Synthetic
appeal’, Securities and Investment Review, October; Figure 5.3 from Ross, A.
(2011), ‘Understanding ETF risks, investors warned’, The Financial Times,
24–25 September © The Financial Times Limited. All rights reserved; Figure
8.1 from Securities and Investment Review, August 2012.
Table 2.1 from Walters, L. (2012), ‘Investment trusts beat open-ended peers’,
Investors Chronicle, 27 July–2 August, using data from Lipper, Morningstar
and Canaccord Genuity Wealth Limited; Table 2.2 from Walters, L. (2011),
‘Trusts that beat their mirror funds’, Investors Chronicle, 1–7 April, using
data from Canaccord Genuity Wealth and Morningstar; Table 2.3 from
Walters, L. (2011), ‘Investment trust fees on the rise’, Investors Chronicle,
3–9 June, using data from the Association of Investment Companies (AIC);
Table 2.4 from O’Neill, M. (2012), ‘Performance fees in decline’, Investors
Chronicle, 14–20 September, using data from Lipper; Table 3.1 from St.
George, R. (2012), ‘When the price isn’t right’, What Investment; Table 4.3
from What Investment, March 2013; Table 7.1 from Duncan, E. (2012), ‘Act
now’, What Investment, May; Table 8.1 from Clarke, G. (2011), ‘Multi-
manager funds serve up few benefits’, The Financial Times, 19–20
November © The Financial Times Limited. All rights reserved.
Text on pages 124–6 from Baron, J. (2013), ‘Japan: a once in a lifetime
opportunity?’, Investors Chronicle, February.
In some instances we have been unable to trace the owners of copyright
material, and we would appreciate any information that would enable us to do
so.
Foreword

Investment trusts have been the City’s best-kept secret. They perform better
and are cheaper than the unit trusts and open-ended investment companies
(OEICs) that dominate the nation’s investment and savings market. Yet many
private investors, charities and smaller pension funds are simply unaware of
them.
This is going to change. The introduction of the Retail Distribution Review at
the beginning of 2013, and other changes to financial regulation, will be one
catalyst. Others will include far greater awareness of investment trusts’ many
advantages. The secret is about to be let out of the bag and investment trusts
are about to have their day in the sun.
Investors need to be ready to benefit. The Financial Times Guide to
Investment Trusts will help you better understand investment trusts.
Characteristics such as their structure, gearing and discounts will all be
explained as will other factors that affect how trusts perform and are
perceived. I will also discuss the stepping stones to successful investing, and
how to construct and monitor a trust portfolio. Finally, I will explain the
workings of the two live and benchmarked portfolios that I have been sharing
with Investors Chronicle magazine readers in recent years.
As any investor will know, knowledge is the bedrock of successful investing.
This book aims to explain the potential of investment trusts in a clear, concise
and jargon-free manner. It shows their apparent complexity is a myth – a
myth which has tended to obscure investment trusts’ merits to professional
and private investors alike for too long. I hope readers will then see the
wonderful opportunities on offer.
Happy investing!
Introduction: The changing landscape of
investing

Why is it so little is known about investment trusts? After all, they have been
around for a very long time – many trace their ancestry back to the nineteenth
century. Some of them are very large with market capitalisations of around
£2,000 million – not easy to miss! Sections of the financial press often talk
about the merits of investment trusts, including better performance and
cheaper fees when compared with the unit trusts that dominate the market.
And yet, the typical investor is unaware of them – the first chapter will
therefore explain what investment trusts are.
Most of us love a bargain. So why have we been over-paying for our
investments? Why is it that, in the past 10 years alone, the amount invested in
unit trusts and open-ended investment companies (OEICs) has risen three-
fold to over £600 billion, whilst assets held by investment trusts have only
grown less than 50 per cent to around £100 billion? And why is it few
investors outside the wealth managers in the City know about them?
The answers are various. But the common thread linking them is a
competitive landscape which has been tilted against investment trusts for
some time. All this is about to change.
The key catalyst has been new regulations that came into force at the
beginning of 2013. Hitherto, many investors have turned to an independent
financial adviser (IFA) to help them run their portfolios. Most of these
professionals have earned their money not by charging the client a fee, but
rather by receiving commission payments from the managers of the products
they sell to the client.
Investment trusts do not pay commission to IFAs. Open-ended funds such as
unit trusts do. As a result, there has been an in-built bias in favour of these
open-ended funds, which is why they tend to dominate the retail market.
Some clients might have thought they were getting ‘free’ advice as they
could not see fees coming out of their pockets. Most clients would have been
aware of the arrangement but perhaps hazy about the scale of commission
fees paid to their IFAs. Whichever, there is no free lunch. The commission
fee has been deducted from the product sold, and therefore comes out of a
client’s overall investment returns.
In the UK, much of this changed in January 2013 when new rules were
introduced by the Financial Services Authority (FSA) as a result of the Retail
Distribution Review (RDR). These rules now ban commissions. Instead,
IFAs are now expected to earn their fees by charging the client directly
themselves and up front. The fee may be an hourly charge depending on the
time spent or a fixed fee depending on the type of advice. Whichever, the
effect will be the same – fees will be paid directly by the client.
One aim of the RDR is to make charges much more transparent. The theory is
that clients will now more readily understand the fee structure. Another
objective is to eliminate potential conflict of interest claims against IFAs –
regardless of how well they have served their clients in the past. Meanwhile,
the FSA has ruled that the new adviser-charging structure should not
commercially disadvantage clients when compared with the old commission
fee arrangement. Time will tell whether the RDR has been a success.
But whether a success or not, the RDR’s effect on investment trusts will be
profound. These trusts can now compete with the open-ended funds on a
more level playing field. No longer will they have an in-built disadvantage
when being recommended. The gloves are off and the fight is on. And
investors are set to benefit as a result.
However, this is only half the story. The advent of the RDR is certainly a
catalyst for change, but investment trusts have been the poor cousin to the
more dominant unit trusts and OEICs for a number of other reasons –
although this too may be changing.
In the past, investment trusts have not always been good at setting out their
stall. They are a slightly more complex beast when compared with the open-
ended funds that have dominated most clients’ portfolios. But this complexity
has been grossly exaggerated, possibly by those with vested interests.
Yet where were the marketing campaigns to sell the product? Compare this
omission to the massive marketing by the unit trust and OEIC managers,
especially each year when the new ISA season approaches. Where could
investors get a simple explanation of how investment trusts work? Certainly
not from the banks or building societies.
And, perhaps more importantly, where have investors been able to find those
advisers willing and able to use investment trusts to their clients’ advantage?
The major exception has been the private client wealth management
operations. Typically, these have served their clients well, but they have
traditionally been the preserve of charities and private investors with
£500,000 or more to invest.
This failure to reach out to investors has not been helped by the odd bit of
bad publicity. Some investors will remember the ‘split-capital’ investment
trust scandal. During the late 1990s, these trusts were marketed as low-risk
investments, particularly for those seeking income. But it turned out they had
borrowed from each other in what was dubbed the ‘magic circle’. High
gearing and intricate cross-holdings made for a volatile mix. The detail is
unimportant, but a number of investors lost out after the market crashed in
early 2000.
Though severe for those involved, the bad publicity was out of all proportion
to the scale of the affair. Only a few fund managers were felled by the
scandal, but it threw a dark shadow over most of the investment trust
industry. The episode seemed to confirm for many that investment trusts
were a dark art best avoided, the characteristics of which bordered on
mysticism. It certainly did not help the industry’s profile or appeal to
investors.
However, this perception is slowly changing. There has been more coverage
in the financial press highlighting the better performance of investment trusts
compared to their open-ended cousins, and often by some margin. The press
has also confirmed that investment trusts are a cheaper way of gaining
exposure to markets – an issue of increasing importance. These two facts are
not unrelated.
And more investors are coming to appreciate their other useful features.
These include the ability to ‘store’ dividends and so produce a growing
stream of income for investors even when markets are rocky – helpful for
long-term planning. Increasing awareness that their structure is better suited
to certain asset classes, such as private equity and infrastructure, has also
helped.
In short, investment trusts are beginning to combat the ignorance and
sometimes prejudice that has characterised attitudes. The momentum is
slowly moving in their direction. However, there is one further factor in this
changing landscape. The RDR and better awareness of trusts’ advantages
apart, there has been another force bubbling away – which may now be
coming to the boil.
There is a growing realisation – in part driven by ageing demographics and
poor finances – that the country’s population needs to do more financially to
prepare for later life. The pressure is on government finances, and this will
not change for decades to come. The penny has dropped and various
government initiatives abound. One example is the subtle yet significant
changes to the inflation indexing of state pensions. The government’s latest
attempt to encourage more people to take up a pension is another. More effort
to teach basic finance to school students is yet another.
In addition, people are finding it harder to access debt – the financial ‘system’
is less sympathetic and this is likely to continue for some time. The banks
have tightened up lending to businesses and individuals alike whilst
continuing to repair their balance sheets and mitigate against future risk.
Interest rates on credit cards remain stubbornly high despite interest rates in
general being close to zero.
Furthermore, the financial climate is less sympathetic in another sense – less
tangible, but important all the same. Today’s generation does not have the
same trust as previous generations in its perception of certain assets.
Yesterday, there was an almost unshakeable belief that house prices would go
up over the longer term, pensions were safe and worthwhile, and that the
stock market would rise. Banks were considered trustworthy. Not today.
Instead, there is greater uncertainty and, with it, a view that more self-help is
necessary.
This view has been reinforced of late by news that many high street banks are
exiting the financial advice market for customers with less than £100,000 to
invest. Further evidence of a potentially large ‘advice gap’ has come from a
recent survey quoted in the Investors Chronicle which found that two-thirds
of financial advisers said it would not be profitable to advise clients with less
than £50,000 to invest.1 It is these very people who need good financial
advice more than much wealthier clients. In addition, a Financial Times
survey2 suggested that one-third of those with more than £50,000 in liquid
assets would now stop using IFAs when charged directly under the RDR
rules. More and more people are now contemplating DIY investing – whether
through necessity or choice.
Given these various factors in this changing landscape, making your money
work harder and greater awareness of the range of investment possibilities on
offer becomes more important. There are many people for whom this
information will become more relevant. And in the search for more cost-
effective and better returns, investment trusts will be one of the key
beneficiaries.
For too long investment trusts have remained the City’s best-kept secret.
Their moment is approaching when they will step out of the shadows and into
the glare of investors – both large and small. The challenge for the industry is
to explain clearly how they work and how they can serve investors.
I hope The Financial Times Guide to Investment Trusts will play a small part
in achieving this goal. Chapter 1 explains what trusts are and how they differ
from unit trusts and OEICs. Chapters 2 to 4 will cover the pros and cons of
trusts including performance, fees and discounts. Chapter 5 looks at some
other factors which will further help investors make informed investment
decisions.
The following three chapters (Chapters 6 to 8) then focus on how to construct
and successfully run a portfolio. They cover the importance of mapping out
your investment objectives, the secrets of successful investing and several
other tips and pointers. Finally, Chapter 9 talks you through my Investors
Chronicle portfolios as a way of illustrating the key themes of this book.
Investors will be well rewarded if the opportunities and risks of investment
trusts are better understood – very well rewarded indeed!
What are investment trusts?

Investment trusts do have a slightly more complex structure than unit trusts
or open-ended investment companies (OEICs), but therein lies the
opportunity for those investors who take the time to understand them. The
effort can be very rewarding!

Structure and differences

Most investors will have at least some element of their portfolios invested in
funds. The concept is simple. An investor will join many other investors in
pooling their money and, in effect, giving it to a fund manager to invest. Such
an approach is sensible – it means investors can access a diversified portfolio
and so lower risk, whilst the costs are lower because they have been shared.
Most funds are unit trust or OEICs – both being ‘open-ended’. These are so
called because when any investor buys or sells them, they are directly adding
or subtracting from the pot of money invested in that fund and managed by
the manager. In doing so, as investors buy and sell, they are creating or
cancelling shares in line with investor demand.

Open-ended funds

Before purchase After purchase

Investor buys
Fund size = £1,000,000 10,000 units @ £1 Fund size = £1,010,000
each
1,000,000 shares in issue. 1,010,000 shares in issue.
Therefore each share = £1 Therefore each share = £1

But there are other funds called investment trusts. These are listed or public
companies and as such are ‘closed-ended’ in that they have a fixed number of
shares: they are ‘closed’ after the initial launch or share issue. Their shares
are listed and traded on the stock exchange like other public companies such
as Shell, Marks & Spencer and GlaxoSmithKline.
Instead of specialising in the management of oil, clothes or drugs, investment
trusts specialise in the management of portfolios – typically of other quoted
companies. Their purpose is to make profitable investments in financial
assets for the benefit of their shareholders.
By buying the shares in Shell, M&S or GSK, an investor is not adding more
oil, clothes or drugs for the company to manage. That is for their
managements to decide. Likewise, buying the shares of an investment trust
does not add to the size of the portfolio. You are simply buying part
ownership of the company itself – not adding to the underlying portfolio – in
the hope of profiting from its successful management.

Closed-ended funds

Before purchase After purchase

Investor buys
Portfolio size = 10,000 shares
Portfolio remains £1,000,000
£1,000,000 through the
stock market
1,000,000 shares in issue. Shares in issue remain
Share price reflects 1,000,000. Share price
demand and supply in continues to reflect demand
the stock market and supply in the stock market

If Shell, M&S and GSK manage and grow their assets well and profits
increase as a result then, all things being equal, this will be reflected in a
rising share price – to the benefit of those shareholders who own the shares.
Whether these companies succeed will depend on a number of factors, such
as the economic environment, the business model and above all the quality of
management.
Similarly, investment trusts strive to grow the value of their portfolio of
stocks. Success or failure will eventually be reflected in the share price of the
trust. Factors such as the economy, the method of research and stock
selection, and the investment acumen of the manager will all play their part.
But essentially, the business of an investment trust is the same as that for any
other quoted company – to make money for those who hold its shares by
growing assets under management.

Figure 1.1 Open-ended v. closed-ended trusts

Net asset value (NAV)

In the case of investment trusts, the assets are the portfolio values and a
common way of pricing this value is by referring to the net asset value
(NAV), which is the value of the portfolio divided by the number of shares in
issue.
By way of example, let us assume that today the total value of ABC
investment trust’s portfolio of stocks, shares and cash is £100 million. There
are 100 million shares of ABC in issue. The NAV is therefore £1.00 (£100
million value divided by 100 million shares). If, in the future, the value of the
underlying portfolio was to rise to £120 million because the stock market and
therefore the portfolio had risen, then the NAV would rise to £1.20 (£120
million value divided by 100m shares), and so on.
The NAV is a useful way of relating the value of the portfolio to the share
price, and is closely watched by investors.

Discounts and premiums

Being closed-ended with a fixed number of shares, the share price of an
investment trust is not dictated by the underlying value of the assets under
management – the NAV – but rather by the extent to which investors wish to
own the shares of the trust itself. Trading in the shares does not affect the
value of the NAV.
As such, the share price can be more or less than the NAV. If it is less, the
trust is said to be trading at a discount (see Figure 1.2). Most investment
trusts trade at a discount to NAV. Presently, discounts average between 5–10
per cent. This effectively means that an investor is buying £1’s worth of
assets for 90–95p.
This reflects that, historically, institutions have been sellers. It may also
reflect the fact that investment trust prices can be a little more volatile than
those of open-ended funds. This is because their price is not only affected by
movements in their NAV (like open-ended funds) but also by movements in
the discount (unlike open-ended funds). Investors may therefore be seeking
compensation or a margin of comfort for holding investment trust shares.
A discount to NAV is not necessarily an opportunity. A large discount may,
for example, also reflect low confidence in the fund manager – perhaps
because of poor performance – or a dislike of the trust’s focus on a particular
region or sector. It can also reflect the fact the investment trust is not
communicating well its investment strategy to the market – investors do not
like uncertainty.
If the share price is more than the NAV of the underlying portfolio, then the
trust is said to trade at a premium. There may be a good reason – the fund
manager may be well respected, or the underlying focus of the portfolio very
much in fashion. But beware, as buyers you are effectively paying an
additional charge for obtaining exposure.

Figure 1.2 NAV and share price

This ability of share prices to trade at discounts or premiums to NAV can
present wonderful opportunities and risks for investors. This is something
covered in later chapters, but for the moment it is important to recognise that
this characteristic of discounts and premiums does not exist with unit trusts
and OEICs.

Price and size

Being public companies, the price of investment trusts is decided by how
keen investors are to own the shares – there only being a limited number. The
price will rise if there are more buyers than sellers, and vice versa.
By comparison, being ‘open-ended’, there is no limit as to how many shares
– or units – can be created by unit trusts or OEICs if the demand exists.
Prices are dictated directly by the value of the underlying portfolio and not by
investor demand. The individual unit price is decided by the value of the fund
divided by the number of units in existence, and not by the extent to which
investors want to own the shares.
Being public companies, the size of investment trusts in terms of market
capitalisation is therefore decided by the number of shares in issue multiplied
by the price of those shares. Murray International Trust has 118.9 million
shares in issue which means a share price of £10 equates to a market cap of
£1,189 million. By comparison, the size of unit trusts and OEICs is decided
by how much money investors have placed in that particular fund – as
reflected by the number of units in existence.
Investment trusts vary in size enormously. The largest have a market
capitalisation of around £2,000 million, whilst some of the smallest come in
under £10 million. The larger tend to invest across markets globally and
access all the major markets. These are typically suitable for investors with
smaller portfolios who may just want to start with a few investment trusts.
The smaller trusts tend to have more specialist briefs such as smaller
companies, equity income or bonds.

Range and reach

All public companies invest in and manage a portfolio of assets. Like other
listed companies, investment trusts tend to specialise in certain categories of
assets. Just as Shell specialises in oil and M&S in clothes and food, different
trusts will manage different assets – be they equities, property, bonds, private
equity, etc.
Whatever the asset, the fund manager’s objective will be the same: to buy
and sell the portfolio’s assets in the hope of outperforming the benchmarks
for the benefit of shareholders.
Being 400 in number, investment trusts offer a huge range of investment
opportunities covering all global markets and a diverse variety of asset
classes. The investor is spoilt for choice.
For those just starting and who may only want to hold a few, there are the
large generalists such as Scottish Mortgage, Alliance and Foreign &
Colonial. These can roam the global markets and make decisions on your
behalf as to which investments are best. If cautious about the outlook, they
can take defensive action such as raising cash levels and bond exposure, but
their brief is essentially to invest in equities (the shares of other public
companies) for the longer term.
For the more experienced investor and those whose assets allow them to have
a spread of trust holdings, then the world is your oyster! Investors can create
a portfolio of trusts to reflect their risk tolerances, income demands and
market outlook. There are investment trusts to suit every taste. From the UK
market, one can choose a combination of growth, income growth, high
income, medium-sized and smaller companies.
Looking abroad, all the markets are covered – from trusts covering continents
to individual countries. These include ‘emerging’ markets and ‘frontier’
markets, such as the remote parts of Africa. One can also combine themes.
For example, if income is important but you also want overseas exposure
then the two can be combined. There are trusts offering exposure to Latin
American, European and Far Eastern companies with decent dividends – to
name just a few.
Furthermore, there are trusts that focus on all sorts of specialist or thematic
areas – bonds, commodities, infrastructure, life sciences and technology for
example. Globalisation does mean that there are many profitable themes to be
pursued that transcend national boundaries. And investment trusts have the
full coverage. Indeed, some have access to areas that closed-ended funds
simply cannot access or replicate – one being RIT Investment Trust, which is
the personal investment vehicle of Lord Rothschild.
A comprehensive (but not exhaustive) list of categories under which most
investment trusts operate is as follows:

Global – growth Global – specialist

Global – income growth Global – smaller company
UK – growth UK – income growth
UK – high income UK – high income/smaller companies
UK – mid cap UK – small cap
UK – fledgling Europe – general
Europe – smaller company Europe – high income
US – general North America – income
US – smaller company Japan – general
Japan – smaller company Asia Pacific – ex Japan
Asia Pacific – including Japan Asia Pacific – income
Asia Pacific – smaller company Asia Pacific – single country
Emerging markets – global Emerging markets – income
Emerging Europe Latin America
Emerging markets – single country

And:

Bonds Commodity Financials

Environmental Alternative energy Infrastructure
Life sciences Technology Timber
Utilities Private equity Property
Hedge funds

The following chapters cover the many advantages of investment trusts over
their open-ended cousins.
Better performance and cheaper fees

It is a little known fact that investment trusts have not only performed better
than unit trusts or their benchmarks, but have also beaten their ‘mirror’ funds
– their unit trust equivalents run by the same trust manager. The key, but not
the only, reason for this is cheaper fees.

Better performance
With open-ended funds dominating the retail market, you would have been
forgiven for thinking that unit trusts and open-ended investment companies
(OEICs) were the best collective investment vehicles in town. But you would
have been wrong. History shows that investment trusts have soundly beaten
the performance of their open-ended cousins over the longer term.
As you can see from Figure 2.1, financial advisory group Collins Stewart
compared the performance of investment trusts to both unit trusts/OEICs and
their relevant benchmarks (local stock markets) over the 10 years to 31
December 2011. The results were revealing.
Investment trusts have produced better returns than their benchmark indices –
local stock markets – in seven of the nine regional sectors analysed. In
addition, they have outperformed unit trusts in eight of the nine regional
sectors. Japan was the exception, largely due to the lacklustre performance of
the largest investment trust in the sector, JPMorgan Japanese. Performance
differentials were greatest in the global growth sector where trusts’ NAV
growth averaged 4.4 per cent a year, compared to just 2.4 per cent from open-
ended funds.
Figure 2.1 Investment trusts v. unit trusts v. benchmarks
Source: From Moore, E. (2012) ‘It’s an open and closed case for fund
investors’, The Financial Times, 25–26 February © The Financial Times
Limited. All rights reserved.

Perhaps just as damning for unit trusts and OEICs is the fact that, over the
same period, not only did they come second to investment trusts in all but one
sector, but they also underperformed their benchmarks in every sector
analysed. The same is true of one- and five-year figures.
You could argue that I am being unfair to open-ended funds! Why? Because
the performance figures cited above relate to the share price of investment
trusts – and not their NAV. Remember from Chapter 1 that, being a closed-
ended fund, investment trusts have issued shares like other public companies
to be traded on the London Stock Exchange and abroad. As such, the price of
these shares can rise and fall according to investor demand.
This means the shares often do trade at a different value to the assets held in
the portfolio, and discounts can and often exist – the discount arising when
the share price falls below the value of the underlying portfolio (or NAV).
And, over the past decade, average discounts have narrowed from around 11
per cent to 8 per cent: in other words, the share price has risen faster than the
NAV by about 3 per cent. This has boosted the returns of those holding the
shares, and flattered the share price performance of the investment trust
relative to its underlying portfolio or NAV.
In order to show that investment trusts really have performed better, we need
to look at how successful they have been at growing their NAVs – and not
just their share prices – and compare this to unit trusts and OEICs. Otherwise,
you could accuse me of cheating! There is only one value for unit trusts,
whereas investment trusts have two – their share price and their NAV.
It is therefore useful to look at Table 2.1. This focuses on comparing the
NAV performance of investment trusts and unit trusts/OEICs over a 10-year
period to 31 May 2012.
The table confirms that, in most cases, investment trusts’ assets or NAV have
beaten both the relevant benchmarks and the NAV of unit trusts and OEICs.
It also confirms the pedestrian performance record of the open-ended funds
relative to the benchmark. Canaccord Genuity calculates that the annualised
outperformance over both open-ended funds and relevant benchmarks in the
core regional sectors is 1.93 per cent and 1.35 per cent respectively.
Table 2.1 Ten-year asset performance to 31 May 2012

Source: From Walters, L. (2012), ‘Investment trusts beat open-ended peers’,

Investors Chronicle, 27 July–2 August.

The figures also bring into stark relief the extent to which these annualised
outperformance figures add up over the years. The figures quoted above may
not sound large but it is too easy to forget what a powerful cumulative effect
this outperformance can have on a portfolio, particularly over 10 years.
Investing £10,000 in the Global sector in an average investment trust would
have produced an NAV of £17,410, compared with £14,020 for open-ended
funds – a significant difference.
These are of course average figures. Many good unit trusts and OEICs do
beat their benchmarks and the poorer performing investment trusts. But
having a better performance average increases the chances of profitable
investing for investors: it is easier to reach your objective if the current is
with you.
It is also true that there are some sectors where comparison is not possible. In
the fixed-income sector, for example, there are few investment trusts
compared to unit trusts or OEICs, and so no meaningful comparison can be
achieved.
However, the charts and figures tell a convincing story: investment trusts
have outperformed open-ended funds over the past 10 years, over most
meaningful timescales, and in almost all of the major comparable sectors,
whether you’re comparing share prices or NAV. The same is true when
comparing investment trusts with their benchmarks. Rarely in the investment
world is the evidence so conclusive – it’s an open and closed case!

Beware unit trust tables

I also want to reinforce the message that, in many cases, past performance
tables flatter unit trusts and OEICs. Performance figures do not always
indicate past performance because there have been many fund closures,
predominantly in the open-ended sector, resulting in poor track records being
removed from the equation. The assets of a poorly performing fund are then
added to a better-performing fund whose performance figures are then quoted
going forward, or are added to a new fund launch, or are simply returned to
investors.
Either way, the poor performance figures are hidden from view. Fund
management groups spend a lot of money marketing their products in what is
a very lucrative industry. The last thing they want is the media and investors
being able to highlight poor performance figures that could tarnish their
record and the record of their better performing funds. The stakes are too
high. Better to remove the poor figures entirely, and focus attention on the
good news.
This is more of a common occurrence than many investors would imagine.
Figures from the Investment Management Association (IMA), the fund
industry’s trade body, reveal that the investment fund industry undertook a
near 100 per cent turnover of funds between 1998 and 2010. Nearly one fund
was closed or merged and another launched for every working day over the
period. The total number of funds launched in those 12 years was 2,660,
while there were 2,486 ‘closures’ including mergers. This is a phenomenal
turnover rate, given that the total number of funds in existence at the end of
1999 was 2,437 – little changed from the 2,574 at the end of 2010 (see Figure
2.2).

Figure 2.2 Fund launches v. closures, 1998–2010

Source: From Walters, L. (2011), ‘Fund performance tables hide bad
records’, Investors Chronicle, 19–25 August.

This is why many clients have questioned why the performance of their unit
trust holdings has never been as good as the tables would indicate – their
poor performance no longer exists! Indeed, it could be argued that five-year
sector-average performance statistics reveal only half the story – the good
half. Certainly 10-year data should be taken with a pinch of salt because of
the near total turnover in funds and therefore performance.
A further disadvantage of unit trusts is the expense involved. The closing and
then merging with or launching of other funds, on the scale highlighted
above, is costing millions of pounds in consultancy, tax and legal fees. And
guess who is paying?

The strange case of ‘mirror funds’

Could the better performance of investment trusts be explained because trusts
have employed better managers with different investment goals and
strategies? Different football teams have different managers who produce
different results, even though they are playing in the same league. It would be
a logical explanation.
However, this is not the case. Many fund management groups have the same
managers running both open- and closed-ended funds. It makes commercial
sense. All the technology, systems and people are in place so there is little
duplication of effort or expense. And with open-ended funds charging higher
fees, it can be a lucrative business.
Further research by Collins Stewart confirms this is not the reason. It has
compared the performance of investment trusts and unit trusts that have the
same fund manager and similar, if not the same, investment strategies and
goals. Over 20 comparisons were made and Collins Stewart found that more
than three-quarters of investment trusts performed better than their open-
ended equivalents, despite having the same fund manager in charge. Table
2.2 highlights some of the comparisons.
The outperformance figures are annualised and we have seen previously how
this adds up over the years on a cumulative basis. But the real message here,
in many cases, is the difference in performance. Logically, this should not be
happening. Why should the same fund manager with the same investment
brief and benchmarks produce such different results? What are the factors
contributing to this?
The answers to these questions go to the very heart of why investment trusts
perform better than their open-ended equivalents.

The effect of cheaper fees on performance

The media has been understandably obsessed with bankers’ bonuses. But
there is another area of the financial sector that deserves similar scrutiny yet
largely escapes attention, much less admonishment – unit trust management
charges.
When comparing the performances of both funds run by the same fund
manager, it is interesting to note that the unit trust charges are significantly
higher. On 15 April 2012, The Sunday Times compared the performance of
two funds run by Neil Woodford – the Invesco Perpetual High Income Fund
and Edinburgh Investment Trust. Over three years, the unit trust had returned
58 per cent having charged an annual management fee of 1.5 per cent. The
investment trust had returned 100 per cent, yet had charged only 0.7 per cent.
The same is true of other fund managers. Harry Nimmo runs both a unit and
investment trust called Standard Life UK Smaller Companies. The unit trust
returned 111 per cent having charged 1.6 per cent, whilst the investment trust
returned 152 per cent having charged a more lowly 0.8 per cent management
fee.
Table 2.2 Investment trusts that beat their open-ended equivalents

Source: From Walters, L. (2011), ‘Trusts that beat their mirror funds’,
Investors Chronicle, 1–7 April.
Is it a coincidence that the better-performing investment trusts charge
significantly lower fees? I suggest not. But higher charges by open-ended
funds are not restricted to such ‘mirror fund’ situations. Unit trusts generally
charge higher fees – typically 1.5 per cent, but they can be higher. Higher
fees can only be taken from one source, the fund’s underlying portfolio,
which in turn reduces its performance.
In trying to quantify the effect of higher fees on performance, we should start
by looking at the effect of fees in general. They make a big difference to
returns over the longer term, particularly if one is starting with a lump-sum
investment.
Assume a client invests £11,280 in a self-select individual savings account
(ISA), and it is left for 30 years earning 6 per cent a year – a not untypical
return. With no charges, except for a small capped fee to the provider for
administration, it would be worth £61,940 at the end of the term. A
management fee of 1.5 per cent a year brings the value of the same portfolio
down to just £41,169 – a whopping one-third less.
Various statistics are available to help clients quantify the difference higher
fees can make to their returns. One of my favourites assumes a client invests
£100 a month for 30 years in both an investment trust and a unit trust. We are
told that both funds grow by 5 per cent a year, and that the management fees
are 0.75 per cent for the investment trust and 1.5 per cent for the unit trust.
Not a big difference you might think. But after 30 years, the investment trust
will have returned £71,800 compared to £63,100 for the unit trust – a
significant difference.
However, although the above investment returns and charges are based on
evidence, the examples are academic exercises. The fund management firm
TCF examined the returns of the three main fund categories recognised by
the IMA – ‘active’, ‘balanced managed’ and ‘cautious’ – according to total
expense ratio (TER, see later). It analysed how both the cheapest 25 per cent
and the most expensive 25 per cent of funds compared with the average
performance of funds in each category over three and five years.
The results were revealing. In both the ‘active’ and ‘balanced’ categories, the
cheaper funds performed on average 1 per cent better per year than the more
expensive. In the ‘cautious’ category, the cheaper funds outperformed by
around 0.6 per cent a year – producing an average performance of 2.9 per
cent a year compared to 2.3 per cent for the more expensive.
Now these figures may not sound like big differences, but by now you will
recognise that small figures become large ones over the longer term. If an
investor could increase the performance of £10,000 invested over 25 years by
1 per cent a year – from 5.5 per cent to 6.5 per cent – then the increase in the
total sum at the end would be more than the original sum invested. It is worth
thinking about. The unit trust industry thrives – intentionally or not – on
investors’ ignorance about the extent to which time transforms small numbers
into bigger ones. Do not be caught out!
A small but growing number of unit trust managers are recognising that such
high charges are indefensible. A few, for example, have launched hybrid
funds that combine low fees and active fund management in return for a cut
of any outperformance over the benchmark. However, these are few and far
between. Despite tentative signs that the penny has dropped, the majority of
the unit trust industry still over-charges when it comes to fees.
You could legitimately argue that it is worth paying for good performance,
and you would usually be right. But we know that unit trusts tend to
underperform both investment trusts and their benchmarks. Most unit trust
fund managers fail to beat their benchmarks and higher fees are one of the
main reasons.
Indeed, costs are a key indicator of future returns. Every pound of
management cost is a pound taken off performance. Expense ratios need to be
much more closely monitored by investors and advisers alike – choose funds
or trusts with lower costs, unless consistently good performance warrants
paying more.

Lesson from America

To illustrate the point further, we should look overseas. Figures from US
mutual funds (unit trusts) seem to confirm that low-cost products usually
outperform high-cost ones. Having adjusted for the fact that US funds tend to
be cheaper because they are larger in size, the average TER (fees and costs
combined) is around 0.9 per cent. This compares to around 1.6 per cent for
our unit trusts.
Again, it does not sound much but it has helped US managers to consistently
outperform their UK rivals. Research by Lipper in 2011, commissioned by
the Financial Times,1 showed American global equity funds having returned
32 per cent more than their equivalent British unit trusts during the past 15
years. The research pointed out that, in the past decade, US funds beat UK
funds across every sector including Europe. The reason put forward was the
difference in fees.
Other research focusing on the US confirms the message. When looking at
the period between 2005 and 2010, Morningstar found that the cheapest US
equity funds returned on average 3.35 per cent a year, compared to just over
2 per cent for the most expensive. In fact, over any time period tested
Morningstar found low-cost funds beat high-cost funds every time.

Be careful of hidden charges

When investigating further as to why American funds are cheaper, you
cannot help but conclude that it is the differing fee structures for financial
advice. As we know, in Britain independent financial advisers (IFAs) used to
receive a commission from the open-ended funds they sold the client. So
these funds had to charge an extra fee – typically 0.5 per cent – to cover it.
Whereas in the US, advisers charge clients directly for their services, and so
there is no need for commission charges to be added to fund costs to
compensate. Such is the thinking behind the Financial Services Authority’s
Retail Distribution Review (RDR).
The message is simple. Although the difference between 0.75 per cent and
1.5 per cent on an annual basis seems small, over the longer term this
difference can have a huge effect on portfolio returns. And this is one of the
key reasons – if not the key reason – why the same fund manager adhering to
the same brief can produce such different returns when running an investment
trust and unit trust.
It is strange that in this more transparent world – assisted by the internet –
where customers increasingly buy goods at a discount to asking price, that
investors do not ask more searching questions about fees when considering
investment decisions. And these decisions usually involve relatively large
sums of money. The fact that fund charges in the UK are almost twice as high
as they are in the US can no longer be ignored.

The TER and more

In order to help investors when asking searching questions regarding charges,
I cover the current debate about fees – both declared and hidden. We have
established that higher fees significantly erode portfolio returns, so it is
important to check the costs of investing.
The total expense ratio (TER) is considered a better measure of overall costs
given that it does not just include the annual management fee but also other
costs such as administration, legal and audit fees, together with any
performance fees levied by the fund manager. This TER is then presented as
an annualised figure.
For those wondering, the good news is that the TER of investment trusts
remains significantly cheaper than that of open-ended funds. Research from
Lipper2 suggests that the average trust’s TER is around 1.3 per cent,
compared with 1.6 per cent for open-ended funds. Nearly a third of trusts
have TERs of less than 1 per cent. Indeed, many charge much less – their
TER being little more than that of passive funds such as index-trackers or
exchange-traded funds (ETFs). The investment trust average is raised by
trusts focusing on specialist areas such as property, infrastructure or hedge
funds, which charge higher fees because of the nature of the investments. But
despite such trusts expanding in number, the Association of Investment
Companies has still found that on average expense ratios are falling (see
Table 2.3).
But the total costs of investing do not stop there. For TERs do not include
hidden charges such as dealing costs, stamp duty, research costs and entry or
exit charges. And these extra hidden charges can be significant. One or two
insiders have suggested that the average annual turnover (the extent to which
a fund manager changes the portfolio) on a typical unit trust is around 50 per
cent: in other words, the portfolio is changed completely once every two
years.
Table 2.3 The 10 cheapest investment trusts in 2011
Investment trust TER(%) TER inc performance fee (%)
Independent IT 0.36 0.36
Edinburgh US Tracker Trust 0.4 0.4
Bankers* 0.42 0.42
Law Debenture Corporation* 0.49 0.49
City of London* 0.49 0.5
Mercantile 0.55 0.55
Henderson Smaller Cos* 0.56 0.56
Scottish Mortgage 0.56 0.56
Temple Bar 0.56 0.56
Electric & General* 0.62 0.65
British Assets Trust* 0.62 0.74
* Trust which has a performance fee in place
Source: From Walters, L. (2011), ‘Investment fees on the rise’, Investors
Chronicle, 3–9 June.

The wealth management firm Spencer-Churchill Miller (SCM Private) says

that these further charges bring the total cost of investing in the average UK
unit trust up to 2.8 per cent a year, rather than the often quoted TER of
around 1.6 per cent. The sum of £10,000 invested over 10 years and
producing a 7 per cent a year return would grow to £16,761 with a fund
charging 1.6 per cent. However, if the total cost of investing was actually 2.8
per cent then this return would decrease to £14,862 – a decrease of £1,899.
The Millers, a husband and wife team who run SCM, certainly believe that if
investors were fully aware of all costs then they would make very different
investment decisions – and the industry would be forced to bring down costs.
Such findings are confirmed by other studies. John Lang and the economist
Kevin James have shown separately that hidden charges add around 1 per
cent to the TER of an average unit trust.
Some in the industry are trying to address the issue – to make fees more
transparent. For example, Fidelity has proposed a new figure called the total
cost of ownership (TCO). This would include the fund manager’s fee,
administrative charges, dealing costs and stamp duty, together with the costs
of distribution and advice. This would be a much fairer reflection of the true
costs borne by the client. SCM has suggested something similar.
Of course, whatever the chosen method, there is no precise way of measuring
these extra costs, if only because fund managers can and do vary the extent
they change their portfolios from one year to the next. Any number of factors
can affect turnover, including market conditions and company-specific news.
Although evidence would suggest the more successful fund managers tend to
have lower turnovers, investors should not seek to dictate how their money is
being managed.
Even when it comes to turnover, once again investment trusts have an
advantage over their open-ended cousins. Being closed-ended, investors are
trading the shares and not the portfolio, which therefore remains unaffected.
By contrast, open-ended funds that see inflows or outflows of money,
particularly if large, will see higher turnover in the underlying portfolio to
match these money flows even if holdings are not being changed.
The message remains the same: be aware of the costs of investing and how
this can affect portfolio performance, and remember that investment trusts
look to be the better deal.

Performance fees and Warren Buffett

Some managers charge performance fees on top of the annual management
charges. These can take various forms, but the theory is the same: a fee that
rises with improved performance helps to align the interests of investors and
managers alike.
It sounds good, but the case has not been proved. There is little difference in
performance between funds charging performance fees and those that do not
when looking at the 12-month returns of the IMA absolute return category.
This is one reason why the number of open-ended funds using performance
fees has been in decline in recent years. There are now around 80 such funds
– just 3 per cent of the entire UK funds universe. By contrast, Lipper has
confirmed that around half of investment trusts still use performance fees.
According to Lipper, another reason for the demise of performance fees is the
‘Hargreaves Lansdown effect’. Hargreaves Lansdown is a major and
reputable independent financial services provider that has regularly attacked
the concept of performance fees. Scepticism from such UK intermediaries
has resulted in fewer funds imposing performance fees (see Table 2.4).
TABLE 2.4 Funds launched with performance fees, to September 2012
Year Number of funds
2004 5
2005 7
2006 19
2007 13
2008 17
2009 18
2010 12
2011 6
2012 2
Source: From O’Neill, M. (2012), ‘Performance fees in decline’, Investors
Chronicle, 14–20 September.

While it is fair to say that performance fees can work well in the interests of
investors, there is a wide variety of structures in place. So investors need to
examine the detail closely. For example, some fee structures encourage fund
managers to increase or decrease the risk profile of the portfolio regardless of
the investment opportunities on offer. To counter this, a performance fee
should have a high water mark so that such considerations do not typically
enter the mix. It should also be calculated against the average performance
achieved over a three to five year timeframe to encourage long-term
investing.
As to whether managers should be rewarded when beating the index but not
cash, or penalised when they underperform to the same extent they are
rewarded when they outperform, investors should be aware that there are
several views.
I suggest managers should only be paid when they outperform their
benchmarks, having charged for covering essential running costs – this latter
charge being capped so that investors do not pay more simply because the
underlying portfolios have increased in value beyond a certain point. This
would be the best way of aligning the interests of investors and managers,
whilst acknowledging that managers do have legitimate administrative costs.
One of the best examples of this approach is that of Warren Buffett when he
ran his own investment business. His water mark was 6 per cent. He did not
get paid any fee until he had produced a 6 per cent performance. He then
retained 25 per cent of any return in excess of 6 per cent, subject to an agreed
minimum. Therefore, if the fund produced a 14 per cent return, the investor
would get 12 per cent and Buffett 2 per cent.
Having shared the gain, Buffett would also share the pain. Any returns less
than 6 per cent would have to be earned or made up in future years before he
could take his fee. A bad year could not simply be written off – the manager
and investor would both suffer. Furthermore, Buffett believed a manager
should invest a significant proportion of their own money into the fund to
help focus attention.
There must be few better ways of ensuring the interests of investors and
managers are matched and it would perhaps encourage managers to adopt a
different approach when investing. First, they would focus on not losing
money or falling behind the agreed water mark for fear of having to make up
lost ground in future years. But it would also encourage managers to focus
more on investing in undervalued companies and less on copying the
benchmark or index.
This is not a popular suggestion. Despite – or because of – its attractions to
investors, many fund management groups would not survive under such a fee
structure. There would be a downsizing of the industry or, to be more precise,
a downsizing of the ‘active’ fund management sector. Investors could still
invest in cheap index-trackers such as ETFs to keep pace with markets. But
they would also have the added option of paying for active fund management.
There is, of course, no perfect answer when it comes to charging structures,
but at least the above method would ensure investors got what they paid for –
good performance and managers acting in their interests. The future belongs
to those fund management groups who adopt such a method, and who then
perform well.
The opportunities and risks of discounts

Better performance and cheaper fees are two powerful reasons why
investment trusts should be favoured. But there is a host of other advantages
(and some disadvantages) to these trusts which are largely ignored or
misunderstood by both professional advisers and investors alike. The
discount is chief among them.

Opportunities and risks

Buying something at a discount to its true value is a national pastime – we all
love a bargain. Buying investments should be no different, yet the majority of
investors do not take advantage of this generous offer from investment trusts.
As investors know, unlike open-ended funds, an investment trust’s share
price can deviate from the net asset value (NAV) of the underlying portfolio.
The price is influenced by investor demand, whereas the NAV reflects the
value of the portfolio. When the share price is below the NAV, the trust is
said to be at a discount. Most trusts trade at a discount. A 10 per cent
discount means that investors are paying 90p for shares when the assets (the
NAV) are worth 100p. But trusts can also trade at premiums, when the share
price exceeds NAV.
Changes to the discounts or premiums of these trusts present both
opportunities and risks for the investor. A discount that narrows or a premium
that expands helps shareholders because the share price has risen faster (or
fallen less) than the NAV. Conversely, a widening discount or contracting
premium is unhelpful as the share price falls further behind its NAV (see
Figure 3.1).
Figure 3.1 Price relative to NAV
Furthermore, because of fluctuations in the discount, an investor does not
know how much others will pay for their shares even though the NAV is
known. This contrasts with open-ended funds where the share price is firmly
rooted to the NAV.
We shall look at both the opportunities and risks in a little more detail later in
the chapter, but first we need to better understand the factors that affect
discounts, and why individual trusts trade at the discounts they do. This is
important when making investment decisions because it helps investors to
balance the opportunities and risks.

Factors affecting discounts

A variety of reasons helps to explain why most trusts trade at a discount, and
why changes in the discount level occur.
One is ignorance. Because investment trusts are a little more complex and
therefore less understood than unit trusts and open-ended investment
companies (OEICs), and because they have not yet entered the investment
mainstream, there is understandably an element of caution. Because discounts
can and do exist, and with them concurrent volatility, some advisers view
trusts as ‘risky’ and therefore best avoided. This is reflected in share prices. If
trusts were better understood, then extra investor demand would push up
prices and narrow the discount.
Another is performance and with it demand. Investors understandably do not
wish to own those trusts that are not performing well. More sellers than
buyers weigh on the share price which then falls relative to NAV, and so the
discount widens. The discount may then stay wide for some time until
performance improves.
But it is interesting to note that those fund managers who have consistently
good long-term track records tend to be rewarded by the market with
discounts close to NAV, or even with premiums. This is true even in those
sectors where decent discounts are the norm: for example, Standard Life UK
Smaller Companies Trust (SLI) is standing close to NAV, compared to a
sector average discount of 15 per cent.
Additionally, sentiment regarding the future prospects of a sector or region
can move discounts regardless of the past performance of the relevant trusts.
The future is more important than the past. Discounts can narrow when
investors get excited about prospects and buy the shares, and widen when
they fear the worst and sell.
Investor demand may not just reflect performance or sentiment. In this low-
interest environment where good-quality yield is hard to find, premiums often
exist in those trusts offering a decent and safe yield – even for those where
NAV performance has simply been acceptable, rather than exceptional.
Examples include trusts within the UK Income Growth, Global Income
Growth and Infrastructure sectors, although some trusts within these sectors
have performed exceptionally well.
Another factor affecting discounts can be the quality of communication
between the trust and shareholders. If the trust’s management is not good at
marketing and communicating long-term strategy, and explaining why
buying and selling decisions are made, then shareholders are unnecessarily in
the dark.
Trusts can perhaps get away with this when things are going well and the
NAV keeps rising, but share prices tend to suffer when the shocks come
along as they invariably do. Shareholders who understand and believe in the
strategy, and know the trust well, will tend to hold and not sell their shares
when times are tricky. Trusts have become better at understanding the
importance of good communication and many now have monthly web-based
factsheets to update investors as to progress. A host of other information is
available on these websites, including the report and accounts, and all are
well worth a read.
Many other reasons can and do affect discounts. For example, the make-up of
the shareholder list is sometimes important. Those trusts that have a large
individual private client shareholder base relative to their institutional
shareholders tend to have narrower discounts. This is often because private
investors are longer-term investors and so hang on to their shares through
thick and thin, perhaps encouraged by capital gains tax considerations if
decent gains exist.
A change in fund manager or strategy can also affect investor demand and
therefore discounts. News of the appointment of a new manager with a good
track record elsewhere can narrow the wide discount of a hitherto lacklustre
trust. Conversely, a successful manager leaving can result in selling pressure
and discounts widening if there are doubts about the incoming manager’s
track record or ability.
A change in strategy can also affect the discount and this happens more than
investors may think. Investment trusts have rightly adapted to changing
circumstances over the years. Part of the job of the independent board is to
review trust policies and strategy, and introduce change where it is felt
necessary. 2011 saw 11 trusts change their investment policies in response to
challenging times – up from five the previous year.
Association of Investment Companies (AIC) data suggest that one theme
influencing these changes is that trusts have broadened their scope globally.
For example, the Martin Currie Global Portfolio (MNP) had been
benchmarked against the UK’s FTSE All-Share index, but now measures
itself against the FTSE World index. The hunt for income remains another
key theme in this low-interest environment, and again trusts are now
extending their search into overseas markets for that yield – a theme we will
pick up in later chapters. The level of the discount is affected depending on
how well the change is perceived by the market.
Big picture strategy decisions aside, day-to-day management decisions can
also have a marginal effect on the discount. One example is when a manager
changes the level of gearing – the level of debt carried by the trust – even
within the tolerances set by the board of directors. Increased gearing has the
effect of accentuating the movement of the underlying assets. This can deter
or encourage investors depending on their outlook on the market.
Another factor can be market volatility – particularly when markets fall. Like
other public companies, investment trusts can be traded every minute that
markets are open – whereas open-ended funds are usually traded once a day,
with the order having to be placed by mid-day for the price to be known the
following day. When bad days come along, some investors want to sell
immediately regardless of NAV movements. This is possible with investment
trusts but not with open-ended funds, and discounts often widen as a result.
An additional factor is, of course, the level of gearing which can accentuate
this volatility.
In short, all sorts of factors affect the extent of discounts. But it is the fact that
discounts exist which presents the opportunities.

How to judge value

Investors should always be seeking discount value when it comes to
monitoring investment trust portfolios: to ‘prune’ portfolios by constantly
asking whether existing holdings look expensive relative to potential
alternatives, and thereby conversely questioning whether potential holdings
look cheap by comparison. A host of factors needs to be considered.
You should always compare apples with apples – trusts within the same
sector or geographic region. An investor needs to get a feel as to what the
sector or region discount average is, which will help to put a trust’s discount
into perspective. But seeking value is not just about a simple comparison of
discounts.
Do not base investment decisions purely on the extent of a trust’s discount. If
the discount is significantly different to its sector average or to its own recent
average, then there is a good reason. Performance is the usual answer but it
may also be other factors, as already discussed, such as communication, a
change of manager or strategy, etc. Such factors may be valid, in which case
the trust’s discount or premium – out of sync though it apparently is – may
remain in place for a long time.
However, anomalies can and do exist. Some trusts do represent better value
than others over the longer term, and switches are worthwhile. For example,
the market can be lazy and sometimes brand trusts in an unfashionable sector
with the same wide discount – even the better-performing ones. Likewise, the
market often attributes premiums to trusts which are difficult to justify or
simply wrong. Investors should seek such opportunities.
One of the best strategies with investment trusts is to buy a good fund
manager who is temporarily out of favour because of a difficult patch in
performance, preferably in a sector that is also out of favour, and then tuck
this away for the longer term. Patient investors are usually disproportionately
rewarded in the trust sector, helped by the wide discounts created by
impatient investors.
Seeking value is also about comparing discounts and premiums relative to
performance. Sometimes, premiums are justified if performance is
consistently ahead of the peer group. A good example is Jupiter European
Opportunities Trust (JEO) which stands at a premium despite the sector
average, including smaller companies, standing at a 10 per cent discount.
This is justified given its vastly superior performance over the years. Wider
discounts may exist, but this is rarely an opportunity if these trusts’ relative
performance is poor by comparison.
However, it should always be remembered that the importance of discounts,
relative to performance, wanes with time. The quality of the product as
reflected in its good performance is what really matters over time. As with
life generally, quality will be remembered long after price is forgotten.
Discount considerations should no more than help to time long-term changes
in portfolios, and not short-term trading opportunities which will typically
raise costs and hit performance.
Speculating over the short term requires constant discount monitoring.
Getting the market direction right is also important. It is difficult to make
money if the NAV is heading in the wrong direction, regardless of
movements in the discount. But if the objective is long-term investment, then
performance considerations are paramount. Pick a good fund manager and,
within reason and over time, the discount matters much less – especially as
consistently good performance is rewarded with tighter discounts or even
premiums. It is wise to monitor changes in fund managers for this reason.
The risks of investment trusts
Opportunities and risks are usually travelling companions. Just as the fact
that discounts exist can present opportunities, they can also present dangers
to the unwary shareholder.
Discounts widen when the share price falls further behind the NAV, whether
in a rising or falling market. In a rising market, shareholders may feel no pain
at all because the share price will often go up even if the discount widens.
Where discounts can really hurt shareholders is when they widen in a falling
market – the NAV fall is magnified by the share price falling further.
And investment trust discounts do widen when markets are going through a
rough patch or are very volatile. This tends to be because investors can deal
in these trusts every minute the market is open – subject to the size of the
trust and hence its marketability. When investors get scared about markets,
they can and do sell the shares without knowing precisely how the underlying
portfolio is performing relative to the market fallout. By comparison, unit
trust prices – calculated just once a day – usually better reflect their NAV.
Meanwhile, those who determine the prices in these trusts – the market
makers – anticipate this wave of selling. They often mark down prices before
the selling materialises and/or limit marketability by reducing the number of
shares in which they are prepared to deal. This is perfectly legitimate, if
somewhat annoying for investors. The same happens to shares in other listed
companies.
It can all add up to be a bloody affair. But we should remember that these
market sell-offs also tend to be short-term affairs. Given the outperformance
of investment trust NAVs over the longer term, and their many other
advantages, it is no surprise that discounts on average have narrowed
somewhat in recent years. Recent developments, such as the change to paying
dividends out of capital and the introduction of the Retail Distribution
Review, may see this trend continue.
But even if such factors have little effect, it is the portfolio performance that
looks set to continue to dictate the level of discounts. And this is absolutely
logical and right – for investors should always focus on the long term.

Discount control mechanisms

The average discount across the sector at present is around 8 per cent, but
there are large variances between sectors and trusts. Furthermore, discounts
add a layer of volatility to share prices – these prices being influenced by
investor demand, sometimes irrespective of movements in the NAV, which
can therefore make for fluctuations in the discount. Accordingly, in recent
years there have been increasing efforts by investments trusts to reduce the
discounts and hence the volatility. The theory is that this should help to
reduce the risk factor for shareholders and so make the shares more attractive
to own, with prices reacting accordingly.
Often the investment trust will publicly make it known that it has a discount
control policy in place to limit the extent of the discount – the ‘discount
trigger’ – and give an indication as to its level. Trusts achieve this by buying
back their own shares in the market from existing shareholders using surplus
cash. These shares are then cancelled or retained and then re-issued at a
higher price if market conditions allow. Other public companies do likewise
as a way of enhancing returns, using cash that would otherwise lie relatively
dormant.
By reducing the number of shares, the trust is increasing the NAV per share
because the number of shares in the market has been reduced. Such a policy
also creates demand or at least clears an overhang of stock. Investors should
check whether a discount control mechanism is in place with existing or
potential holdings (see Table 3.1).
Table 3.1 Trusts with discount control policies
Investment trust Discount trigger (%)
Aberdeen All Asia 12.0
Aberdeen Asian Income 5.0
Aberdeen Latin American Income 5.0
Aberdeen New Thai 15.0
Baring Emerging Europe 12.0
BH Macro 5.0
Biotech Growth 6.0
BlackRock Latin American 13.5
Dunedin Smaller Companies 7.5
European Assets 5.0
F&C Commercial Property 5.0
F&C Global Smaller Companies 5.0
F&C Managed Portfolio Growth 5.0
F&C Managed Portfolio Income 5.0
F&C US Smaller Companies 10.0
Finsbury Growth & Income 5.0
Foreign & Colonial 10.0
Henderson Asian Growth 10.0
Henderson European Focus 3.5
Henderson EuroTrust 5.0
Henderson Global 8.0
Henderson Private Equity 5.0
Inv Perp Select Global Equity Income 4.0
Inv Perp Select UK Equity 4.0
JPMorgan Brazil 5.0
JPMorgan Emerging Markets 10.0
JPMorgan Emerging Growth 10.0
JPMorgan European Income 10.0
JPMorgan Overseas 5.0
JPMorgan Russian Securities 8.0
JPMorgan US Smaller Companies 10.0
Jupiter Primadona Growth 8.0
Martin Currie Global Portfolio 7.5
Midas Income & Growth 5.0
Miton Worldwide Growth 3.0
Personal Assets Trust 0.0
Schroder Oriental Income 5.0
Schroder UK Growth 5.0
Scottish Investment Trust 9.0
Securities Trust of Scotland 7.5
Standard Life UK Smaller Companies 5.0
Troy Income & Growth 0.0
Witan 10.0
Source: From St. George, R. (2012), ‘When the price isn’t right’, What
Investment.

The mechanism itself is simple. Trusts buy back their own shares in one of
two ways. The first is a simple purchase in the market. The trust benefits
from the discount by purchasing the shares cheaply. The second is a tender,
when the trust offers to buy shares slightly above the market price.
Shareholders benefit, whilst this policy allows the board of directors to
highlight its confidence in the trust to the market. Opinions differ as to which
method is best. BlackRock’s Greater Europe Trust extends a tender offer to
its shareholders every six months, offering to buy shares at 98 per cent of
NAV. This appears to have succeeded in keeping the discount very narrow.
Others prefer the open market buyback.
There is of course no guarantee that the discount trigger level will be attained
and held, for this is not an exact science and other factors such as market
conditions are at play. However, whichever method is chosen, the policy has
tended to work regardless of scale. Alliance Trust, the largest investment
trust, significantly reduced its discount in 2011 – in one 24-hour period from
28 per cent to 20 per cent – by buying back a record level of shares, because
of pressure from shareholders concerned by the wide discount. The trust now
trades at a 15 per cent discount.
However, one downside with discount control mechanisms is that they can
raise the TER. Buybacks reduce the number of shares in existence and
therefore the capital base of the fund, which means the fixed running costs
become proportionately higher. This is less of a problem for larger trusts than
it is for smaller ones. Indeed, the assets of small trusts have been known to
fall to such a level that the board has decided the TER is too great a burden,
and have therefore handed the assets back to shareholders.
There is no definitive guide, but I suggest trusts with assets of less than £50
million are approaching the level at which these considerations become
meaningful. The implication from this being that these trusts are unlikely to
instigate discount control mechanisms, and wide discounts lasting a long time
may be the consequence – something to consider if one is thinking of buying.
Another factor affecting buybacks is the level of liquidity within each trust.
Buying back shares draws on the trust’s cash and sometimes – because the
cupboard is bare – assets have to be sold to fund these purchases. This can be
a problem for a trust with illiquid assets such as property or private equity. So
these types of trusts tend not to have discount mechanisms in place, for fear
of becoming a forced seller of assets – never a good idea.
Finally, if a discount control policy is in place, the trust’s board needs to
decide whether it should establish a fixed policy, known as a ‘hard’ discount
control mechanism, or retain some flexibility. Opinions are divided. Foreign
& Colonial (F&C) Investment Trust operates the former whenever the
discount exceeds 10 per cent. Before this policy was adopted it had operated
a different one, but believes the present policy serves both shareholders and
the trust well. There can be little doubt that certainty benefits shareholders –
if only as to the timing of purchases should, for example, the discount for
F&C be wider than 10 per cent.
However, there are disadvantages with the ‘hard’ discount mechanism. Short-
term calculations relative to the discount threshold can drive demand, rather
than longer-term investment considerations. And it is usually the large
institutions that benefit from arbitraging the difference between NAVs and
discounts, rather than the private investor.
In conclusion, buybacks work well when used sensibly. A trust’s discount
relative to its sector average is a factor – defending a 10 per cent limit when
the average discount is double that, would be difficult to justify. But on
balance, the evidence suggests they work because they lessen discounts and
hence price volatility, help provide liquidity and reassure shareholders that a
backstop is in place.
Other pros and cons of investment trusts

The tendency of investment trusts to outperform both open-ended funds and

the benchmarks – a performance assisted by cheaper fees – is a powerful
reason for investors to favour them. The opportunity presented by
fluctuations in the discount is another, although the risks need to be
understood. But there are other pros and cons that you also need to
understand.

Investment trusts are better understood

Despite investment trusts being the earliest form of mutual fund, loved by a
small circle of investors both professional and private, they are neither well
known nor widely recommended by independent financial advisers (IFAs).
Historically, IFAs and some investors have viewed investment trusts with
suspicion, believing them to be more volatile and complex than their open-
ended cousins, and therefore more risky. This is of course partly true.
Discounts do increase the volatility of share prices, and the structure of trusts
is more complex. But this does not make trusts more risky.
In fact, the situation is quite the reverse. We have seen in previous chapters
how investment trusts perform better, assisted by cheaper fees. If you are
investing over the longer term, then the effects of volatility are neutralised
and there really is no better investment vehicle. Indeed, investors need to
remember that if volatility is a measure of risk, then in shunning volatility
they will always be underweight good opportunities. As an investor, you
should learn how to embrace it. Volatility can be exploited by investors to
help time their deals.
As to trusts’ so-called complexity, this is again overplayed. Trusts are no
more complex than any other quoted company such as Shell or Marks &
Spencer. Their structure is the same. They have a board of directors whose
members monitor how well the management is looking after the assets. This
management can take day-to-day operational decisions, such as buying or
selling assets and increasing borrowings, with the aim of enhancing
shareholder value. In many ways, this structure adds to their attraction.
What is needed is a better understanding of the merits of investment trusts –
both by advisers and investors alike.
This is where the Retail Distribution Review (RDR), which was enacted in
January 2013, may have a profound effect. As we know, the RDR has banned
trailing commissions from open-ended funds to IFAs: this should allow
investment trusts to compete on a more level playing field. But the Financial
Services Authority (FSA) has also made it clear in the RDR that investment
trusts should now be included in the full spectrum of retail investment
products considered by IFAs.
This is good news, because the better education of professional advisers can
only benefit investors. Both initiatives – related but separate – will help trusts
become better understood.
Whichever route investors now take to accessing markets, it should lead them
to trusts. If you employ an IFA or wealth manager, they will want the better
investment vehicles most suited to their objectives. In addition, the IFAs –
through better training because of the RDR – will be better able to help. If, on
the other hand, investors manage their own portfolios then, with the help of
the media and I hope books like this, their investigations should unearth the
treasure that is trusts.
Either way, investors will benefit – just as clients of City wealth managers
have for decades.

Gearing
Like other public companies, investment trusts are free to borrow subject to
any restrictions agreed with their board of directors. By contrast, open-ended
funds are restricted by regulations and so cannot. Borrowing can work both
ways of course. But a good trust that is geared will produce enhanced returns
when markets are rising.

Example
As an example, let’s assume that there are two trusts – A and B
 – each with £100 million under management (see Table 4.1). A
is positive about markets and so decides to borrow £30 million
and buys stocks with this money. B is less convinced and
doesn’t borrow. The market then rises 40 per cent over a
period of time. A then decides to pay back its borrowings by
selling some of its stock. Assuming A’s performance matches
the market, the portfolio will therefore be worth £152 million
(£130 million × 140 per cent = £182 million, minus £30 million
repayment of debt). B’s portfolio, on the other hand, will be
worth £140 million (£100 million × 140 per cent). Shareholders
in A’s trust benefit through an enhanced net asset value (NAV).

Table 4.1 Performance of two trusts (A and B) each with £100 million
under management (all figures in £ million)

In reality, investment trusts do not usually gear up by as much as 30 per cent,

but the example illustrates the point. Managers can gear their portfolios in a
variety of ways, but typically gearing is executed via fixed-term borrowings
that need to be redeemed by a certain point. Flexible borrowing has become
more common, such as short-term bank credit, in the low-interest
environment. But whichever method is chosen, increased borrowing can
enhance share price performance as it accentuates movements in the
underlying NAV. If the gearing has benefited the portfolio, borrowings can
then be repaid from the enhanced profits.
But of course it can work the opposite way. Just as gearing can magnify
profits on the way up, it can also magnify losses on the way down. And the
losses to NAV can of course be magnified further if share prices are hit by a
widening discount.
As an investor, you may be reassured to know that there are safeguards in
place. Managers cannot just borrow what they please. Restrictions as to the
extent of borrowing are stipulated by the independent board of directors and
confirmed by shareholders at the annual general meeting. Should managers
wish to borrow beyond the agreed limits then they have to seek permission –
and justify their requests. The board of directors will scrutinise proposals on
behalf of shareholders and make the appropriate recommendation to
shareholders. Meanwhile, they will be monitoring the manager’s use of the
existing debt facility.
But gearing can also be unhelpful in other ways. If an investment trust is
heavily geared, with various layers of debt, then this can make for
complexity, which can put investors off. Even analysts can sometimes
struggle to quantify how such debt can affect portfolio performance under
different market scenarios – particularly if the debt is multi-tiered and being
serviced at different interest rates.
An example of this is Ecofin Water & Power Opportunities Trust (ECWO).
This trust has a high and growing dividend yield of 5.5 per cent, a good
quality portfolio and invests in global utilities, which are considered
‘defensive’ or safe relative to other ‘more sexy’ sectors of the equity market.
And yet it still stands on a more than 20 per cent discount in 2013. But the
level of gearing and complex capital structure (see later chapters) is perceived
to have added a level of risk which shareholders need compensating for by
what appears to be a wide discount.
I say wide discount but debt, in effect, reduces the portfolio value and
therefore NAV. If markets go sideways and the portfolio stays static, then in
reality the portfolio is reduced in value by the value of that debt. The debt
only becomes a positive factor if the portfolio rises. Worse still, if the
percentage interest rate on that debt exceeds the percentage gain on the
portfolio, then a further negative factor is added to the mix. This negative
multiplies if the portfolio goes down in value.
All in all, you must be aware of the level of debt carried by investment trusts.
In the vast majority of cases, it is relatively benign. Those trusts which are
geared are usually by no more than say 10–15 per cent. However, a minority
well and truly exceed this and, the market being aware, can trade on what
appear wide discounts and therefore look cheap.
Always look under the bonnet. Most brokers’ lists or publications highlight
gearing, but you should not buy without knowing the facts and always keep
an eye on changes. Investment trusts do need a little more monitoring than
open-ended funds for this reason. We will touch upon gearing again when we
cover split-capital trusts in the next chapter.

Directors and shareholders

Like other public companies, investment trusts have an independent board of
directors whose brief is to represent shareholders’ interests. And these
directors have teeth. They can, for example, with shareholder approval, fire
an underperforming manager and move the trust to another fund management
house – something I have never heard of in the unit trust industry!
It is true to say that, in the past, investment trust boards have been accused of
having too close a relationship with their fund managers, or for being a bit
too sleepy. This has changed a lot in the past decade. The more professional
composition of boards has helped, and now the vast majority do a good job
on behalf of shareholders. And so they should because, being a listed
company, it is the shareholders who own the trust. The directors are there at
the shareholders’ behest, and their salaries are drawn from the assets of the
trust.
A related but separate bonus is the fact that, being a public company,
shareholders have significant powers. For a start, they can vote on issues such
as changes to investment policy and the appointment of directors. They can
turn up at shareholder meetings and ask awkward questions, typically about
remuneration and the introduction or alteration of performance-related fees. It
is, after all, their company.
This leads to a much more transparent environment – certainly more so when
compared to closed-ended funds. As such, the concept ‘survival of the fittest’
prevails and is certainly strongest in the investment trust sector. Because of
its much larger size, it is easier for lacklustre funds to survive in the open-
ended universe. Not so with investment trusts. Shareholder agitation, both
private but usually the larger institutions, will challenge investment trusts
where performance is mediocre or poor and/or discounts are consistently
wide. Trusts can be closed down or managements changed as a result.
This is what happened to the Eaglet Trust in 2008. This trust had suffered
from a consistently wide discount, which it had failed to narrow despite some
pressure from shareholders. So activist investors replaced the manager – it
then became known as the Directors’ Dealing Investment Trust. The
following year, the trust’s biggest shareholder then forced a second change
and replaced the manager with Midas.
The possibility of management change, proven over time, is in shareholders’
best interests. Investment trusts are on notice. Trusts need to do what they
reasonably can to enhance shareholder returns through good performance,
low fees, efficient use of gearing, and reduced discounts and volatility.

The long term and alternative assets

Because unit trusts and open-ended investment trusts (OEICs) are open-
ended and so portfolio size is affected by investors’ demand for their shares,
their managers have to buy and sell holdings as money flows in and out of the
portfolio. This may not always be the right investment decision. Some
investors sell their unit trust holdings after market falls, when in fact they
should be buying. The fund managers may also think so, but may be forced to
sell because they have no choice – redemptions have to be met. Conversely,
managers may have to buy holdings after a strong market run, against their
better judgement. This can hinder performance over time.
Investment trust managers do not suffer from this pressure. They buy and sell
when they – and not the investor – think the time is right. The structure of
investment trusts helps good fund managers make better investment
decisions. The structure makes it easier for managers to take a long-term
approach to the market, not influenced by short-term market fluctuations or
money flows which can encourage short-term decisions. This is a
contributory factor as to why trusts tend to outperform not only unit trusts,
but also the ‘mirror’ open-ended funds run by the same manager.
And because trust managers do not have to worry about meeting redemptions
and therefore can take longer-term decisions, the universe of investible assets
widens.
Less liquid assets such as very small companies, commercial property,
private equity and infrastructure projects – investments which by their very
nature can involve time horizons of several years – are better suited to the
structure of investment trusts. The managers running these portfolios are
better able to invest in such assets for the benefit of their shareholders,
knowing they can take a long-term view in line with their investments.
Of course, shareholders in these sorts of trusts are not locked in. They can
sell the shares when they like. Investment trusts therefore solve one of the
key problems for many alternative assets in that investors can buy or sell the
shares in the same way as any other listed share, and not have to wait for
lengthy lock-up periods to expire. For this reason, trusts have benefited both
these alternative assets and their investors alike.

Size and marketability

Investment trusts tend to be on average smaller than open-ended funds. I
believe this makes it easier for them to focus on their objectives because they
do not become too large and unwieldy. Trusts require shareholder approval if
they wish to grow beyond their initial remit. Many also have a fixed life,
which again requires shareholder approval to extend.
Conversely, the size of open-ended funds fluctuates with investor demand.
Large funds can work – big can be beautiful – because economies of scale
can kick in for the benefit of shareholders in the form of lower relative costs
and better buying power. But evidence suggests that open-ended funds find it
harder to replicate their past performance the larger they become, possibly
because the investment process loses its focus.
Some assets are best managed in smaller funds. The smaller company sector
is one example. Dealing in size is often not possible because such companies
are often illiquid or difficult to deal in a reasonable size. Large portfolios,
whether open- or closed-ended, would therefore typically need to have lots of
small holdings. This can make such portfolios more difficult to monitor.
When it comes to the marketability – the ability to deal in the market – of the
investment trust or the open-ended fund, two factors should be considered.

1. Being a publicly listed company, the shares of an investment trust can

usually be traded easily and frequently without restrictions. They can be
bought and sold every minute the market is open. This is not the case
with unit trusts where deals are placed the day before, usually by mid-
 day, in advance of knowing the next day’s price. A lot can happen in
that time, but the process cannot be rushed.
2. Unit trusts are usually easier to deal in size. Small investment trusts – as
with very small public companies generally – can be somewhat illiquid
and therefore difficult to deal.

But liquidity can mean different things to different people. The average
investor will have no trouble in dealing in the vast majority of investment
trusts. According to WINS Investment Trusts, when it comes to the nine
largest trusts with a market capitalisation exceeding £1 billion, the average
trading activity in a day is just under £2.5 million. Even the average trust sees
just over £300,000 of shares traded each day – more than enough for the
average investor.
Where problems may be encountered is when firms of wealth managers and
private client brokers trade investment trusts en bloc across a swathe of their
clients. Managers increasingly construct core lists of trust portfolios in order
to ensure consistency of performance and proper monitoring of holdings.
These lists will vary depending on such factors as the risk tolerance of the
client, the level of income required and the choice of base currency.
But the principle is the same – in the majority of cases, core lists are adhered
to once a client’s individual requirements have been identified and the
appropriate list assigned. The days have largely gone when fund managers
sitting next to each other could be trading in opposite directions. Things have
been tightened up. The process encourages research rigour and risk control,
and clients have benefited.
Once a trust is to be traded, it is usually in size and may take a number of
days to execute. The size can be a couple of million pounds. There are no
consistent guidelines but, as a rough rule of thumb, many wealth management
companies are unlikely to invest clients’ money in trusts with a market
capitalisation of much less than £50 million. Otherwise, liquidity can be a
problem. It is no surprise then that the larger investment trusts tend to feature
on these lists.
Some investment trusts help the situation by issuing more shares when
standing at a premium to NAV. The underlying portfolio increases in size
through the issuance of these extra shares, which are usually priced at a slight
reduction to the prevailing premium at the time. Short term this can have the
effect of lowering the premium as more shares hit the market and satisfy
investor demand. Longer term, such a policy should reduce running costs and
the total expense ratio (TER) as the costs of running this larger portfolio are
no different to before. This should benefit existing and new shareholders, if
only marginally.
But there are a few investment trusts which, because of their size (market
capitalisation), will usually present difficulties for the average investor. These
are the very small trusts with market capitalisations of usually less than £30
million to £40 million. Think about the difficulty in dealing before investing
– especially as this difficulty increases significantly in turbulent markets, just
when you may want to deal to get out!
Such smaller-sized trusts, particularly if rarely traded, can often have their
price moved by the smallest of trades. It is not always easy to buy or sell at
prices that suit you. But if you wish to deal in such a trust, then it is usually
best to leave the deal with your broker or online provider, having set a limit
order so you do not overpay. If you wish to deal in size, then holdings usually
have to be bought or sold over a number of deals and/or periods of time.
At this stage, we should also remember that some open-ended funds are also
difficult to deal. Restrictions can exist as to when in the week they can be
traded, and some can even close without notice to new money because of
size. Difficulty in dealing can exist for both open- and closed-ended funds,
and is a function of the market.

Dividends
One of the most attractive features of investment trusts is their ability to
retain up to 15% of dividends and income received from holdings in the
underlying portfolio, in any one year. This ‘surplus cash’ is called the
revenue reserve, and it is always worth checking the level of reserves
particularly if you are investing for income. For me, the best way of
quantifying it is by expressing it as a period over which the existing dividend
could be maintained if there were suddenly no dividends generated by the
portfolio. Advisers will say, for example, that reserves cover one year of
dividends.
Table 4.2 shows how revenue reserves tables are usually portrayed. The
second column of the table gives the annual cost of each trust’s total
dividend. The third column shows the total revenue reserves that have been
accumulated over the years for each trust. The final column shows the third
column divided by the second, and then expressed as a percentage: 100 per
cent denotes that the revenue reserves cover one year’s dividend. Such tables
are usually broken down by peer group, such as UK Income Growth.
Table 4.2 Revenue reserves

These reserves can be used to supplement future dividend payments. Money

is put aside in the good times. Such a strategy is helpful when economic
times are tough and the companies held in portfolios are having trouble
increasing their dividends. In such times, investment trusts – especially those
with a brief to produce a decent level of income – have increased their
dividends to their shareholders by drawing upon these reserves.
Some investment trusts have very proud histories when it comes to growing
dividends. The trusts with the longest records are highlighted in Table 4.3.
City of London, Alliance Trust and Bankers Investment Trust have all
increased dividends for 46 consecutive years – quite a record. But where
revenue reserves and records become particularly important is with those
trusts that strive to produce a decent income for their shareholders. Safety and
growth are key objectives.
Table 4.3 Dividend heroes
Number of consecutive years dividend
Investment trust
increased
City of London 46
Alliance Trust 46
Bankers Investment Trust 46
Caledonia Investments 45
Foreign & Colonial 42
F&C Global Smaller
42
Companies
Brunner 41
JPMorgan Claverhouse 40
What the table shows: the investment trusts that have increased their actual
dividend per share for the greatest number of years in a row. Trusts are all
from the AIC’s Global Growth sector except City of London and JPMorgan
Claverhouse (UK Growth).

Source: From What Investment, March 2013.

Another advantage with decent-yielding investment trusts is when they are

standing at a discount to NAV. The trust’s portfolio is producing an income
which the shareholder is getting at a discount. Let us say a portfolio is
yielding 10p a share, which is a yield of 5 per cent on a share price of 200p.
If the price were to drop to 160p, then the underlying portfolio would still be
producing the same level of income and so the yield becomes 6.25 per cent
(i.e. 10 divided by 160). The same is true of public companies generally,
except that investment trusts have a greater ability to grow dividends in hard
times if reserves permit.

Capital changes
New legislation effective from 6 April 2012 could enhance the dividend
attractions of investments trusts even further. Prior to this, they could only
pay dividends to the limit their revenue reserves allowed. Investment trusts
will now be allowed to dip into their capital – crystallising gains from the
underlying portfolio – in order to supplement their dividend-paying ability.
This could have a number of advantages. Those managers with an income
brief could become less constrained in their stock selection because they
would no longer have to rely so much on higher-yielding equities to meet
dividend targets. This would give them a greater freedom as to where to
invest. Using capital would also allow greater flexibility for trusts to pay out
a stable dividend for a long period of time – and ride out the ups and downs
of the economic cycle.
There is a good chance that raising dividends from capital could tighten
discounts. In 2011, this was the reason why the activist hedge fund Laxey
Partners wanted Alliance Trust to raise its dividends from its capital profits.
Higher dividends do tend to narrow if not eliminate discounts – particularly
in this low-interest environment. Laxey Partners argued that this would have
been a cheaper option for Alliance than share buybacks, and more effective.
It may have had a point.
If you look at the range of discounts across the various sectors, there is little
doubt that higher-yielding investment trusts are trading on tighter discounts
or premiums to NAV compared to lower-dividend payers. Of course, there
are exceptions. Lower-yielding trusts with excellent short-and long-term
investment records are highly sought, and this is reflected in tight or zero
discounts. I can think of Finsbury Growth & Income and Aberdeen Asian
Smaller Companies – neither are high yielders but both consistently close to
NAV.
Conversely, high-yielding trusts which have mediocre track records can stand
at discounts – although it is noticeable how few exist today. What is more, it
is interesting to note that higher-yielding investment trusts have tended to
trade on lower discounts over the longer term – this is not just a recent
phenomenon because of low interest rates. And this is despite the often better
total return performance from their lower-yielding peers.
This perhaps is understandable. There will be a greater demand for an income
trust. Those who require income are unlikely to go elsewhere and, as the
population ages, this demand will hardly abate. These investors will not tend
to look at low or zero dividend trusts. However, in circumstances where
income is not the priority, investors are likely to consider all trusts – income
or not. It is this group of investors who are rightly interested in achieving
good total returns – income and capital growth combined. And they do not
mind how this is achieved, whether by capital growth alone or a combination
of the two.
This legal change could have a profound impact on the sector.

Enhanced flexibility
In recent years, trusts have acquired greater flexibility when it comes to the
financial instruments available for use. This was largely because of the 2011
Finance Act that tidied up much investment trust legislation: for example, it
removed the need to seek approval to be an investment trust every year.
But the key changes concerned permitted investments. This included the
removal of the 15 per cent maximum holding limit – whereby single holdings
were not permitted to exceed 15 per cent of the total value of a portfolio’s
assets. Holdings can now exceed this level provided this is allowed by the
board of directors. Other changes include the creation of a ‘white list’ of
permissible investments within investment trusts and the expansion of the use
of derivatives.
The changes will particularly benefit trusts investing in the more exotic asset
classes. Most of the new launches during the past decade have been in
‘alternatives’, such as funds of funds and private hedge funds, and the
enhanced flexibility introduced by these rule changes has best suited these
types of trusts.
Useful investing miscellany

There are some other useful terms and factors that we should cover. Taken
together, they can help to inform and thereby increase the chances of getting
investment decisions right.

Directors’ and managers’ shareholdings

As with any public company, it is reassuring for investors to see that those
closest to the investment trust have a stake in the company. The larger the
stake the better: the interests of investors and those running the trust are more
closely aligned. So potential investors should look in the report and accounts,
where directors’ shareholdings are listed, and ascertain whether these
directors increased or decreased their stakes over the year.
The actions of fund managers – and not just their warm words – are also
worth noting when it comes to shareholdings. Most fund managers can talk a
convincing story about the merits of their particular trust – and regularly do
so when making presentations to existing and potential investors. Many are
well paid. Yet too few have a decent shareholding, or indeed any stake at all.
It is no coincidence that those trusts that do have fund managers with decent
stakes tend to perform well. For example, Alex Darwell has for some time
had a significant shareholding in the Jupiter European Opportunities
Investment Trust (JEO) which he runs together with its mirror unit trust. Both
have a phenomenal track record against both the benchmark and peers – but it
is the investment trust that shines the most.
Monitoring fund managers’ holdings can also give reassurance in other areas.
Sometimes fund managers change – it is the way of things. Some are
replaced because of poor performance. Some move on through their own
volition. When the latter happens it is worth keeping an eye on shareholdings.
It is also interesting to note whether positive noises from the fund manager
about future prospects, particularly if supported by higher gearing, is matched
by that manager or director adding to their holdings.
For example, I know of one investment trust where the report and accounts
state that the fund manager responsible for its excellent performance has
stood aside, whilst still running other funds on behalf of the group he founded
and built. The report reassures readers that this manager will still provide
‘guidance and strategic oversight’. What it could have highlighted better is
that the manager in question retains a £2 million stake in the trust – now that
is reassuring!

The report and accounts

I have mentioned the report and accounts a number of times, and investors
are recommended to obtain a copy of the trust’s accounts before dealing.
These can usually be printed from the trust’s website, but if hard copies are
required then the website will give contact details, and most companies
oblige promptly. There is the main annual report and accounts, but also an
update at the half-year stage. Most trusts also produce useful monthly
factsheets which are available from their websites.
These publications remind the investor of the benchmark and investment
objective and policy. The benchmark is usually a single index such as the
FTSE All-Share, but can be a combination of indices perhaps reflecting the
generalist nature of the trust. Murray International Trust (MYI), which is a
holding in my Income portfolio, has a composite index made up of 40 per
cent of the FTSE World UK index and 60 per cent of the FTSE World ex-UK
index. Being benchmark aware is important, particularly when comparing the
performances of different trusts. There is little point in comparing trusts’
performance if they have different benchmarks.
The performance and investment highlights are also covered, together with
other useful information such as the level of discount over the year and the
extent of any share buybacks. The chairman’s statement comments on such
things as investment performance, dividend payments, any board changes and
share buybacks. Typically, the statement will take a general view by putting
into context the portfolio’s performance relative to the bigger economic and
market picture – usually worth a read.
The fund managers’ report is also worth reading. This covers the portfolio’s
performance in some detail. It will usually describe how the past year (or half
year) has unfolded, the rationale behind portfolio changes, and the
contribution to performance from different sections of the portfolio. A list of
best and worst performers is included, as is a complete list of the portfolio’s
holdings and also usually a paragraph or two about the top 10 or 20 holdings.
Pie charts will detail portfolio breakdown by sector, geography (if there is an
overseas component) and sometimes by market capitalisation. The reader is
left in no doubt as to the portfolio’s recent history and present state.
However, the future is more important than the past. The manager’s report
will usually look forward and give the reader a useful insight into future
strategy and outlook – something which is not usually well covered in the
monthly factsheets. It will focus on how the portfolio is positioned relative to
the manager’s assessment of the economic situation. This is the most
interesting part of the report, particularly when the manager in question has a
good track record. It will also indicate the extent of any changes to the
gearing of the trust. Adding to gearing usually reflects a positive outlook, and
vice versa.
The report and accounts will also detail information about the directors, their
remuneration, shareholdings, board attendance record and any changes. The
trust after all belongs to its shareholders. There is then the directors’ report
and financial statements which will hopefully prove that the accountants
believe the books balance. Bringing up the rear is usually a glossary of terms,
corporate information and general shareholder information including contact
details.

Doing the splits

Split capital investment trusts (splits) are like ordinary trusts in that they have
a portfolio of investments which are managed on behalf of shareholders.
However, splits issue more than one class of equity share – unlike
conventional trusts which issue just the one. These different shares have
different pre-determined entitlements to the capital and income returns of the
portfolio. At least one component will have a fixed wind-up date – if not all.
This sounds complex, but is not. A normal investment trust will have equal
ranking shares with the same entitlement to capital growth (or loss) plus any
dividends along the way. In its simplest form, a split will have two types of
share. An income share will entitle the shareholder to all the dividends
generated by the underlying portfolio during its life, plus perhaps a
predetermined capital value as well on wind-up. A capital share will entitle
access to the remaining capital value of the portfolio upon wind-up, once any
income share entitlements to capital value have been honoured.
This allows shareholders with different priorities to pursue different strategies
from the same portfolio. Elderly investors might appreciate the income,
whilst younger investors may favour the capital shares. There is a
predetermined order of entitlement to the portfolio both during its life and at
wind-up, which should also take into account other prior charges such as
loans.
There is typically a third type of share called a zero-dividend preference share
(a zero for short). As the name implies, no dividends are paid but the share is
worth a certain predetermined value at wind-up if the portfolio has enough
assets to sustain the entitlement. For example, you buy a zero at 70p and
when the trust is wound-up in four years’ time it will be worth 100p provided
there are sufficient assets. No income is paid along the way. Meanwhile, like
all share classes, it can be traded in the markets.
Being a fixed return, the attractions of such a return will vary according to the
outlook for interest rates. If interest rates look set to shoot upwards, then the
relative attractions of holding the zero look far less, and vice versa. The fact it
has a fixed return also distinguishes it from the capital share, which will
normally have entitlement to the remaining capital – whatever that may be –
once the zero and income shares have been satisfied upon wind-up. The
predetermined order of entitlement at wind-up is therefore zeros, income and
then capital shares.
Let me give you a real example of a split that will better illustrate the aspects
of these different shares.

Example
The M&G High Income Investment Trust runs a portfolio
consisting mostly of UK equities with a small balance in
corporate bonds. Overall, the portfolio’s yield is around 3.8%
at the time of writing. The fund manager has beaten the UK
FTSE All-Share index since inception. The trust is due to wind
 up on 17 March 2017 and its present NAV per share is around
150p.
There are three classes of share – zeros, income and capital.
The share capital of the trust was split into three equal
numbers of shares, equating to 250 million shares each.
The holders of the zeros are entitled to the first 122.83224p per
share upon wind-up, or lesser sum as remains, of the final
assets of the trust (see Figure 5.1). They are first in the queue
for the assets that are available on wind-up. At the time of
writing, they can be bought for 98p. This represents an annual
return of around 5 per cent over the next four years, which, if
held in an ISA or crystallised within your capital gains tax
(CGT) exemption, would be tax-free as these shares represent a
capital return. You would need to keep an eye on portfolio
performance: the zeros are well covered at the moment (NAV is
150p), but a market setback of 15–20 per cent would change the
risk profile. However, on balance they would appear to
represent good value assuming interest rates remain low for the
next few years.

Figure 5.1 The various entitlements of the three classes of share of

the M&G High Income Investment Trust
Meanwhile, the income shares (MGHi) are entitled to the next
70p per share subject to the prior entitlement of the zeros. With
the number of shares being equally split three ways, all the
dividends paid are channelled into just a third of the shares,
which means the running yield of these income shares is around
11%. This is attractive but remember the present NAV is
 around 150p, and so their present ‘capital’ worth is 27p (150p
NAV – 122.83p zero entitlement). The income shares are
presently priced at 47p. Given the running yield, I consider
these attractive despite the projected capital loss – something
which could change if markets advance – which is why my
Investors Chronicle Income portfolio holds them.
Finally, capital shareholders will be paid the balance of net
assets on wind-up after the prior zero and income entitlements
have been met in full. By their very nature, these are the
riskiest of the three shares: no investor knows how well the
portfolio and markets will perform up to 2017. They are
entitled to all assets exceeding 193p (122.83p zero entitlement +
70p income entitlement) – 43p ahead of where the NAV
presently stands. If markets do well, they could be a good
investment with a price today of 4p.

In short, splits are complex and require continual monitoring. I have

introduced them here so readers can get a flavour and ask the right questions
when necessary. Investors need to fully understand the capital structure, the
order of entitlements and the underlying portfolio before investing. I suggest
you seek professional advice, unless you fully understand the various factors
at play.

ETFs and trackers

You may have heard a lot about exchange-traded funds or ETFs. They are
simply collective investment funds (like investment or unit trusts) that aim to
track or mirror the performance of a particular market – whether it is a sector,
entire equity or bond index, commodity or currency. They are listed on a
stock exchange and are open-ended like unit trusts and OEICs and so
investors can buy or redeem units.
One of the key attractions of EFTs is that they charge low fees. Being a
tracker or ‘passive’ fund there is no expensive fund management team trying
to beat the market – to be ‘active’ managers. This saving is passed on to
shareholders. Most ETFs have a total expense ratio (TER) well below 1 per
cent and sometimes as low as 0.2 per cent for bond funds. As highlighted in
previous chapters, this compares with an average TER of 1.6 per cent for
actively managed unit trusts, and this does not include the ‘hidden’ costs of
dealing which can often push the real expense ratio towards 2.5 per cent and
more.
ETFs have proved to be an attractive proposition for essentially two reasons.
The first is that investors are becoming increasingly aware that most active
managers underperform. Various studies show that as much 90 per cent of
such managers have failed to beat their index over three years. So why pay up
for such service? Why not just track the market with a low-cost ETF that
does what it says?
The second reason is that in this low-growth environment where equity
markets are expected to make pedestrian progress at best, cost-effective
investing becomes more attractive. Previous chapters have illustrated the
extent to which higher fees can eat into performance over the longer term. So
again, why pay up – particularly when more and more ETFs are coming to
market offering even more choice to investors?
I happen to disagree with both propositions. Particularly when it comes to
investment trusts, there is no shortage of good, active, fund managers who
outperform their benchmarks. Certainly enough to justify the construction of
an investment trust portfolio – but I would say that wouldn’t I! There is then
the issue of tracking itself. Because of the fees charged, low though they may
be, and tracking error which usually proves a negative, by their very nature
ETFs will underperform the markets they promise to mirror. It is a fact of
life.
However, my considerations aside, I can understand why ETFs have grown
enormously in popularity. They were first introduced in the US in 1993 and
have been around in Europe for over 12 years. But they have enjoyed
exponential growth and this will continue. A 2011 survey from Charles
Schwab1 suggested that nearly half of their investors were planning to
increase their ETF holdings.
Figure 5.2 European ETF asset growth
Source: From Barnes, D. (2011), ‘Synthetic appeal’, Securities and
Investment Review, October.

Lower fees to one side, ETFs have a number of other attractions. They do not
usually trade at wide discounts to NAV as investment trusts can. ETFs give
investors quick access to a market in one trade, and allow smaller investors
easier access to hitherto forbidden investments such as gold and oil – assets
that are less correlated to mainstream securities such as shares and bonds.
ETFs also cover a wider range of assets compared to the few unit trust
trackers that exist, including those less liquid ones. It is interesting to note
that when some corporate bond markets froze in 2008–09, credit bond ETFs
by and large kept trading. Furthermore, ETFs can be traded at will whereas
other trackers can only be traded once a day and are more expensive.
For a combination of these advantages, I do have a few ETFs in both my
Investors Chronicle investment trust portfolios. Typically they are there to
gain exposure to bond markets, for this is an area not well covered by
investment trusts. I also use ETFs when it comes to boosting income from
emerging markets and when wanting to gain exposure to the gold price.
Again, areas not well covered or not covered at all. All these EFTs have
contributed to performance.
But investors should also be aware of the risks and other characteristics of
ETFs before investing. ETFs can be divided into physical and swap-based or
‘synthetic’. Physical ETFs own at least a selection of the assets in the index
they are tracking – a FTSE 100 ETF will physically own some if not all of
the individual companies. By comparison, a synthetic ETF relies on a third-
party investment bank to provide the index return via an index swap contract
with that bank, which is designed to duplicate the performance of the index in
question.
Investors in synthetic ETFs must therefore be aware that there is always a
third party solvency risk, no matter how small. If that third party were to fail
and go bust, then there is every chance you would not get back much of your
money. In Europe, counterparty risk is limited to 10%, which is therefore the
maximum an investor would lose.
But there is also a counterparty risk for holders of physical ETFs when these
ETFs lend stocks to a third party – they may not, in extreme cases, be able to
get them back. However, we should remember that actively managed funds
such as unit trusts also engage in stock lending.
Figure 5.3 How do synthetic ETFs work?
Source: From Ross, A. (2011), ‘Understanding ETF risks, investors warned’,
The Financial Times, 24–25 September © The Financial Times Limited. All
rights reserved.

I have touched on an ETF’s tracking error earlier, but it is worthy of note.

Rarely does an ETF exactly duplicate its index. This can happen for a number
of reasons, but common among them is the fact that an ETF often only buys a
sample of the index rather than all of its components. This happens more in
smaller company markets when it is difficult to hold all stocks in what can be
illiquid markets. Tracking errors rarely favour the investor and, when added
to the ETF’s charges, result in a performance marginally lagging behind the
index in question.
But even tracking a mainstream index such as the FTSE 100, different ETF
providers can have quite different tracking errors. Looking at the tracking
difference between providers over two years, the figure varies from around
0.5 per cent behind the index through to 2.0 per cent behind the index. As we
have seen in earlier chapters, these ‘small’ figures become large ones over
time. Typically, the ETF’s TER can account for around half the figure. So
investors beware! In fairness to the ETF industry, serious attempts are being
made to reduce these tracking errors – a challenge given added impetus by
their ever-increasing popularity.
Finally, you should also be aware that some leveraged ETFs borrow money
to amplify returns, and some aim to provide the inverse daily performance of
the index. Complicated stuff, so investors should seek advice.

Portfolio turnover
Investors should be aware of the extent to which their fund managers are
‘turning over’ the underlying portfolio. The former, and much maligned, US
president Ronald Reagan was once reputed to have said: ‘Don’t just stand
there, do nothing.’ It is sound advice for investors and fund managers alike.
A study by FE Trustnet in 20112 revealed that fund managers with a high
portfolio turnover underperform those who do not change their holdings as
frequently. The research group compared performance between the 10 per
cent of unit trusts with the highest and lowest turnover over one year. To
confirm the robustness of their findings, they sampled across three fund
styles – balanced managed, actively managed, and cautiously balanced. It is
no surprise that, on average, returns were 0.8 per cent lower per year for
those 10 per cent of funds with the highest turnover. Investors will be aware
of the extent to which this small figure can have a detrimental effect on
portfolio performance over the years.
The reason is easy to understand. High turnover results in high dealing costs,
which of course eat into performance returns. And these dealing costs are not
transparent – in many respects they are hidden. Dealing costs, including
brokerage fees and stamp duty, are not included in the various measures
gauging expense ratios, including the TER. Yet given that each trade can cost
around 1 per cent, they can have a significant impact on total costs. Some
estimates suggest excessive turnover can add as much as 0.8–0.9 per cent to
the TER – which ostensibly comes in at only 1.6 per cent. Such figures tally
with FE Trustnet’s findings.
The worrying development for investors is that turnover is on the increase.
FE Trustnet has pointed out that the average period for holding a stock is
around nine months, whereas 50 years ago it was around eight years. Part of
the reason is a short-term culture among fund managers encouraged by an
institutional adherence to benchmarks and a remuneration policy to match –
something we will cover in future chapters. But it also has to be said that
some investors are partly to blame: their short-term focus also encourages
fund managers to deliver positive returns and news in the short term.
This is where investment trusts have an advantage. These managers do not
have to worry about money flows. Because investors trade the shares, which
does not impact on money flowing in and out of the underlying portfolio, the
manager has the luxury of taking a long-term approach to investing. As such,
dealing costs tend to be lower.
As if to highlight this point, it is interesting to note that a disproportionate
number of the trust managers who have excellent long-term track records do
tend to keep dealing to a minimum. This is not a coincidence. Nick Train
runs one of the trusts in my Growth portfolio called Finsbury Growth &
Income (FGT). It has performed superbly over the years. Part of his
investment philosophy is to hold shares for the long-term regardless of short-
term volatility, with the aim of doubling their value and more. This makes for
extremely low portfolio turnover and dealing costs, so helping performance.
Indeed, because it is not easy for investors to track the impact of dealing costs
on performance – little data are published – choosing fund managers with a
‘long-term’ investing style is a sound approach. Another such manager is the
well-respected Neil Woodford at Invesco Perpetual. He has an average
holding period of five years, which has served both him and investors well in
the past.

Different investment styles

Finally, allied to fund managers’ varied approach to portfolio turnover,
investors also should be aware that there are a number of different investment
styles used by different managers. This is important to understand if only
because a portfolio slanted towards one particular style may be taking on
more risk than was generally assumed. The fund’s website will usually give
an indication, and the report and accounts certainly will.
But recognising different styles also helps in other respects. It assists in
understanding why certain investments do better than others when there is a
change in stock market direction or leadership, for ‘seeing through’ fund
managers’ poor performance over the short term, and for monitoring progress
towards achieving investment objectives.
It is worth remembering from earlier chapters that most ‘active’ fund
managers underperform the market. Chapter 2 highlighted that in the majority
of investment sectors the average actively managed unit trust has
underperformed its benchmark index over the past 10 years – sometimes by a
wide margin.
Indeed, in every sector there were periods lasting some years when the index
beat the sector average. Investors would have done better in cheaper passive
funds such as ETFs. However, the research also rightly confirmed that some
active managers do consistently outperform. The challenge is to identify
them.
Having done so, it is wise to understand investment styles. If an investor is
seeking a decent and growing income then typically they will be drawn to a
portfolio consisting of good quality blue-chip companies. Many will be
considered ‘defensive’ in that they are able to grow earnings, and hence
dividends, better than most through the various economic cycles. Such
sectors include pharmaceuticals, utilities and household goods. These sectors
typically do well when economic growth is sluggish.
This is less the case when economic growth is picking up, for here more
‘cyclical’ companies – usually yielding less – are deemed to benefit better
from the healthier economic climate. Sectors include banking, construction,
technology and smaller companies in general.
Meanwhile, some fund managers and trusts can be categorised as having a
‘value’ or ‘growth’ bias. Value managers will typically be looking to invest
in undervalued companies in a recovery or turnaround phase, and which may
be standing at a significant discount to assets if broken up and sold. A growth
manager will focus on those companies that consistently generate above-
average earnings growth, and perhaps are cheap relative to the market given
the extent of growth. Again, the prospects for both types of companies will be
influenced by the prevailing economic cycle.
Appreciating the investment style of the manager can help investors see
through difficult periods. If a manager sticks with one particular style but is
not performing well relative to the market in the short term, it could be
because of the economic cycle. This does not make him or her a bad
manager: it may simply be because the individual’s investment style is out of
favour. This raises once again the importance of looking at longer-term
performance.
The legendary investor Anthony Bolton is a good case in point. His track
record when running the Fidelity UK Special Situations fund was superb – it
was beyond comparison. However, he then agreed to come out of a brief
retirement to run the freshly launched Fidelity China Special Situations
investment trust just months before the Chinese market crashed in 2011. The
NAV collapsed 32 per cent during the year, well beyond the benchmark fall
of 17 per cent. But the underperformance was not because Bolton had
suddenly become a bad manager, but rather because his ‘value’ style of
investing meant he was more exposed during the downturn. I would hope for
better performance as the economy recovers.
The well-respected Neil Woodford is another example. He very much
believes in investing in blue-chip companies with predictable earnings and
good dividends – the ‘defensives’ which usually do well in a tough economic
environment. But these types of companies do not do so well when there is a
strong economic recovery. Accordingly, there have been periods – sometimes
lasting a few years – when he has trailed the market. But he has stuck to his
guns, and come through.
Understanding the investment style of your fund manager is therefore
crucially important. Do not be eased out of a good fund through ignorance.
But it is also important to ensure your fund managers are indeed sticking to
their guns, and not being whip-lashed by markets. Be wary of managers who
chop and change their style, perhaps trying to keep up with markets, unless
they have a proven track record. You should always be careful of labelling
managers too easily, but such factors need to be considered when investing.
I will finish this chapter by mentioning momentum investing. This is when
shares that have already been performing well are bought, and when poor
performing shares are sold.
A recent report by Credit Suisse and the London Business School (LBS)3
suggests that the momentum approach would have produced much higher
long-term returns than passive or index-tracking, value investing or smaller
companies. Figures show that, since 1900, buying the previous year’s top
performing shares would have produced annualised returns of 14.3 per cent
in the UK – compared to just 9.5 per cent for the market. Similar results
occurred in most of the other developed markets.
The success of this approach is possibly explained by share prices taking time
to reflect new information. However, this winning strategy can produce
volatile results and has been known to disappoint when markets suddenly
change direction. In 2009, when markets bounced strongly following the
credit crisis, momentum investing would have missed the start of the
recovery and missed those shares, such as banks, which had been falling but
then bounced the most.
Once again it shows, and it deserves repeating, that investment styles do not
necessarily work every year and can, indeed, be out of fashion for many
years. But what the track record of momentum investing also seems to
confirm is the old adage that, if change is thought necessary or cash needed,
it is usually better to sell your losers and stick with the winners.
Deciding investment objectives

In earlier chapters we looked at investment trusts in some detail and

compared them to their competition. The conclusion has been positive: they
are a better investment vehicle for the long-term investor. We have also
looked at other factors that should be considered, including the different
investment styles of fund managers.
But, as an investor, how do you put this theory into practice? Whether
monitoring how others run your portfolio, or doing it yourself, how should a
portfolio be constructed and managed? These questions will be answered in
the next three chapters. But first, the starting point in any investment journey
is deciding your investment objectives.

Saving and investing

The very first question to ask is whether you should be investing in the
market at all, because there is a difference between saving and investing.
Most people are saving for something – whether it is a car, kitchen or
holiday. These are short-term objectives and the answer is to put cash aside in
a building society or bank until the target has been reached. Certainty counts
for a lot.
Other short-term objectives for your cash should be to provide sufficient life
insurance for any children and other dependants, the establishment and
maintenance of a will if sufficient assets justify this, and the elimination of
any costly debt such as credit cards or loans. I would also suggest surplus
cash be used to put any mortgages on a capital repayment basis.
That said, most people will also be planning for the longer term. Such plans
could be for the children’s education, retirement or some long-promised
special treat. This takes more thought. Because of the timescale involved you
need to be aware of the effects or ravages of inflation. Assuming inflation at
2 per cent, £10,000 today will be worth just £8,000 in 10 years’ time. As it
happens, inflation is higher at the moment and some believe it could rise
further.
This means that, in order to finance your long-term plans, you need to invest
your money in something that will grow faster than it would in a bank
account. Some people choose any number of assets, for example property,
gold, art and wine. But these usually require expertise if not decent deposits.
For most people, particularly those starting with relatively modest sums, the
answer is the stock market.

Risk tolerances: time and volatility

However, like other assets such as property and gold, investing in bonds and
equities involves taking on risk. Prices can fall, and sometimes dramatically.
You can lose some or all of your money depending on the nature of your
investments. So your starting point is to gauge your risk tolerances – to know
how comfortable you feel when investing in the stock market even when your
portfolio is falling in price.
Generally speaking, high returns mean high risk. There are no free lunches.
The greater the potential for return, the greater the chance of suffering a loss.
If it were any other way, then more investors would be focused on riskier
investments and doing very well. But it does not work like that. The stock
market mirrors life generally – the riskier activities involve more potential
downside!
And this is particularly the case for equities. Government or corporate debt –
known as bonds – tends to be less risky than equities because performance is
less dependent on the company’s short-term profits. Debt interest tends to get
paid regardless of short-term swings in profitability. However, at the
extremes, this rule can break down. High-risk debt can eclipse solid blue-chip
equities when it comes to losses – as holders of Greek government bonds
have recently discovered. But as a general rule, bonds are ‘safer’ – they are
less volatile and less risky.
So, with this in mind, what factors should influence your risk tolerances? The
greatest risk, apart from perhaps the opportunity cost of investing, is that of
losing money. I suggest the two key factors are your time horizons and the
extent to which you can tolerate volatility in the value of your investments.
Time horizons
You should only invest in the stock market if you have a decent time horizon.
All the evidence shows that equities, with dividends re-invested, perform
better than bonds or cash in a bank over the longer term. Figures produced in
the annual Credit Suisse Global Investment Returns Yearbook are revealing.
Looking back since 1900, global equities have returned an annual 5 per cent
after inflation, compared to 1.8 per cent for bonds and 0.9 per cent for cash.
In the UK, the respective figures are 5.2 per cent, 1.5 per cent and 0.9 per
cent.1
Logic dictates that good companies should be growing profits faster than
prevailing interest rates. Otherwise, what is the point of being in business:
entrepreneurs might just as well put their money in the bank and avoid risk?
Shareholders in such companies should benefit accordingly, but the path is
rarely a smooth one. Equity investors can suffer poor decades. Factors such
as economic cycles, management decisions and often luck ensure share prices
fluctuate more in value than cash earning interest in the bank and provide
lacklustre returns. Therefore, the longer an investor can remain invested the
better. Financial advisers vary in detailing what ‘longer term’ actually means,
but I suggest a minimum of five to ten years is required when it comes to
equities.
There used to be a very approximate guide that the percentage of bonds in a
portfolio should reflect the investor’s age – for example, 30 per cent if aged
30 and so on. This reflected the view that as an investor got older and time
horizons shorter, they would want to reduce the risk of the portfolio by
investing in bonds. This would particularly be the case as you came closer to
meeting the funding objective, in order to reduce the risk of a short-term fall
in the portfolio’s value scuppering the looming requirement.
Volatility
The second factor affecting your risk appetite will be how sensitive you are to
market volatility. If the thought of a significant drop in the value of your
investments – even if only over the short term – worries you then perhaps
you need to reduce your investment risk. There is little point in owning an
investment portfolio if it keeps you up at night – it is not good for your
health. The money would be better placed in a bank or spent on making
people happy.
Reducing investment risk can essentially be done in two ways. You can
reduce the risk profile within the portfolio by increasing the proportion of
bonds and cash relative to equities. Or you can reduce the size of the portfolio
itself and put the cash in the bank. But this of course then increases another
risk, and that is not being able to fund your longer term goals because money
is lacking. There is always an opportunity cost to investing. If your money is
placed in low-risk, low-return assets then you risk missing higher returns
generated elsewhere. You also risk inflation eroding your wealth over time.
Finally, whether monitoring your financial adviser or running your own
portfolio, it is important that regular checks are made to ensure that the risk
profiles of both client and portfolio are aligned. In 2011, the Financial
Services Authority (FSA) conducted a regulatory investigation into 16 wealth
managers. It found that the majority had failed to match the level of risk with
the objectives or circumstances of the investor.
Further research by the FT into wealth managers found many balanced
portfolios held significant levels of equities – at one firm, 83 per cent of
client money in a ‘balanced’ portfolio was invested in shares.2 Poor record
keeping was thought to be the cause, rather than mis-selling. But the episode
does illustrate the need to check that risk profiles match.

Currency considerations
Most UK investors will think in sterling because their assets and liabilities
are based in the UK. Accordingly, they tend to have the majority of their
portfolio invested in the UK. But some investors may have assets or liabilities
based abroad, and may consequently want to hedge their currency risk – so
not to lose money because of currency swings – by having portfolio exposure
in that particular country or currency.
This can be done by investing in equities, bonds or indeed cash denominated
accordingly in the chosen currency, or by investing in funds specialising in
the country where the currency exposure is not hedged. Such considerations
can often influence investment weightings within a portfolio.
But investors may also think other currencies are attractive as an investment
in their own right, and want to benefit accordingly within their portfolios. As
such, it is always worth investigating whether an investment trust is hedged
or not – because this can have a big impact on portfolio returns.
If un-hedged then, regardless of how well the underlying portfolio performs
relative to its own index or stock market, its total value will be influenced by
swings in the local currency relative to the pound. A 10 per cent gain in the
portfolio will be lost if the local currency weakens by more than 10 per cent
against the pound. But it can also work the other way. A local currency, in
whose market a portfolio is invested, which strengthens against the pound
can enhance the returns gained from that portfolio.
By contrast, a hedged portfolio is, by and large, not influenced by currency
moves because the fund manager has ‘pegged’ the local currency to sterling
via the derivatives market. Swings in the portfolio’s currency will not affect
the total value when it is transferred back into sterling. In one respect, this
reduces risk, for currencies are notoriously difficult to predict, particularly in
the short term.
The key reason for this is that politicians, including the central bankers
appointed by them, are an additional factor – over and above economics –
that can disproportionately influence matters. And politics can add an
unpredictable mix to the economic equation. For example, if economics was
left to prevail, the euro would have fractured by now – with countries like
Greece having defaulted and left the single currency. But the single currency
has a political dimension – that of ‘ever closer political union’, as described
in the Treaty of Rome. Therefore, economics takes a back seat to a very large
extent.
I prefer to look at the longer-term factors that influence currencies, and which
usually prove the more powerful. Strong currencies are typically the hallmark
of countries with strong finances, a positive balance of trade and sound
politics: one reason being that these countries do not usually have to buy
other currencies, and therefore sell their own, to fund debt or trade deficits.
Whatever the meddling of politicians or central bankers, the realities of the
market usually prevail.
It is no coincidence that a number of Asian countries enjoy strong currencies
compared with their more indebted counterparts in the West. Investors can
benefit accordingly by gaining exposure to these currencies, simply by
holding their bonds and equities – through funds or individual holdings –
ensuring, of course, that their exposure is un-hedged.
It should also be recognised that currency movements can influence stock
markets. For example, falls in sterling have usually been good for the UK
market. Since 1990 there have been 64 months in which both the pound fell
by more than 1 per cent and the FTSE All-Share index rose by an average of
1 per cent. To illustrate that the correlation holds good in all weathers, there
have also been 79 months in which the pound rose by more than 1 per cent
and the markets fell by an average of 0.6 per cent.
This relationship exists because around 60 per cent of the stock market’s
earnings are derived from overseas – a falling pound will typically increase
the value of overseas earnings. Furthermore, a weaker pound should also help
exporters as goods manufactured will be cheaper, and therefore more
competitive. Both consequences should boost shares. But whatever the
reason, the anticipated direction of sterling may be a factor in determining a
UK investor’s investment objectives.

Income requirements
Another factor to consider when clarifying your investment objectives is your
income requirement. You may be investing in the market because income is
important to you and it is difficult finding it elsewhere. Certainly at the
moment, with interest rates low and set to remain so, the stock market offers
some attractive alternative ways of generating income through mostly bonds
and cash. Good corporate bonds and decent yielding blue-chips are certainly
in demand by investors.
You may be seeking a growing income in which case good-quality equities
should very much feature in your portfolios. As companies grow and prosper,
many reward their shareholders with increased dividends. Many companies,
including numerous investment trusts, have excellent longer-term track
records in growing their dividends – helped by healthy revenue reserves built
up over many years. This can be important to investors who have income
requirements, and ones that are growing. This is typically the case with
elderly investors who have health and care costs or who may wish to help
with the costs of grandchildren.
Because interest rates have been so low and look set to remain so for the
foreseeable future, good-yielding and decent-quality investment trusts are
typically standing at a premium to net assset value (NAV) at the moment.
This is not just confined to blue-chip equities but also those trusts that invest
in corporate bonds, property, smaller companies, infrastructure etc. –
anything that offers a high and sustainable yield.
Investors need to be careful. One of the attractions of trusts is the discount –
the idea that you are buying assets at a discount. By paying a premium, it
could be argued you are overpaying. And when market shocks come along or
sector leadership changes, then a widening discount can compound the loss.
But it remains the case that a quality portfolio of trusts can be created which
yields well in excess of what banks can offer – and this portfolio would hope
to grow dividends over time.
One final thought. It used to be the case that if an investor wanted equity
income, then the UK market was where it was found. Overseas equities
yielded less in comparison. Income-hungry portfolios would therefore be
biased towards the UK. However, this is changing.
For a variety of reasons, more and more overseas companies are becoming
dividend payers with a particular emphasis on the Far East and emerging
markets generally. Indeed, companies in emerging markets now pay over 40
per cent of the world’s equity income. This relatively recent development has
important consequences when it comes to asset allocation – investors should
take note.

Choosing a benchmark
Having identified your risk tolerances, you can create a portfolio. But how do
you know whether the investments chosen to reflect these tolerances are
performing well relative to other possible investments? After all, there are
usually a range of investments available that could have been chosen to
reflect your risk profile. Markets may well swing around, but as an investor
you should at least have an indication as to whether these investments have
been well chosen. The wiser the choice, the faster you reach those longer-
term goals.
This is where benchmarks come in. They are a method of measuring how
well the chosen investments are performing once a portfolio has been
constructed. The benchmark should reflect the portfolio’s objectives and risk
profile, to ensure we are comparing apples with apples. But there is a big
debate as to what benchmarks to use, and just how relevant they are.
For those investors who simply want a real or absolute return, such as
inflation + 1 per cent, or cash + 2 per cent, then the benchmark is
straightforward. Risk is therefore minimised, but not eliminated. But for
those who want superior returns over the longer term, and are willing to take
on a commensurate level of risk, then the issue of benchmarks becomes more
important.
When the live portfolios were created for my Investors Chronicle column, I
chose the Growth and Income indices of the Association of Private Client
Investment Managers and Stockbrokers (APCIMS) as the benchmarks to
objectively measure how well the portfolios were performing. Performance
relative to these benchmarks is updated each month.
These benchmarks are widely recognised. One of their attractions is that the
different components of each benchmark are made up of the actual indices –
the relevant markets – as illustrated by Figure 6.1. Occasionally, the asset
allocations are changed in response to quarterly surveys to ensure the
benchmarks continue to reflect investors’ requirements.
Figure 6.1 FTSE APCIMS Private Investor Index Series Asset Allocation
But such benchmarks will not suit everyone. A client’s risk profile and
objectives may not match the bond/equity weightings as reflected in either. In
my fund management days, I used to regularly agree with clients on a
composite benchmark made up from the relevant market indices. Clients then
had something to gauge how well the portfolio was performing.
But things have moved on. There are now benchmarks that compare how
well a portfolio is performing relative to both its peer group and the amount
of risk inherent in the portfolio – in effect, measuring a unit of return against
a unit of risk. After all, some equity portfolios are riskier than others. Is it
right, for example, that a portfolio biased towards ‘defensive’ sectors (such as
pharmaceuticals, tobacco and food retailers) compared to one biased towards
the more economically sensitive sectors (such as mining, technology and
banks) should be measured equally against the FTSE All-Share from whence
they all come?
Such benchmarks help investors become aware of what are called risk-
adjusted returns. But I maintain that for the majority of investors it is wise not
to lose sight of how the indices themselves are performing. Otherwise, peer-
like comparisons can make for herd-like performance. This is one reason the
APCIMS benchmarks are widely recognised.
There are two other points that should be mentioned briefly about
benchmarks. Once the portfolio is up and running, it is essential to regularly
assess the relevance of the benchmark. Your circumstances and risk profiles
change over time, and the benchmarks need to reflect this. This is especially
true if performance has deviated from the benchmark by some measure – in
which case, both the investments and the benchmark need to be reviewed.
Finally, you should always remember the golden rule about benchmarks:
never let them dictate how a portfolio is constructed. They are a method of
measuring performance, not a blue-print to copy slavishly. This is important
to understand. A weighting in any index tells you about the past in that it
reflects how well a particular company or country has performed, relative to
its peers. But it says nothing of the future.
The investment objective should be to beat the benchmark, which means you
have to deviate from it – and not mimic it. Otherwise, you are simply trading
an investment simply because everyone else has – the worst reason to trade
and the first step on the road to ruin. You can only beat the benchmark by
thinking differently – not by copying it. When it comes to buying investment
trusts, focus on those fund managers who have a good track record at being
able to do this.
‘But the roof extension looked good on that house!’

The route to market

Having considered the factors that help you to determine investment
objectives and the role of benchmarks, investors need to appreciate the choice
they have in accessing the market and the tools at their disposal. There are
several routes to market: whether as a DIY investor, or taking advice, or
allowing a manager to run your portfolio, and a number of options in
between.
Many people will already have some exposure to the stock market via their
company pension schemes. It is always worth reading the literature these
schemes send you, which usually includes a report as to how the assets are
performing. Meanwhile, recent government pension initiatives should also be
considered. But this area of financial planning is complicated, not helped by a
myriad of rules and regulations. You should always seek advice from an
independent pension adviser as pensions require expertise. However,
focusing on this area can save headaches further down the line.
ISAs and SIPPs
Outside these options, the individual savings account (ISA) and the self-
invested personal pension (SIPP) are the two main savings vehicles to
consider. These are not investments or assets, but rather tax-free ‘wrappers’
into which your investments are placed. Both shield investments from capital
gains tax (CGT) and income tax, which means the underlying assets should
grow faster than they otherwise would.
Each tax year, you can put a sum of money into an ISA which can then be
invested in the stock market. The 2013–14 total ISA amount is £11,520. The
ISA can be self-select – you choose the investments – or managed by the ISA
provider. Up to half the amount can be saved in a cash ISA. Any unused
allowance does not carry forward into the next tax year. Money can be
withdrawn at any point. Parents can open a ‘Junior ISA’ for their children
and invest up to £3,600 in a tax year but the money cannot be accessed until
the child is 18.
A SIPP is a bigger ‘wrapper’. £50,000 a year can be invested in a wider range
of investments although the lifetime allowance is £1.5 million. Another
difference is that the tax break comes up front: a £100 pension contribution
would cost a 20 per cent taxpayer £80 and a 40 per cent taxpayer £60 – the
government pays the difference. Your money is locked away until you are 55,
after which you can withdraw 25 per cent tax-free, but the balance must be
used to buy an income which will be taxed.
For choice, I prefer ISAs as they are more flexible. But it does depend on
your investment goal and time horizon. A SIPP may be preferable for long-
term saving objectives such as retirement. The tax relief is generous,
particularly for those higher-rate taxpayers who may expect to pay basic rate
tax when they retire. For more medium-term objectives like school fees or
house purchases, the flexibility offered by ISAs is hard to beat.
IFAs
Apart from ISAs and SIPPs, most investors will be invested in open-ended
funds courtesy of their independent financial advisers (IFAs). The
introduction to this book outlined the changes brought in by the Retail
Distribution Review (RDR), and how this may affect the small investor.
Many major names such as Lloyds, Barclays and HSBC withdrew from the
tied-advice market because of the RDR. This, together with those investors
being unwilling to pay up front for advice under the new RDR rules, could
well lead to a black hole – or advice gap – in the market. And the numbers
are not small. A survey by Deloitte in 20123 suggested 5.5 million people
will stop taking advice. The consequences could be significant: the emphasis
could easily change from banks misselling to clients misbuying.
Meanwhile, IFAs are going to see a reduction in their income. The
elimination of trailing commissions and higher costs because of FSA
requirements will result in the adviser market having to adjust. Some firms
may offer a form of simplified advice. Others may move into asset
management, and perhaps adopt a ‘model portfolio’ approach where clients
are slotted into one of a range of strategies best suited to their individual
needs. Such an approach is far less labour-intensive than the IFA–client
relationship, and so will be cheaper than what IFAs will have to charge under
the new RDR regime, but it does require focus in the early stages to ensure
the right strategy is chosen.
This post-RDR response by the adviser market will typically suit investors
with medium-sized portfolios (£100,000 to £200,000). But if you are a
smaller investor it is not yet evident where to go for advice. Perhaps the
model portfolio approach will be adapted for smaller investors. Certainly, if
Deloitte’s figures are even close to the mark, a number of firms may see the
potential in this market and react accordingly. It will be worth any investor in
this situation surveying the field well before deciding from whom they should
seek advice.
Wealth managers
For the very wealthy, there is of course a host of wealth managers across the
UK who will help you manage your money. These usually have all the
financial services at hand either directly or indirectly. Their business is not
just about investing, but also tax and financial planning. But their investment
service essentially breaks down into three categories.

1. Discretionary management is where the client clarifies their risk

tolerances and income requirements, and then allows the wealth
manager to get on with the job.
2. Advisory management is when advice is given to the client, who then
cracks on.
 3. A managed advisory service is a mix between the two, and involves
closer involvement of the client with strategy whilst the manager
oversees the day-to-day timing decisions.

If starting from scratch, take the time to meet a few managers. Pay particular
attention to their breadth of offering, investment style and fee structure.
Investors are spoilt for choice. Personal chemistry is important and, to get the
best out of them, they will need to get to know you well – the extent of your
wealth, your family circumstances, your goals and time horizons. This person
could be advising you for many years so take time in assessing your choices.
An important part of this is the fee and charges structure. Good wealth
managers understandably do not come cheap. Many are adapting to the new
focus on costs. Some are now charging low initial fees but introducing
performance fees. This should be welcomed, but I would ask for fee rebates
or credits carried forward should they underperform! But have a clear
understanding of costs, so that the early meetings are focused on establishing
the portfolio and building trust.
Given the costs, particularly the charges when first establishing a portfolio, I
suggest wealth managers are best suited to those investors with a minimum of
£150,000 to £200,000 to invest. Much less and they are unlikely to offer
value for money. Some well-established names have much higher thresholds:
Coutts has recently raised its minimum from £500,000 to £1 million.
Do-it-yourself
Finally, in discussing how best to access markets, never underestimate your
own skill!
The Wall Street Journal looked at the investment returns generated by retired
investors between 1999 and 2009. It compared the performance of those who
ran their own portfolios to those who hired a stockbroker. The former group
outperformed the latter by around 1.5 per cent a year – amounting to over 16
per cent for the period. Fees accounted for only half the difference.
Very few managers consistently generate ‘alpha’ – this being the return
produced by the manager in excess of the market, having taken into account
the risk profile adopted. Instead, investors often receive high fees and
mediocre performance. So consider becoming a DIY investor.
Such an investor would need to establish an execution-only service with one
of any number of banks or broking firms – they usually advertise their
services in the financial press. Dealing online is usually cheaper than the
telephone, but check costs – some online trades come in as little as £5
regardless of the size of deal.
Some firms in addition offer model portfolios, research facilities and online
tools to help investors make informed decisions – but the decision remains
with the investor. Furthermore, there is a welter of advice offered by various
websites. With the fixed costs of running a web-based service falling, many
advisers are using the internet to service clients both large and small. The
range of product varies, including both ‘active’ and ‘passive’ or index-
tracking options.
My Investors Chronicle investment trust portfolios are designed to help the
DIY investor. This monthly column sets out two portfolios – one Growth,
one Income – and aims to explain the thinking behind any changes to
holdings that have occurred during the previous month. Both portfolios are
measured against appropriate benchmarks so readers can gauge performance.
Being live portfolios, a DIY investor could mirror either or both of these
portfolios using an execution-only service. (There is more on these portfolios
in Chapter 9).
Successful investing

So you have thought through various points and decided upon your
investment objectives. You have also decided on whether to be a DIY
investor, seek advice or allow a wealth manager to run the portfolio for you.
Whatever the chosen method of accessing the stock market, it is important to
understand the principles of successful investing so that you can either
execute them yourself or be better informed when questioning your adviser or
manager. The right knowledge is worth its weight in gold when it comes to
investing!

Getting started
Let us start with an investor who, for whatever reason, is sitting on a cash pile
that needs to be invested. How do you best construct a portfolio? Theory is
fine, but the practice is often more difficult.
If you already have an established portfolio, maybe inherited or taken back
from a financial adviser, then this question is less relevant. You can sell your
holdings and reinvest the proceeds in investments that better reflect your
objectives. In doing so, it is wise to keep an eye on the extent of gains in
order to be aware of when you are approaching the annual capital gains tax
limit, which for the 2013/14 tax year is £10,600. Any gains beyond this will
be taxed at the investor’s marginal rate of tax.
Selling should not be a deterrent if you feel that instigating changes would
benefit the portfolio. Taxation should not dictate investment policy.
However, the CGT limit can influence the timing of changes. This is
particularly the case if you are contemplating changes close to the tax year
end, in which case two annual exemptions can be utilised by staggering
changes into the next tax year. Also remember that portfolios held in joint
names will enjoy twice the annual limit.
However, those investors starting from cash have more difficult decisions to
make. How quickly should you invest the cash, which investments to start
with, how should the cash be best managed until it is invested? You are not
alone in contemplating these choices: novice and professional investors toy
with such questions. On a number of occasions when working in the City,
entrepreneurs asked me to invest a sizeable chunk of the proceeds of a
business sale built up over decades, often amounting to several millions of
pounds. No matter how confident about the prospects, I was always mindful
that a stock market crash could, overnight, wipe out years of work.
The answer in such situations is usually to invest gradually over a period,
typically of 6–12 months, trying to buy on bad days. However, you need to
be flexible. If there is a market correction, then a more aggressive stance is
warranted. A strong run by the market would suggest more caution, at least in
the short term. The important thing for me was to have discussed matters
with the client so that we were both happy with the strategy. Sometimes
clients had strong preferences, which it was usually wise to accommodate,
provided they were aware of my assessment.
A similar strategy should be employed by investors creating a portfolio from
cash. Money should be invested gradually. There is a term called pound-cost
averaging, which describes a version of this tactic. The idea is that an
investor should determine to invest an equal amount of cash at regular
intervals. This would mean that fewer shares would be bought if the market
had had a strong run and prices were high. Conversely, it would also mean
more shares would be bought for the same amount of cash if the market had
fallen back. Investing at regular intervals has the advantage of taking
subjective decisions as to the timing of purchases out of the equation.
On first inspection, the maths looks attractive.

Example
Let’s imagine you invest £4,000 at a rate of £1,000 for each of
the subsequent four months. Purchase details are as follows:

50 shares are bought at £20 each.

The price then falls in month two, so 100 shares are bought at £10
each.
200 shares are bought for £5.
 Finally, 50 shares are bought again for £20.

In total, 400 shares have been bought for an average cost of £10
(£4,000 divided by 400). By contrast, the average monthly price
per share on each of the days of purchase was £13.75 (£20 + £10
+ £5 + £20 divided by four). So pound-cost averaging has
worked on this occasion.

But pound-cost averaging does not work all the time. The above example
takes advantage of a falling share price. But share prices rise more than they
fall. During the past 80 years or so, the US market had risen 70 per cent of
the time. The market usually outperforms cash. Therefore, there is a good
case for lump-sum investing – committing the cash to the market in one go.
After all, history is on your side, and it would save on dealing costs.
This message was reinforced by investment consultant Michael Edesess a
few years ago. He showed that, over the preceding 83 years, investing a lump
sum actually beat investing through pound-cost averaging by more than 3 per
cent a year whether you took one-, three- or five-year rolling periods.1
Which method is chosen will depend on your attitude to risk. Given that
various studies show most investors fear losses more than they hope for
gains, then perhaps pound-cost averaging should be seen as an element of
insurance against market losses. But given that markets tend to rise rather
than fall, it is advisable not to delay completion of the process for too long:
the longer it takes, the higher the cost will be. Four to six months feels about
right.
And always remember, as an investor you should only be committing to the
stock market the proportion of your wealth that allows you to sleep at night
even when markets are turbulent. If you cannot do this, then perhaps you
should not be invested at all. If low risk is your stated objective, then a bank
account is the better option.

Why it is important to stay invested

When committing cash to the market, it is important to try and get timing
right. But over the longer term, a more important contribution to successful
investing is to stay invested once committed.
Markets are naturally volatile. Much wiser investors than I often take
advantage of these short-term market swings and make a lot of money in the
process by, for example, selling stocks when they look pricey, and buying
them when they are cheaper. This is not investing, it is trading. But a few
managers are consistently good at it, and such expertise is highly valued.
However, for the majority of investors, the lessons of history suggest it is
better to stay invested. A study carried out by Barclays Wealth in 20102
suggested that UK investors were losing on average just over 1 per cent a
year because of market timing errors. This does not sound much, but over
long periods it can add up. Indeed, Barclays highlighted that in the period
1992–2009, investors who tried to time the market were down 20 per cent
compared to those who had simply stuck with it.
The study also suggested that the more volatile the markets, the greater the
loss. Investors dealing in global equity funds apparently lost 2.25 per cent a
year on average, compared to just losing 0.5 per cent for UK funds. The
explanation being that global markets tend to be more volatile, and therefore
there was more scope to get market timing wrong – which investors
apparently did!
Research from Fidelity3 seems to reinforce the wisdom of sticking with
markets. Fidelity has highlighted the extent to which returns are affected if
just a few of the best days are missed. Investors who put £1,000 into the
FTSE All-Share in October 2000 would have seen it grow to £1,330 by
October 2010 – this was not a good decade by historical standards! But if the
10 best trading days had been missed, then the return would have almost
halved to just £720. If the next 10 best trading days were also missed, then
the return would have dropped to £475 (see Table 7.1).
Longer timescales confirm the message. Dr Kate Warne, whilst market
strategist at Edward Jones in 2008, pointed out that if you had missed the 10
best trading days over the previous 39 years, the average annual return on
your portfolio would fall to 5.6 per cent from 7.5 per cent. To put this into
numbers, a £10,000 investment would have been worth £168,204 if it had
remained invested between December 1968 and March 2008. But missing the
best 10 trading days reduced the end value to £84,252 – an almost 50 per cent
drop!
Table 7.1 Impact of timing the market
What happens if you miss the best days (10-year time frame)

Source: From Duncan, E. (2012), ‘Act now’, What Investment, May.

Now it could be said that an investor would have to be extremely unlucky for
this to happen. But markets often make big moves when sentiment is poor
and markets have fallen: in other words, when a lot of the bad news is in the
price. And evidence from a number of unit trust managers suggest retail
investors have a tendency to buy when the market has risen, and to sell when
markets have fallen.
Often, investors sit on high cash piles for some time after markets have hit a
low – they let past market movements influence investment behaviour. This
is easy to criticise with the benefit of hindsight, but difficult to counter at the
time. Yet it is precisely at these moments – with sentiment rock bottom – that
markets tend to bounce. Investors are then often left behind. It is worth
remembering that the single best trading day during the past 10–15 years
occurred when the FTSE All Share rose 9.2 per cent on 24 November 2008,
in the middle of the ballooning credit crisis and when investors’ confidence
was probably at its lowest level.
Another report by Blue Sky Asset Management in 20104 confirmed that
investors rattled about market falls were failing to take advantage of cheaper
prices. It argued that Fidelity’s focus on the 10 best trading days was more
relevant to day traders, rather than the average retail investor. It therefore
looked at the effect on returns if an investor had hoarded cash for one year
after a market low, which it argued was the more typical behaviour of the
private investor. And, having analysed bear markets in the UK since 1972, it
found that such an approach would have reduced returns over the following
four years by up to 75 per cent.
So missing some of the best trading days is not uncommon. The advice
understandably given by advisers is that investors should reverse their normal
behaviour and buy low and sell high. In doing so, investors should try to be
more forward-looking and not be influenced by past events and the gloom
that surrounds you. In other words, buy the future and not the past!
However, this is easier said than done. It is not easy for many investors to be
buying when all hell is breaking loose. Instead, my advice is that investors
should stay invested and ignore the small talk and chatter of the markets.
Time in the market is more important than market timing. Market timing is a
mug’s game and, unless you are one of a very small number of investors who
consistently get it right, best avoided.
In short, time is your friend. Ibbotson Associates analysed the S&P 500 since
1926 and concluded that an investor with a portfolio that mirrored the index
would have lost money just 14 per cent of the time, based on five-year
periods with dividends re-invested. The figure drops to 4 per cent over 10-
year periods, whilst there would have been no losses at all over 15-year
periods.
This is why investment is a long-term endeavour – the longer in the market,
the better the chances of success. It is also why investors should stay invested
and not try to second-guess volatility. Treat the market with respect and
approach it with humility. If you stay loyal, it will reward you; but stray, and
it will punish you. Repeat again: market timing is less important than time in
the market!
However, there is one downside with this rule: the longer in the market, the
greater the chance of experiencing a market crash. And crashes are painful
when they happen. The stock market fell by a quarter in 1973, and then by a
further half in 1974. On Black Monday in October 1987, the FTSE 100 fell
22 per cent in one day. In 2008, the FTSE 100 lost around a third of its value.
These setbacks can be particularly galling if you were about to liquidate a
portfolio because objectives had been met. The risk of this happening can
never be eliminated, but a couple of strategies pursued together can help
reduce the chances of a market collapse completely scuppering plans:
 1. You should gradually start liquidating a portfolio some time before the
money is required or objectives have been met (see ‘Reaching goals’ at
the end of this chapter).
2. As an investor, you should always diversify your portfolio.

Diversification
The aim of diversification is to reduce portfolio risk by investing in
‘uncorrelated’ asset classes. These are assets that tend not to move in the
same direction over the same period. The theory is that you should not put all
your eggs in one basket, and that by apportioning a portfolio between non-
correlated assets one is reducing risk – but not eliminating it – should markets
fall.

Don’t put all your eggs in one basket!

If two shares move together – for example, pharmaceutical stocks such as

GlaxoSmithKline and AstraZeneca – it is said they are highly correlated.
However, holding a ‘defensive’ stock such as Glaxo (demand for medical
treatment tends to be immune to economic swings) and a more ‘cyclical’
stock such as Barclays (demand for banking services are more geared to the
economy) should reduce risk because they are less likely to fall together.
But how many individual equities should be held to diversify properly?
James Montier suggested a few years ago that 32 stocks would eliminate 96
per cent of non-market risk (all but a stock-market crash). Research confirms
that 30–40 holdings achieve the most diversification benefits.
Yet the average US fund manager holds anything between 100–160 stocks,
which many consider excessive. The reason is that many want to replicate, as
far as possible, the market and therefore market returns, in order not to
underperform their peers. As the legendary investor Sir John Templeton once
noted, the poor performance of US mutual (retail) funds was primarily due to
‘institutional factors that encourage them to over diversify’ and so incur high
dealing costs.
So much for local equity markets. It is generally recognised that, within the
equity asset class, you should diversify overseas. In a research paper,
‘International Diversification Works (Eventually)’, C. Asness, R. Israelov
and J. Liew from AQR Capital Management compared the performance of
local portfolios from 22 countries with globally diversified ones, covering the
period 1950–2008.5 The conclusion was that, for periods longer than five
years, global funds performed significantly better during global crashes.
This reflects the fact that, whilst crashes drag down all markets in the short
term, economic performance varies across countries over the longer term.
International exposure therefore reduces risk as the fortunes of the portfolio
are not riding on just one economy. As if to emphasise the point, portfolios in
the US lost money over the first decade of this century, whilst emerging
market equities generated returns of around 10 per cent a year.
However, equities – whether local or global – are only one asset class. There
are others. Most typically these are bonds, real assets (such as gold, rare
stamps or fine wine), genuine wealth-preserving absolute-return funds,
property, commodities, private equity and cash. The price of such assets is
influenced by different economic factors at different times.
For example, if there was an economic slump and deflationary fear, then
typically bonds and cash would perform relatively well. If, on the other hand,
economic growth surprised on the upside and inflation looked set to rise
modestly, then equities and real assets would typically outperform.
During turbulent markets, it would be very unlikely for all these asset classes
to fall in the same direction. Even during the equity sell-off in 2008, at the
height of the credit crunch, perceived safe havens such as government bonds
and good-quality corporate debt performed well. Meanwhile, cash produced a
positive return. But some so-called ‘equity diversifiers’ did not live up to
their billing. Many hedge funds, so called because they are meant to protect
wealth in all markets, sank faster than other equity-based investments. Only a
small minority honoured their title.
The answer is to keep it simple. Do not over diversify. As the US investor
Warren Buffett once said, ‘Wide diversification is only used when investors
do not understand what they are doing.’ The main diversification is between
equities and bonds – asset classes driven by very different economic forces.
And be wary of exotic ‘alternative’ assets classes such as hedge funds that
promise the earth. If it sounds too good to be true, then it probably is.
To emphasise the point, a few years ago MoneyWeek discussed an FT article
that highlighted a report by James Norton of Evolve Financial Planning.6 It
suggested that assets split 60/40 between the FTSE All-Share and the Citi
Bond index between 1988 and 2008 would have earned 8.8 per cent a year. If
the portfolio was widened to eight asset classes then the figure rises to 9.9 per
cent for very little extra risk. Go beyond that and you add little extra return
for a lot more risk.
Furthermore, costs go up the more asset classes are held, especially if you
invest in the more exotic classes such as hedge funds, rare wine and stamps,
or private equity. The best approach is to diversify across three or four asset
classes at most. Investors are better off getting a good level of exposure to a
small group of assets that represent attractive value than trying to spread the
portfolio too thinly.
Of course, most asset classes are represented by investment trusts – the
exception being certain ‘real’ assets such as gold and silver, and to a lesser
extent government bonds. These can be accessed through exchange-traded
funds (ETFs). So there is no reason why trust portfolios cannot be adequately
diversified. The two Investors Chronicle trust portfolios I manage only have
four asset classes: equities and bonds (mostly corporate) are the main ones,
with commercial property, cash and perhaps commodities/gold (via mining
shares) bringing up the rear.

Reinvesting dividends
I have highlighted why it is better to stay invested over the longer term, and
not to trade market volatility in the hope of making short-term capital gains.
But there is another reason not to stay out of the markets for extended
periods. Over the longer term, it is dividends – and not capital gains – that
produce the vast majority of market returns. Finding and re-investing
dividends is the key to healthy returns.
The very useful annual Equity Gilt Study from Barclays Capital illustrates the
point.

Example
£100 invested in UK stocks at the end of 1899 would have been
worth £180 in real terms (after inflation) at the end of 2010, if
dividends had not been reinvested. But with dividends
reinvested, the figure shoots up to £24,133 – a very real
increase. Shorter time frames since 1945 also confirm the story.
(See Table 7.2.)
Table 7.2 2011 value of £100 invested in 1899 and 1945, comparing
dividends reinvested and not reinvested
Income reinvested 1899 £24,133
1945 £4,370
Without reinvested income 1899 £180
1945 £255

This validity of this message is not confined to UK markets. The US Dow

Jones index was worth the same in 1992 as at the peak in 1929 in real terms,
if dividends were not included – and the same in March 2009 as in 1966.
Legendary investor Jeremy Siegel put it another way in his book The Future
for Investors (Crown Business, 2005). He calculated that, over a 130-year
period, as much as 97 per cent of the total return from US stocks came from
reinvested dividends. The figures were eye-opening. $1,000 invested in 1871
would have been worth $243,386 by 2003. Had dividends been reinvested,
the figure rose to $7,947,930!
The message is clear: if you want to succeed over the longer term then do not
spend your dividends. Almost every research paper proves that reinvesting
dividends is the best way to grow wealth over time – and is less risky than
trying to make short-term trades in the hope of crystallising capital gains. To
access these dividends, you must stay invested.
And the good news at the moment is that companies are in good financial
health. Whereas governments and consumers are mired in debt that will take
years to work off, corporate balance sheets are healthy. A study by Capita
Registrars7 has shown that dividends paid to shareholders by UK-listed
companies surged to an all-time high of £41.4 billion in the first half of 2012.
This was 21 per cent higher than 2011 and well above the previous high of
£34.5 billion in the first half of 2008.
Analysis suggests healthy dividend growth is not just a recent phenomenon.
The 2012 Barclays Equity Gilt Study highlights that, while there have been
fluctuations, dividends have tended to increase over the longer term.
Meanwhile, looking forward, corporate balance sheets are set to strengthen
steadily over the next few years. This should enhance their ability to pay
increased dividends.

Regular rebalancing
Investors should never be complacent about the market. No matter how well
a portfolio is performing, you should always treat it with respect for it can
often surprise. And almost regardless of economic or market outlook, history
suggests investors should regularly rebalance their portfolios.
Rebalancing is one of the first principles of investing, and yet it is often over-
looked. The concept is simple. If a 60/40 bond/equity split is adopted and
equities then have a very good run relative to bonds, you could end the period
with a 70/30 split. This is because the value of the equities has increased
more than your bonds. Evidence suggests that it pays to rebalance this
portfolio – back to the 60/40 split – provided your risk profile and investment
objectives remain unchanged.
Rebalancing worked well during the recent downturn. In the period 2007–09,
a portfolio starting with a 60/40 split would have lost 37 per cent if
unbalanced, compared to a loss of 30 per cent if balanced annually. However,
this time frame is too short to prove the principle worthwhile.
Longer-term case histories are more revealing. Forbes has shown that
£10,000 invested by way of a 60/40 split in the US in 1985, and rebalanced
annually, would have been worth $97,000 in 2010. By comparison, an
unbalanced portfolio would have been worth $89,000.
What is also noteworthy is that the rebalanced portfolio particularly protected
investors better when markets fell significantly – which is logical. Over the
longer term, shares have performed better than bonds. Therefore, rebalancing
will typically involve selling equities and buying bonds. When markets fall,
usually shares suffer most as good-quality bonds are seen as a safe haven.
Rebalancing therefore reduces the impact. Investors with higher-risk
portfolios take note. Unbalanced portfolios can seriously increase the risk
profile of unguarded investors – who only realise their error too late when
markets fall.
Rebalancing is recommended but be careful not to do it too often, because
dealing costs eat into performance. City fund managers tend to rebalance on a
quarterly basis, but their dealing costs are far lower. An annual rebalance is
probably about right for most private investors, depending of course on how
markets have performed. Such a rebalancing exercise is also a good time to
revisit investment strategy, and to check it is still on course to meet
objectives.

Reaching investment goals

During the life cycle of a portfolio, much care and attention is given to
establishing and monitoring the component parts in the hope of healthy
returns. This is perfectly right and understandable. However, as you approach
the attainment of investment goals or a time when money is required, then as
much care should be taken in the planning of this liquidation as it is in the
running of the portfolio. It is an obvious point to make, but one that is
nevertheless sometimes forgotten both by investors and managers alike.
Investors must always have in the back of their minds the consequences to
them of a market crash. These are rare but largely unpredictable. This is
particularly the case as you approach the finishing line. It is a great shame
when, after many years of productive investing, a market setback severely
dents overall gains just as investment goals are being reached. There are two
answers to this, usually working in tandem.
Earlier in the chapter we discussed the merits of diversification. The second
answer is to spread the liquidation over time as the finishing line approaches.
This can be done over a matter of months, or even years if the portfolio has
been running for a long time.
As to the precise method, you can obviously stagger sales in equal measure
across all holdings so the portfolio largely retains its balance and shape as it
is drawn down, or one can time sales of different holdings and assets
according to perceived value and the economic backdrop. But whichever
method or methods is chosen, it is important to execute this staged liquidation
and then allow the balance of the holdings to carry the portfolio over the line,
even though this may take a little longer in reaching.
Peace of mind should not be under estimated, particularly if this comes at the
end of a long investment journey!
Other investment secrets

Having covered the basics when it comes to successful investing, this chapter
will highlight some other pointers that you may find helpful when
constructing and/or monitoring a portfolio, whether run by your manager or
yourself. I start with what I consider to be the most important.

Sentiment versus fundamentals

If I had to sum up in one sentence the secret of successful investing, I would
suggest ‘to know when sentiment and fundamentals part company, and then
to have the courage to act’. When market sentiment runs too far ahead
relative to the asset’s fundamentals – in other words, investors are pushing
the price up beyond its worth – then the time has come to sell. Conversely,
when sentiment trails fundamentals – the market is ignoring and so
undervaluing the asset’s prospects – then that is the time to buy.
It sounds easy, but it is not. First, you must identify when the market has got
it wrong – when the price is not reflecting reality. You must believe that you
have identified a mispricing which the collective wisdom of the market has
missed. And then, the investor must ignore the perceived wisdom of fellow
investors and deal in the market – to put to the test the courage of your own
convictions. Sometimes it can take nerves of steel, particularly when buying
on a market fall.
A successful investor must be prepared to be a contrarian – to think
differently. It requires a resolute character who can withstand peer pressure
and remain true to a conviction even if short-term results are disappointing.
Such investors must stand back from the noise and clatter of the markets, and
marry up their investment objectives with a calm assessment of what they
believe assets are worth. Whichever benchmarks you apply, it can only be
beaten by deviating from it. As Sir John Templeton once said, ‘It is
impossible to produce superior performance unless you do something
different from the majority.’
Many commentators have suggested markets are driven by greed and fear.
Greed pushes prices up to levels beyond the underlying assets’ worth, in the
hope that profits can be maximised – taking comfort from the fact the market
itself is doing likewise en route. There is always comfort in numbers.
Meanwhile, fear pushes prices down to levels below the assets’ worth,
assisted by the fact investors dislike losing money more than they like
making it. Such concern is again perhaps influenced by the actions of those
around you – a free-falling market must know something.
Generally speaking, contrarian investors tend to be value investors, because
unloved assets are sought whilst the market’s darlings are sold. Obtaining
value provides a margin of comfort: buying at a decent discount to an asset’s
estimated worth offers protection against being wrong. And the benefit of
contrarian investing has been illustrated through various studies showing that
the stocks professional fund managers are selling usually outperform the ones
they are buying.
Some have suggested it can be difficult for ‘small’ investors to compete with
big players such as the pension funds and banks. After all, they have many
advantages including the latest technology. I would disagree. The playing
field is fairly level. The small investor has both advantages and disadvantages
relative to professional fund managers.
Small investor disadvantages
The disadvantages for small investors include poor access to market
information and to those running the underlying investments, whether they
are company directors or the managers who run the underlying open- or
closed-ended funds. But this is less a disadvantage than it might first appear.
There are no shortage of good publications and websites that undertake
detailed interviews and analysis of such assets. Furthermore, the companies
and funds themselves are doing more to reach out to shareholders – existing
and potential – for it is in their interests to do so. And if this were the
determining factor in deciding whether managers outperformed their markets
then most would, but it is not – because most do not.
Small investor advantages
Meanwhile, small investors have many advantages that should not be
underestimated. First, and most importantly, they have time. Many
professional fund managers have short-term horizons – quarterly meetings
with trustees or actuaries focus the mind on three-monthly returns. There is
therefore a constant pressure to shadow benchmarks and markets generally –
to over-diversify or to replicate – for fear of being out on a limb and wrong.
Small investors are free of this restraint. They can afford to take a longer term
view, and therefore stand a better chance of recognising mispricing and
capitalising from it. Patience is often rewarded, perhaps because unloved
assets can often be deeply discounted by the market. This is why patience is
an asset. If, on the other hand, you are naturally impatient then perhaps you
should seek your returns elsewhere. As the legendary investor Ben Graham
once wrote: ‘Undervaluations caused by neglect or prejudice may persist for
an inconveniently long time and the same applies to inflated prices caused by
over-enthusiasm or artificial stimulants.’1
Being free of this restraint also helps in other ways. Earlier sections covered
the importance of staying invested until investment objectives had been
attained. Greed and fear are natural human instincts, and they encourage fund
managers to take short-term positions which, with the benefit of hindsight,
are wrong. All the evidence suggests it is best to stick with the market over
the longer term. Naturally, you can tweak things a bit. But, by and large, stay
loyal to the market and it will reward you. Staying loyal also means investors
reap the full reward of market dividends, which have a disproportionate
benefit to overall returns. These advantages far outweigh the disadvantages.
Using the discount
Investment trusts are ideally suited to help the ‘small’ investor in this respect.
Positive or negative sentiment towards an underlying trust and/or the market
in general very often shows itself through the extent of the discount. The
market will always present opportunities and risks that are often exaggerated
by the fluctuation of discounts. Therein lies the investor’s opportunity. And
like good contrarian investors, those investing in investment trusts are natural
value investors for they are looking for good quality trusts on a wider-than-
normal discount – aiming to buy assets below their worth because of market
sentiment.
The ideal purchase is when a trust, with a manager who has a good long-term
track record and who is still in place, stands at a wider than average discount,
possibly because the sector or manager is out of favour short term or the
market is wobbly. It is worth remembering that many investors place too
much emphasis on ‘flavour of the month’ investment themes and short-term
performance when buying funds, often investing just as performance peaks.
Better to focus on the longer-term track record of a good manager and ignore
the short term negative sentiment and noise. The ideal sale is when a trust’s
discount has narrowed substantially from its average, perhaps because the
market has got over-excited about prospects, yet factors such as a change of
manager suggest caution.
Always remember though that these transactions should be based on long-
term horizons. They should typically influence the timing as to when to
introduce a long-term holding or to sell if close to realising overall
investment objectives, and should not represent short-term trading positions.
As earlier chapters have made clear, choosing a trust with good long-term
performance is generally a far better contributor to overall returns than
constant dealing in an attempt to take advantage of short-term swings in
discounts or the twists and turns of the market.

Keep it simple and cheap

Financial professionals have a habit of unduly complicating products and
services. If there is one message in this book, it is that investment is best kept
simple to succeed. Complexity adds cost, risks confusion and usually hinders
performance. This plays out at two levels. The previous chapter highlighted
the importance of not diversifying your portfolios too much via different
asset classes – in many respects, the smaller the number, the better.
But investors should also avoid investing in overly complicated products,
particularly if they are difficult to understand. Therefore, avoid hedge funds
and absolute return funds, structured products, multi-manager funds and any
other investment vehicle that has high costs and poor transparency. History
has shown they tend not to live up to expectations.
The high costs of such products are a particular negative. Allied to keeping it
simple, investors should always try to keep it cheap, whether you are
considering individual funds, diversification or the possibility of a raft of
complicated products to complement portfolios in the hope of higher returns
or certainty.
This message deserves repeating. Picking complicated products can easily
load a further 1.5 per cent of costs onto portfolios. This does not sound much,
but it can have a devastating effect on performance.

Example
Assume you take a 40-year horizon, and invest £100 a month in
a few investment trusts, perhaps broadening the range as the
portfolio gets bigger but always sticking with this monthly sum.
Also assume the portfolio produces a 5 per cent return a year,
which is not unreasonable given past returns. After 40 years,
the trust portfolio will be worth £150,000. However, if you had
added a further layer of costs of 1.5 per cent a year, the
portfolio’s worth would have sunk to just £105,000.

In short, keep your investing simple. Ignore the clever marketing of products
that come with high costs and little transparency. Stick with straightforward
investment trusts and exchange-traded funds (ETFs). If you are unsure
whether to be in the market at all, then play safe and stick your money in a
bank or cash ISA.

Multi-manager funds
By way of illustration, let us look at multi-manager funds, or funds of funds
as they are also known. These are products where a manager will manage a
portfolio of funds – usually open-ended and with at least some home-grown –
and charge investors an additional fee for doing so. Such multi-manager
funds have been popular, and it is easy to understand why. They were seen as
a one-stop shop by financial advisers by providing a simple way of
outsourcing portfolio management to respected fund management companies.
They also deferred capital gains tax (CGT) because the multi-managers made
changes to portfolios within their wrappers which did not attract CGT.
However, research published by Money Management shows that investors
have lost out through poor performance and high fees – despite the promise
of diversified growth and lower risk.
Performance figures published at the end of 2011 show that the average
annual growth rate for multi-manager funds in the IMA Active Managed
sector over five years was just 1.6 per cent compared with an average of 2.3
per cent for all funds (see Table 8.1). The picture looks slightly better over 10
years with figures of 5.3 per cent and 5.2 per cent respectively. However,
when looking at the IMA UK All Companies sector, these multi-manager
funds returned just 0.1 per cent after five years compared to a sector average
of 1.4 per cent. Here the picture does not improve over 10 years – these funds
continue to lag behind the sector average with returns of 3.9 per cent and 4.5
per cent respectively.
The problem with these products is the high cost through double-charging –
investors pay both fees charged by the underlying managers of the funds held
in the portfolios and those charged by the multi-manager picking the funds. It
makes for a heady cocktail of costs. The total expense ratio (TER) for many
multi-managers can be 1.5–2 per cent or more, which is an additional charge
on top of the underlying portfolio fund’s charge of around 1.5 per cent. This
layering of charges means the bar has been raised significantly before
investors can enjoy the benefit of good performance, as the statistics would
seem to confirm.
Because of these high charges and consequential mediocre performance, I
would expect multi-manager funds to struggle as the Retail Distribution
Review (RDR) encourages managers and investors alike to pay closer
attention to fees.
Table 8.1 Multi-manager funds: best and worst in IMA Active Managed
sector, to September 2011
Source: From Clarke, G. (2011), ‘Multi-manager funds serve up few
benefits’, The Financial Times, 19–20 November © The Financial Times
Limited. All rights reserved.

Hedge funds
The situation regarding hedge funds, and their investment cousins the
absolute-return funds (ARFs), is little different. Their purpose is to provide
capital protection and deliver steady, if unexciting, returns with low
correlation to underlying markets. They promise growth whatever the market
conditions, and yet most failed to achieve this when the markets fell in 2008.
There were exceptions of course – funds managed by Brevan Howard and
BlueCrest were notable exceptions in generating impressive capital growth.
But the majority failed.
Meanwhile, performance when markets are rising still leave investors with
questions. 2012 is a case in point. Some estimates suggest that the average
hedge fund produced a 3 per cent gain. This compares with a 13 per cent gain
in the world equity market.
Assessing the longer-term performance of this group of products is not easy.
The widely used HFRX Global Hedge Fund index, which weights each
strategy by assets, gives an average annual total return (net of fees) of 7.3 per
cent between 1998 and 2010. By comparison, the S&P 500 and US
Treasuries produced total returns of 5.9 per cent and 3.0 per cent respectively.
So far so good – investors might think such performance was worth paying
the high fees for.
But these figures tend to ignore the fact that the better performance years
were the early ones when the industry was small. Performance deteriorated as
the industry grew. And most investors came to hedge funds in the later years
when these funds were performing less well – a fact not helped by the extent
of losses in 2008 when the industry might have lost more money than all the
profits it had generated in the previous 10 years.
This is illustrated by Figure 8.1, featured in Simon Lack’s recent book The
Hedge Fund Mirage (2012), which shows the annual percentage return of the
industry between 1998 and 2010.
Lack believes performance is better assessed by using the internal rate of
return (IRR), which gives greater prominence to performance weighted by
assets rather than simply looking at annualised returns. This performance
measure is widely used by private equity and property investors. Over the
1998–2010 period, IRR figures from the alternative-investment database
BarclayHedge suggest a more sombre figure of 2.1 per cent.
Figure 8.1 Hedge fund industry performance
Source: Securities and Investment Review, August 2012.

Meanwhile, performance once again is not helped by very high fees. Some
hedge funds charge ‘2 and 20’, meaning a 2 per cent fee of funds under
management plus a 20 per cent performance fee. Some funds of hedge funds
then charge a ‘1 and 10’ on top. It is therefore perhaps no surprise that Lack’s
analysis shows that, between 1998 and 2010, hedge fund managers kept 84
per cent of the profits they made.
This then begs the question as to why these funds have been so popular. Why
is it that investors have flocked to their standard, despite the
underperformance and high fees? After all, these are not novice investors:
around two-thirds of hedge funds’ assets belong to charitable, pension and
other institutional funds. These are investors who know their stuff. I recently
heard an interesting personal story that may cast some light on this question.

A fund manager once pitched for new business to a lawyer who

represented a large family trust. The trust wanted a new investment
approach. The presentation outlined a simple, balanced and low-
cost portfolio. Other managers also pitched, but their investment
strategies were more complicated and costly. The lawyer then told
the manager in question that the trust had rejected his portfolio
strategy – one key reason being it was too simple. The manager
then re-engineered his proposal by tweaking the return, risk and
cost numbers up a little. He also suggested the new strategy was
overseen by very clever people who would not reveal their methods.
The manager won the trust.
It is harsh to suggest that hedge funds play on human frailty, but there is a
tendency in our natures to want to believe success can only be secured by
complicated methods – otherwise, why would everyone not be succeeding.
This may be true in other fields of human endeavour, but not when it comes
to investment. Investors need to remember, they stand a better chance of
securing portfolio success if strategies are kept simple and therefore cheap.
This is not to deny some investors have been well served by the industry –
particularly those who were early to participate. But the majority of investors
would do well to look closely at performance since the asset class has
become an established part of the investment universe. I cannot help but feel
that those who have used hedge funds in recent years have not been well
served and consequently, until fees become more reasonable and they deliver
promised performance, the industry should be avoided.

Structured products
Structured products promise to protect investors’ capital against market
volatility and pay out a pre-determined sum depending on how well the
underlying asset class or index – typically the FTSE 100 – has performed.
The payout is usually based on two possible outcomes – a rise or fall in the
nominated index – and they have a fixed investment term. FTSE 100-linked
structured products in particular usually pay out either a fixed return when
the market falls, or your capital plus a percentage (e.g. 60 per cent) of the
capital gain achieved by the index, usually minus fees. They are marketed as
a way of protecting against market volatility, whilst providing a degree of
assurance about investment returns. As such, they have proved popular.
I would advise caution. As with all these sorts of products, they are complex
and investors need to understand the risks, so study the small print. It is
important to understand the margins of safety when it comes to the extent of
your losses and gains when markets move. With many of these products, if
the market falls less than 40–50 per cent then the initial sum invested is
recouped, but if the market fall exceeds this figure then often your initial
capital suffers by the same proportion. Conversely, be aware that in many
cases the ‘bonus’ element will not be available if the FTSE 100 index is but
just one point off its opening level.
Meanwhile, such products are inflexible. Heavy penalty clauses usually exist
if investors cash in early. The current investment climate is fluid to say the
least, with very possibly higher inflation due. Locking up capital for up to
five years is not wise in such a scenario. Meanwhile, whatever ‘bonus’ is paid
by these products is less attractive when you consider that no dividends or
interest is paid over the life of the product. An investment trust that performs
well can yield more than 4 per cent and therefore, aided by compound
interest, will produce income equivalent to almost half the ‘bonus’ over five
years.
In addition, they are expensive. The more complicated the product, the pricier
it will be. Fees of 3 per cent are not uncommon and they are usually taken up
front. This compares to a FTSE 100 ETF charging less than 0.5 per cent and a
good-performing investment trust between 1 per cent and 1.5 per cent a year.
Finally, you should always consider the default risk. Most of these products
are backed or sponsored by a third party, usually a bank. And most banks are
perfectly sound with good credit ratings. However, it is worth remembering
that a range of structured products were affected by the collapse of their
sponsor Lehman Brothers in 2008 – a bank which also had a good credit
rating.
Worse still, there is a risk that some products will not be covered by the
Financial Services Compensation Scheme. Santander, the Spanish bank, last
year had to write apologising to all its customers who had invested £2.7
billion into 178,000 complicated structured products between October 2008
and January 2010. The reason was that the bank’s Guaranteed Capital Plus
and Guaranteed Growth Plans – offering various payouts depending on FTSE
100 returns over 3.75 and 5.5 years – were not covered, and it had failed to
point this out at the time.
Structured products are an expensive why to hedge an investor’s own
indecision. Essentially two types of people are attracted to these products:
those who really should not take on any risk, and those who could afford to
do so. If you are in the first camp or are bearish, then place your cash in a
bank account or cash ISA. If you are in the second, buy an investment trust or
two. But do not be left paying for the expensive luxury of indecision – others
are sure to profit.

Ignore forecasts
The renowned economist J.K. Galbraith once said: ‘Pundits forecast not
because they know, but because they are asked.’ History suggests these
forecasts are rarely right. As such, successful investors have a healthy and
sceptical disregard for forecasts – whether they be company, market or
economic. This tallies with their contrarian streak, in that one prerequisite to
behaving differently is to ignore the noise and clatter of consensus forecasts
as to the outlook.
At a company or fund level, the successful investors are asking what could go
wrong – what is the downside with holding this stock? They need to
understand the potential risks. This sceptical approach often uncovers all
sorts of negatives not appreciated. It certainly reduces the risk of unpleasant
surprises, and encourages a better appreciation of the risk–reward balance.
Company forecasts are ignored. The default position for these investors is not
to own the stock.
This approach compares with those professional fund managers who are
more focused on relative performance – they are concerned with tracking,
and not being left behind by their peers. This encourages a different
approach: why should I not own this stock? Non-ownership is less of a
possibility – sceptism takes a back seat.
Successful investors also tend to ignore the broader economic forecasts. It is
questionable why so much effort is expended towards an activity which has
so little value and little chance of success. Simply calculating the
probabilities is revealing.
Even if you have a two-thirds chance of getting right each forecast relating to
(1) economic growth, (2) the path of interest rates, and (3) which sectors will
benefit from the predicted environment, then this still only means you have a
30 per cent chance of getting all three right. And these odds do not even take
into account the need to make a correct stock/trust decision. The message is
to ignore forecasts and rely on your own research and intuition.
As for market forecasts, the successful investor is wary – and right to be so.
End-of-year forecasts are rarely consistently right. The many forecasters who
use the complex maths of Black and Scholes or some other such calculations
would do better studying history. The successful investor fully appreciates Sir
John Templeton’s observation that ‘This time is different’ are the four most
dangerous words in investing – whatever rocket-science black box has
produced the verdict.

The magic of compound interest

Last but not least, it is wise to start investing as early as you can afford. This
is because, as Einstein allegedly said, compound interest is the eighth wonder
of the world.
Compounding is the regular reinvesting of interest or dividends to the
original sum invested with the effect of creating higher total returns (capital
gains and income) over time. The fact that interest/dividends is reinvested
and future interest is paid both on the original sum and the accumulated
interest makes for a significant improvement in total returns over the longer
term – compared to if interest on the original sum only was reinvested
(known as straight or simple interest).
But for compound interest to work its magic, two ingredients are required –
lots of time and a good rate of return. If you invest £100 a month for 10 years
earnings 3 per cent a year, which is added back to the pot, then the total pot
will be worth £14,009. Leave the process to run for 20 years and the total pot
is worth £32,912. Patience brings its own rewards.
But if the rate of return was to rise from 3 per cent to 7.5 per cent (the
average long-term return for US equities) over the periods in question, then
this has a dramatic effect on the final figures. The £100 a month invested
over 20 years creates a total pot worth £135,587. Leave it for 40 years and the
pot is worth £304,272. The challenge is to achieve this higher rate of return.
But the lesson is simple. The earlier you start investing, the greater the
compounding effect in your favour, and the bigger the final pot will become.
By its very nature, the best of the magic is achieved towards the end of a
decent period of time. Start early, be patient and try not to interrupt the magic
of compounding.
The Investors Chronicle portfolios

Theories and words are fine, but the true test comes when putting these into
action. This is the reason for the two Investors Chronicle portfolios, and my
monthly column explaining how they are managed and why any changes are
made.

The rationale
The columns were born out of a frustration that, while there was no shortage
of good financial commentary about markets in general and equities in
isolation, there was and remains precious little to help investors monitor or
manage their portfolios as a whole. Good investment is not simply about
getting a series of separate trades more right than wrong – difficult though
some find that. It is about weaving these together in a coherent strategy via a
portfolio that correctly balances risk with reward, geography with theme,
capital growth with income, etc., so that objectives are reached.
These Growth and Income portfolios have been running since the beginning
of 2009. They are designed to help investors – both novice and expert – to
either run their own portfolios or monitor those who manage their portfolios.
Almost uniquely, these portfolios actually exist (they are not virtual) and are
benchmarked so investors can see how well they are performing against
objective measures.
Each month the column highlights any changes to the portfolios – although
some months there are none. In a very transparent manner, both successes
and failures are shared with the reader – as ever, the aim being to get more
decisions right than wrong! In explaining the logic behind the changes, the
column focuses on key investment themes and strategies, always trying to sift
the short-term noise and clatter of the markets from what is important on a
longer-term view.
The column singles out investment trusts that are looking attractive and are
best placed to harness these themes, whilst monitoring the progress of
existing holdings. The trust managers at the coal face are doing the hard
work. I aim to add value through choice of trusts, asset allocation and themes.
In the one or two areas where assets are not strongly represented by trusts –
bonds are one example – I use exchange-traded funds (ETFs). So far, both
portfolios have performed well relative to their benchmarks, but as I hope
you have realised by now, investors should never be complacent.
I approach the column in the same manner as if I were updating a client as to
progress. Except in this case, the update is monthly instead of quarterly or
half-yearly. As such there is no reason why investors could not run their
portfolios by simply adhering to this column’s advice – providing of course
the risk profiles, yields and benchmarks are broadly appropriate. An
execution-only service, established by the reader, is the only prerequisite. If
you fit into this bracket then this column saves you paying for an adviser or
wealth manager!
The chosen benchmarks are the FTSE APCIMS private investor indices
which are well recognised within the industry. These were set up by FTSE
International and the Association of Private Client Investment Managers and
Stockbrokers (APCIMS) to help private investors benchmark their
investment performance. There are three indices: Growth, Income and
Balanced. I chose the Growth and Income benchmarks for the two portfolios
as the Balanced falls between the two, and my experience suggests most
investors want to achieve one of these two objectives.
Chapter 6 contains pie charts of the two illustrating their components (see
Figure 6.1), but this is shown here in tabular form (see Table 9.1).
Table 9.1 Latest percentage components of the two indices
Another attraction with this series of benchmarks is that the various
components are actual indices – the relevant markets – rather than estimates
reflecting how well the industry in general has performed. As indicated
previously, I remain suspicious of such peer group indices, believing that
peer-like comparisons can encourage herd-like performance. The market
indices themselves remain the best measure as to how an individual portfolio
is performing. Monitoring how the herd performs is of marginal use in
reaching one’s investment goals.
A further attraction of these benchmarks is that, very occasionally, the asset
allocations are changed in response to quarterly surveys to ensure they
remain relevant to investors’ needs.

Investment philosophy
Both portfolios adhere to the basics when it comes to successful investing.
The starting point is that the investment approach aims to keep it simple and
cheap. One of the key messages in The FT Guide to Investment Trusts is that
investment does not have to be complex to be successful. Quite the opposite.
Both portfolios tend to avoid multi-manager funds, hedge funds and
structured products because of their high costs, complexity and typically
disappointing performance. Such products may have a role in the very largest
of portfolios, but I hope both Investors Chronicle portfolios have shown over
the years that it pays to keep it simple and cheap.
Both portfolios tend to remain invested. As I have argued in previous
chapters, trying to second-guess short-term market swings tends to be a
mug’s game. It can also be very costly if good days are missed. I therefore
accept with grace the ups and downs. I accept the slightly higher volatility
that comes with investment trusts – knowing that discounts will widen when
the market struggles, and narrow when things go well. I do this knowing that
trusts tend to outperform their open-ended cousins and the markets generally
over the longer term.
This approach does not prevent me from occasionally ‘tapping the tiller’.
There have been periods when both portfolios have been overweight bonds or
overweight equities relative to benchmarks. My last asset allocation change
was during the Spring of 2012 when I felt sentiment was overly bearish and
so, having been somewhat defensively positioned, both portfolios increased
their exposure to equities. Having enjoyed the subsequent run in equity
markets, I then rebalanced the portfolios. However, these asset allocation
decisions have tended to be modest ‘calls’ as I dislike being out of the market
– the market tends to reward those investors who remain loyal.
Both portfolios are usually rebalanced once a year, particularly following
significant market moves. Rebalancing is one of the first principles of
investment and yet many investors tend to overlook it. The example given
above at the end of 2012 involved increasing the bond exposure in both
portfolios by adding higher-yielding corporate bonds – funded from profits
taken from equities.
The Growth portfolio has a slightly higher turnover rate as the universe of
suitable stocks is much wider. The Income portfolio tends to be anchored in
those trusts with a decent yield, and growth in income is an important factor.
However, the aim is to keep portfolio turnover low because dealing charges
eat into performance. The performance figures cited for both portfolios are
net of all such charges.
Meanwhile, both portfolios are reasonably well diversified with varying
exposure to three to four asset classes – bonds, equities, commercial property
and cash. Within each asset class there are various shades of grey. For
example, as globalisation gathers pace, most equities are highly correlated.
Both portfolios have exposure to ‘Frontier markets’ (markets other than
‘Developed’ or ‘Emerging’) which have tended to display less correlation to
the key markets, and indeed to themselves.
Furthermore, both portfolios reinvest their dividends – performance is
measured on a total return basis, as are the benchmarks. We have seen
previously the extent to which dividends account for the total return of
equities over any meaningful timescale. Portfolio yields are updated each
month with the performance figures.
Finally, I follow my own advice and tend not to allow market forecasts to
guide my investment decisions. I keep an eye on economic analysis because
understanding which parts of the world are growing faster than others is
useful. Not because faster-growing economies necessarily lead to better
performing markets – China’s economy has grown at an average annual rate
of 8–10 per cent during the past decade, yet its stockmarket has hardly
advanced at all. But because faster-growing economies provide a richer, more
profitable, pool of companies in which good fund managers can fish. The Far
East is a good example – one where smaller company trusts in particular have
performed well.
Whilst recognising that economic analysis is useful, I try to adhere to the
most important investment principle of all – and that is to separate the
fundamentals of an asset from the sentiment shown it by the market. This
above all should guide you in your investment choices. If you are to
outperform the market, then you have to do something different to the
market.
An example is the UK smaller company sector where, for reasons explained
in the next section, sentiment continues to trail fundamentals despite the
sector outperforming the wider market – and this why you can still pick up
excellent trusts on 15–20 per cent discounts.
But the point about sentiment versus fundamentals can operate at any level.
For example, when sentiment was rock bottom during the eurozone crisis
because it was being influenced by the poor economic outlook, the market
was ignoring the many excellent companies on the continent that had large
overseas earnings – particularly in the faster-growing emerging economies.
Both stock markets and good fund managers were being unfairly penalised,
and this presented a wonderful opportunity to pick up both cheaply – and the
markets duly rewarded the brave.
However, it is true to say that such an approach can sometimes require
patience, or a short-term catalyst to wake the market from its torpor!

Investment strategy
Both portfolios pursue common themes when it comes to asset allocation. My
long-held mantra has been ‘Go high, go deep, go east’. Both portfolios,
relative to their respective benchmarks, reflect this strategy: they are
overweight high-yielding equities and corporate bonds, overweight smaller
companies, and overweight the Far East. Within bonds they are underweight
gilts, and within equities they are underweight the UK and the US. This has
influenced my strategy for some time – and it looks set to continue to do so in
future.
Performance has been respectable (see Table 9.2) but one can never be
complacent.
Table 9.2 Portfolio performance: 1 January 2009 to 1 June 2013
Growth Income
Portfolio total return [%] 105.7 87.9
APCIMS total return [%] 65.3 53.0
Relative performance [%] 40.4 34.9
Yield [%] 2.2 4.1
The APCIMS Growth and Income benchmarks are cited [Total Return]

The breakdown of holdings (rounded to the nearest half a per cent) at the
time of writing is given in Table 9.3.
Table 9.3 Asset allocation and holdings listed
Go high
The rationale for ‘going high’ is that interest rates are set to remain low for
some time to come. The slowdown in the West is unusual: this is a
deleveraging recession and not a destocking one which has more typically
characterised recessions since Keynes’ time. Traditionally, a good dose of
Keynesian stimulus to encourage demand – using borrowed money if
necessary – would have corrected the situation. This option is not available
today. The hallmark of this recession is excessive debt – both governments
and consumers have lived beyond their means. The cupboard is now bare,
and it makes little economic sense to borrow your way out of debt.
The long-term solution is economic growth. But where are the much-needed
supply-side reforms? Or the measures to encourage greater competitiveness
and reduce taxation? Instead, the debt is simply being moved around the
system, between governments and banks and back again.
In recognising their failure, governments have set upon the course of
‘financial repression’. The objective is to create a little more inflation in order
to help erode the debt over time – a policy pursued after the Second World
War. This is being achieved by keeping interest rates artificially low at both
ends of the yield curve.
This is easy at the short end because of the compliance of government-
appointed central bankers. It is achievable at the longer end by forcing the big
players, the pension funds and banks, to be buyers of government bonds
through regulations such as asset/liability matching and capital adequacy
ratios – and yields reflect this artificial demand. Savers are suffering as a
result.
This is a dark art. Quantitative easing is also part of the script. But whether
successful or not, interest rates will remain low for years – there is too much
debt in the system and governments want to avoid default. In such an
environment, good-yielding equities and corporate bonds will remain in
demand – particularly those equities that can increase payouts. Meanwhile,
overseas income will play a more prominent role in portfolios.
Go deep
As for the ‘go deep’ part of the strategy, I remain of the view that smaller
companies globally will continue to do well relative to the wider markets –
for reasons espoused in my Investors Chronicle column ‘Still set on small
caps’ (3 September 2010). It used to be conventional thinking that investors
should overweight smaller companies during an economic up-swing, but
underweight the sector as the economy struggled. This thinking needs to be
challenged.
Globalisation continues apace. As a result, portfolio diversification by means
of geography will continue to decline in importance relative to global themes.
The hunt is on for those themes that will reward investors. By and large, in
such an environment, the UK smaller companies sector in particular has
tended not to be on some investors’ radar screens because of the perception
that the sector is heavily reliant on the domestic economy, particularly
manufacturing and building.
But this perception is slowing changing. The sector today has much more
overseas exposure and is therefore less exposed to the twists and turns of the
UK economy. Many smaller companies now generate more than half of their
earnings overseas, and have exposure to a much wider selection of sectors at
least in part because of the advances in technology. Those hunting global
themes no longer automatically shun smaller companies. And at a time when
economic growth in the UK and the West generally will be anaemic at best,
the right global themes will produce superior returns for investors.
Another positive change for the sector is that, after the shock of BP and other
large companies cutting their dividends, more investors are looking further
down the market cap spectrum for income. And the potential is huge. Many
smaller companies now have stronger balance sheets and yield as much as
their larger brethren.
In short, better management and greater access to international markets, in
part thanks to technology and globalisation, together with the sector generally
remaining under researched, makes for a powerful combination for good fund
managers.
There is another factor that should be considered. Investors tend not to like
volatility – it leads to sleepless nights and is often associated with riskier
investments – and independent financial advisers (IFAs) have long cited
volatility as a reason to shun the investment trust sector as a whole. Yet
sentiment towards the smaller companies sector may improve as the low-
growth environment ushers in less-extreme economic swings and therefore
lower sector volatility. Some 15–20 per cent discounts on many good-
performing smaller company trusts provide a wonderful investment
opportunity.
Go east
Finally, I am more convinced than ever that investors should ‘go east’ for
superior returns. I buy into the emerging markets story in general. In the
present low-growth environment, you will increasingly have to look overseas
for both growth and income. And whilst accepting that the faster economic
growth rates of the emerging markets will not always necessarily translate
into better-performing stock markets, such growth does make it easier for
good fund managers to find good companies.
Most investors have the vast majority of their assets in developed markets,
with only a small percentage in emerging markets – typically around 5–10
per cent. This remains the consensus despite the attraction of these
developing markets. This will change over time. Those investors who beat
the consensus in realising this will be rewarded.
As Dr Mark Mobius, manager of Templeton Emerging Markets Investment
Trust, put it a few years ago: ‘The key is growth. Growth is higher [in
emerging markets]. The most populated countries in the world are also the
fastest growing.’ Growth rates in China, India, Brazil and many other
emerging markets will continue to beat the western world by some margin.
And these larger countries are now being joined by a host a smaller ‘frontier’
markets such as Nigeria, Saudi Arabia and Vietnam.
Meanwhile, many of these markets are now less risky for investors.
Governments in these developing countries are not burdened by high levels
of debt, corporate governance has improved significantly and there is
improving political stability. Such factors help stock-market valuations.
Furthermore, policy makers in these emerging market countries are gradually
realising they cannot rely on western consumption as much as they have done
in the past. We are seeing a structural change. Those emerging markets
driven by domestic demand and investment will do especially well.
And this is where the Far East comes in. Many emerging markets, but
particularly in Asia, have young populations and high savings ratios – they
have not been great spenders. This may be about to change. Low interest
rates reducing the desire to save, combined with cash-rich governments
investing in infrastructure and social welfare projects, will result in domestic
spending increasing significantly. The region also benefits from a low
entitlements culture and a work ethic. It is full of promise.
In the past, as we have seen, volatility has tended to put investors off. This
volatility will remain despite the lower investment risks, but investors should
embrace and exploit it. As I have suggested before, if volatility is a measure
of risk then investors would always be underweight good opportunities. The
debate is more about timing. Investors should view volatility as an
opportunity and not a risk.

Balancing competing factors

In the search for good investment returns, there are usually competing factors
that need to be accommodated – and these two portfolios are no different.
One is geography versus themes. As can be seen from the breakdown of
holdings, both portfolios hold trusts under the benchmark headings of ‘UK
shares’ and ‘International shares’. This is widespread practice among wealth
managers and advisers, because geography and currency are still important
determinants of investment return. It still pays to specialise in a region as rich
and diverse as Europe, for example, as it will host a very wide spectrum of
companies, sectors and industries.
However, both portfolios also have holdings under the heading ‘Themes’ –
this not being part of either benchmark. This is because, as globalisation
continues to gather pace, the pursuit of themes will become a more important
contributor to investment returns. An example is the biotech sector, where it
is wise to adopt a global approach given the strength of the sector in the US,
and to a lesser extent, Europe and Japan – despite their respective economies
being under pressure.
And it is usually important to ‘look through’ the thematic trusts to
ascertaining geographic exposure. For example, at the time of writing, both
portfolios are underweight the US. But a cursory glance at the holdings
would suggest no exposure at all – there being no direct ‘geographical’
holdings, unlike other regions of the world. Yet exposure to the US accounts
for around 60 per cent of the Worldwide Healthcare Trust (WWH), which is a
major thematic holding in both portfolios. Likewise, the holding of The
Biotech Growth Trust (BIOG) in the Growth portfolio has an 85 per cent
weighting in North America.
In balancing geography and themes, I tend to give greater weighting to
geography. This is because those fund managers specialising in the world’s
countries and continents will already be pursuing some of these themes. It is
advisable to at least get a feel as to how trust portfolios are slanted by
accessing the monthly factsheets or report and accounts. Both portfolios
therefore have greater total weightings under the ‘UK’ and ‘International
share’ headings than they do pursuing themes.
Another competing factor is that between capital growth and income. Both
portfolios recognise that dividends make up the lion’s share of investment
returns – as much as 97 per cent of the total return of the US market over the
past 130 years, according to recent research. Both portfolios therefore have a
healthy yield relative to their benchmarks, and this bias within the portfolios
will continue while the ‘Go high’ element of the strategy remains in place.
The conventional thinking used to be that bonds – government or corporate –
would provide the income, and equities the capital growth. This was
particularly the case after 1959 when the yield on equities fell below that
offered by government bonds for the first time since time immemorial. But as
both portfolios testify, the choice does not necessarily have to be a straight
one between capital or income. Sometimes you can have both. Both
portfolios hold equity trusts which have decent yields and have performed
well in capital terms. Some of the UK income and Far East income trusts
have been stellar performers – the latter helped by a weakening pound.
Of course it is difficult to generate yield from certain themes such as
technology and bioscience. But increasing numbers of companies around the
world are paying out rising dividends – it is almost seen as the rite of passage
toward greater credibility and access to the capital markets. And given
sterling’s tendency to depreciate against other currencies – something that
will continue until the UK rediscovers its ability to manufacture goods for
export – then this overseas income becomes of increasing value.
Furthermore, there are certain parts of the world where I expect to see
excellent capital growth from the equity markets over the longer term –
certainly exceeding mainstream markets – and yet which offer good
dividends. The frontier markets are a good example. Yields here are healthy
because valuations are cheap – something that will change over time.
Perhaps one final point should be made when balancing growth and income.
Even when seeking a decent income is the first priority, an investor should
not sacrifice completely the compelling growth stories. For example, the
Income portfolio has exposure to UK and Far Eastern smaller companies,
Japan, and healthcare and biotech despite their relatively low yields. My
expectation is that, longer term, their total returns will reward investors. Short
term, I am compensating in income for their inclusion by over-weighting
bonds and other high-yielding assets.
A further competing factor when searching for good investment returns is
that between risk and reward. How far does an investor embrace risk in
search for higher returns? The answer is subject to much debate. It is widely
accepted that you cannot access reward without risk. We have examined in
previous chapters the extent to which equity markets in particular can be
volatile – and how government bond markets have sometimes not been far
behind. If volatility concerns you, then perhaps stock markets should be
shunned.
The approach adopted by both portfolios is to accept volatility and invest for
the long term. History is, after all, on our side. The equity markets tend to
reward those who remain loyal and stay invested – and staying invested helps
to access the ever-important dividends.
The Income portfolio is better insulated against volatility because it has a
much higher weighting in lower-risk government and corporate bonds. The
search for yield encourages this, particularly when it comes to corporate
bonds. But both portfolios are also overweight higher-yielding equities both
at home and abroad. Theoretically this should help reduce the risk and
volatility when markets hit turbulent patches – decent yield can act as a
cushion in uncertain times.
But the existence of discounts will result typically in volatility no matter the
investment strategy. I hope both portfolios have illustrated over the years
that, for the patient investor willing to take a long-term view, the rewards are
worth waiting for!

A recent column
By way of illustration as to the nature of these columns, below is one I
prepared earlier! It was published in February 2013 in the Investors
Chronicle.

Japan: a once in a lifetime opportunity?

John Baron believes the Japanese equity market could be at a
major turning point.
In last month’s column, space did not allow me to explain why I
had introduced Baillie Gifford Japan Trust (BGFD) into the
Growth portfolio in December. Readers will know that both
portfolios have tended to avoid Japan in the past, but the recent
election of Shinzo Abe as Prime Minister could be a ‘game-
changer’ – and not another false dawn.
False dawns
Japan’s problems have been well known for years. The country
is drowning in debt, and there are concerns as to its ability to
pay the interest let alone the capital back. Around half of all
government income is consumed by debt interest. A series of
infrastructure initiatives over the years have failed to kick start
the economy, and only added to the debt mountain.
And the debt keeps rising – government expenditure exceeds
income. The deficit will be nearly 10% of GDP this year. The
situation has not been helped by a sluggish economy. A
stubbornly high exchange rate has hindered exports with trade
surpluses now turning into deficits. Connected to all this, the
economy is struggling with deflation.
Governments have needed to raise income but found it difficult.
One reason is that the population is declining and getting older,
and this costs money. In the past, the government has been
helped with its borrowing by its citizens’ tendency to buy
bonds. But bond yields and savings rates are now very low.
This road is nearing its end.
It is therefore little surprise the stockmarket has drifted for
years. There has been no shortage of false dawns – with 20–40
per cent rallies being relatively common. But they have all
petered out because of economic reality. Many believe the
catalyst needed to break this cycle of economic malaise is
inflation. Previous governments have shunned the idea – enter
Shinzo Abe.
The ‘Abe Trade’
On 16 December [2012], Japanese voters finally decided they
had had enough of their deflationary predicament. The rapid
deterioration in Japan’s current account and its growing
inability to finance her large budget deficits has this time
forced political and policy change.
Shinzo Abe won a landslide election – a two-thirds majority –
advocating an aggressive programme of fiscal stimulus, despite
the size of the budget deficit, and almost unlimited monetary
easing. Inflation is now the number one objective. He wants the
Bank of Japan (BoJ) to instigate a 2 per cent inflation target, as
compared to the present 1 per cent, and does not mind the
extent of money printing it takes to get there. He has made it
known that if the independent BoJ does not oblige, then he will
rewrite the law so that he can fire the board.
An all-out attack on deflation is now being executed. Many
have argued that the BoJ’s deflation-fighting efforts in the past
have been half-hearted. It has certainly lagged other central
banks. Between mid-2008 and mid-2012 its balance sheet –
reflecting assets bought with printed money – grew by only 7
per cent of GDP, compared to 14 per cent by the Bank of
England and the ECB. There is scope for the BoJ to be more
aggressive.
And the effect could be dramatic. Japan has been mired in
deflation. Consumer prices are still at 1993 levels; this
compares to a 60 per cent gain since then in the US. As a result,
Japanese government bonds have been in a bull market for 20
years. Equities have disappointed. However, if rising inflation
ends the bull market in bonds – and changes the mindset of the
traditionally conservative Japanese investors – the money
currently flowing into bonds will need a new home. Where else
but equities? After all, after their bear phase, they now yield
the same as US equities.
But rising inflation can take time to materialise. Shifting
mindsets can take longer than envisaged to change. What may
well be a sustainable fillip to the equity market in the shorter
term is a weakening yen because of unlimited quantitative
easing. A strong currency has hit exports over the years. And
because the stockmarket is full of major exporters, equities are
strongly influenced by fluctuations in the currency. A declining
yen would be very bullish for equities. The yen-dollar rate
hovered around 77 for most of 2012. Today it is 90.
And the equity market is cheap on any number of measures.
Companies have grown their earnings by 50 per cent over the
last 12 years and their return on equity, a key guide to
profitability, has risen from 6 per cent to 10 per cent. A strong
yen has encouraged cost-cutting and production being moved
to lower cost countries in Asia. Many companies also trade at
below book value – the ‘break-up’ worth of the company’s
assets. By comparison, the FTSE 100 sits at around one-and-a-
half times book value. Furthermore, their restructuring has left
balance sheets strong, whilst they spend more on R&D than
any other developed economy.
In short, these companies are now lean and mean. But the
stockmarket’s spring coil has remained compressed for a long
time because of deflation and a strong yen. Shinzo Abe’s
policies could well be the catalyst to change this. Investors
should take note and profit from the ‘Abe Trade’. Of course,
this will not be a smooth road. The Japanese establishment is
conservative by nature. The BoJ knows how to put up a fight.
But a landslide victory and policy so far suggest this will not be
yet another false dawn.
Portfolio changes
BGFD, introduced into the Growth portfolio in December, is
run by the well-respected Sarah Whitley. The trust has a good
track record and gearing of around 18 per cent which, when
 speaking with Sarah, confirmed their optimism for the market.
It has done well in the short time it has been with us.
However, it tends not to hedge the currency. I have therefore
increased the Growth portfolio’s exposure to Japan by
introducing an ETF which hedges the yen against the GBP –
namely the iShares MSCI Japan Monthly GBP Hedged ETF
(IJPH). This should mean UK investors will not have any
equity market gains trimmed by the extent the yen weakens
against the GBP. IJPH has exposure to the largest 300
companies which should also compensate for BGFD’s modest
bias towards the mid-caps.
I rarely use hedged investments, believing currencies are
notoriously difficult to predict as politicians and central
bankers often interfere. But it is warranted here given that a
weakening currency is an important ingredient to the story.
This purchase has been funded by top-slicing Temple Bar Trust
(TMPL), whilst standing at a premium to NAV, and City
Natural Resources Trust (CYN) – both having had good runs
recently.
Otherwise, there were no changes to the Income portfolio.
John Baron waives his fee for this column in lieu of donations by
Investors Chronicle to charities of his choice. As these are live
portfolios, he has interests in all of the investments mentioned.
Source: Baron J. (2013) ‘Japan: a once in a lifetime opportunity?’, Investors Chronicle, 7
February.
References

Introduction
1 Leonora Walters (2012) ‘RDR: What it means for you’, Investors
Chronicle, 21 December.
2 Elaine Moore (2012) ‘Fears grow over advice gap’, Money section
Financial Times, 10/11 November.
Chapter 2
1 Referred to in: James McKeigue (2011) ‘Funds: the huge difference a
small fee makes’, MoneyWeek, 6 May.
2 Referred to in: Moira O’Neill (2011) ‘Unique benefits of investment
trusts’, Investors Chronicle, 2 August.
Chapter 5
1 Referred to in: Alice Ross (2011) ‘Understand ETF risks, investors
warned’, Money section, Financial Times, 24/25 September.
2 Referred to in: James McKeigue (2011) ‘The advantages of sitting
tight’, MoneyWeek, 2 December.
3 Referred to in: Steve Lodge (2011) ‘Swing towards momentum’,
Money section, MoneyWeek, 12/13 February.
Chapter 6
1 MoneyWeek (2013) ‘Where UK stocks are heading in the long term’,
15 March.
2 Elaine Moore (2011) ‘FSA warns on portfolio risks’, Money section,
Financial Times, 18/19 June.
3 Referred to in: Beth Holmes (2013) ‘Small fish in a big pond’,
February, www.cisi.org.
Chapter 7
 1 Tim Bennett (2009) ‘Why drip feeding won’t make you rich’,
MoneyWeek, 19 June.
2 Referred to in: Alice Ross (2010) ‘Market timing errors prove too
costly’, Money section, Financial Times, 20/21 November.
3 Ibid.
4 Ibid.
5 Published on 9 June 2011 in the Financial Analysts Journal, Vol. 67,
No. 3.
6 Referred to in: Tim Bennett (2009) ‘Three basic rules for investment
success’, MoneyWeek, 28 August.
7 Referred to in: Matthew Allan (2012) ‘UK dividends hit record high’,
Investors Chronicle, 25 July.
Chapter 8
1 Quoted in: James Montier (2009) ‘Nine rules for value investors’,
Investors Chronicle, 12 June.
Index

Aberdeen All Asia

discount trigger
Aberdeen Asia Pacific
Aberdeen Asian Income
discount trigger
Aberdeen Asian Smaller Companies, 2nd, 3rd
Aberdeen Global Asian Smaller Companies
Aberdeen Latin American Income discount trigger
Aberdeen New Dawn
Aberdeen New Thai
discount trigger
absolute-return funds (ARFs), 2nd
accounts
active fund managers
and ETFs
performance, 2nd
and fees, 2nd
advantages for small investors
advisory management wealth managers
African markets
AIC see Association of Investment Companies (AIC)
Alliance Trust
discount trigger
dividends
raising from capital
annual reports
APCIMS (Association of Private Client Investment Managers and
Stockbrokers)
benchmarks, 2nd, 3rd, 4th, 5th
AQR Capital Management
ARFs (absolute-return funds), 2nd
Asia Pacific sector
performance comparisons with benchmark/OEIC/unit trusts, 2nd
Asian countries
currencies
see also Far Eastern market
Asness, C.
assets
asset classes
Investors Chronicle portfolios, 2nd
portfolio diversification across, 2nd
structured products
asset/liability matching
closed-ended funds
in emerging markets
ETFs and asset growth
and investment trusts
long-term investments
range and reach of
management of
and IFAs
in smaller funds
market sentiment versus fundamentals
net asset value (NAV)
open-ended funds
Association of Investment Companies (AIC)
on strategy changes
AstraZeneca

Baillie Gifford Japan

balanced fund management fees and performance
bank credit
short-term borrowing
Bankers Investment Trust
dividends
banks
and DIY investors
and government bonds
and structured products
BarclayHedge
Barclays, 2nd
Barclays Capital
Equity Gilt Study
Barclays Wealth
Baring Eastern European
Baring Emerging Europe
discount trigger
benchmarks
deciding investment objectives
and fund performance, 2nd, 3rd, 4th
paying fund managers
Investors Chronicle portfolios, 2nd
shadowing
and trust reports and accounts
BGF World Mining
BH Macro
discount trigger
Biotech Growth Trust (BIOG), 2nd
discount trigger
Black Monday (1987)
BlackRock Commodities Income
BlackRock Frontiers
BlackRock Greater European
BlackRock Latin American
discount trigger
BlackRock World Mining
Blue Sky Asset Management
blue-chip investments, 2nd, 3rd
and bonds
BlueCrest
board of directors
investment trusts, 2nd
and gearing
Bolton, Anthony
bonds, 2nd, 3rd
bond exposure
currency considerations
and equities
fixed-rate cash bonds
government bonds, 2nd, 3rd
and income
Investors Chronicle portfolios, 2nd, 3rd
performance
in a portfolio
and portfolio diversification, 2nd
bond/equity split
risk tolerances
see also corporate bonds
borrowing
gearing
investment trusts compared with open-ended funds
see also debts
BP
Brazil
Brevan Howard
British Assets Trust
brokerage fees
broking firms
and DIY investors
Brunner
dividends
Buffett, Warren, 2nd
buybacks, open market, 2nd, 3rd

Caledonia Investments
dividends
Canaccord Genuity
Capita Registers
capital
adequacy ratios
changes
paying dividends out of
capital gains tax (CGT)
limit, 2nd
multi-manager funds
capital growth
balancing with income, in the Investors Chronicle portfolios
capital shares, 2nd, 3rd
cash
creating a portfolio from cash
deposits, 2nd
and the Investors Chronicle portfolios, 2nd
and portfolio diversification
raising cash levels
cautious fund management fees and performance
CF Ruffer Total Return
CGT see capital gains tax (CGT)
China, 2nd, 3rd
Citi Bond index
City of London Investment Trust
dividends
City Merchants High Yield
City Natural Resources
closed-ended funds
investment trusts as
and open-ended funds
range of
Collins Stewart
comparing performance of investment trusts, 2nd
and unit trusts
commercial property
and the Investors Chronicle portfolios, 2nd, 3rd
commodities, investment in portfolio diversification, 2nd
communication, quality of and discounts
complicated products, avoiding
compound interest
construction sector
control mechanisms
discounts
corporate bonds
demand for
and ETFs
and the Investors Chronicle portfolios
and portfolio diversification
Coutts
Credit Suisse
Global Investment Returns Yearbook
currency considerations

Darwell, Alex
dealing costs, 2nd, 3rd
debts
elimination of personal debts
and gearing
and government policies
see also bonds
deciding investment objectives
choosing a benchmark
currency considerations
DIY investors, 2nd
income requirements
risk tolerances, 2nd
routes to market
IFAs
ISAs
SIPPs
wealth managers
saving and investing
derivatives
and currency moves
Directors’ Dealing Investment Trust
directors of investment trusts
board of directors, 2nd, 3rd
directors’ report and financial statements
information in report and accounts
shareholdings
disadvantages for small investors
discounts, 2nd
and capital changes
control mechanisms
and dividends
factors affecting
and gearing
judging value
and market sell-offs
and open market buybacks, 2nd, 3rd
opportunities and risks
and share prices, 2nd, 3rd, 4th, 5th, 6th
and shareholders
and small investors
trading at a discount, 2nd
triggers
in the trust’s report and accounts
discretionary management wealth managers
diversification
dividends
and capital growth
compounding
cuts by large companies
raising from capital
reinvesting
revenue reserves
and small investor advantages
DIY investors, 2nd
see also successful investing
Dow Jones index
Dunedin Smaller Companies
discount trigger

Eaglet Trust
Ecofin Water & Power Opportunities Trust (ECWO)
economic growth
and different investment styles
emerging markets
forecasting
and the Investors Chronicle portfolios
and portfolio diversification
ECWO (Ecofin Water & Power Opportunities Trust)
Edesess, Michael
Edinburgh Dragon
Edinburgh Investment Trust
Edinburgh US Tracker Trust
elderly investors
income requirements
and split capital investment trusts
Electric & General
emerging markets, 2nd
and the eurozone crisis
frontier markets, 2nd, 3rd
and income requirements
investment strategy
performance comparisons with benchmark/OEIC/unit trusts, 2nd
returns generated by
world equities
enhanced flexibility of investment trusts
entry charges
equities see shares (equities)
equity diversifiers
equity trusts
ETFs (exchange-traded funds), 2nd, 3rd, 4th, 5th
and active fund managers
and cost-effective investing
and fund managers
growth of
and the Investors Chronicle portfolios, 2nd
leveraged
physical
and portfolio diversification
risks of
tracking errors
European Assets
discount trigger
European EFT asset growth
European sector
performance comparisons with benchmark/OEIC/unit trusts, 2nd
euros
and politics
eurozone crisis
Evolve Financial Planning
exchange-traded funds see ETFs (exchange-traded funds)
exit charges

Far Eastern market, 2nd, 3rd

income trusts
FE Trustnet
and portfolio turnover, 2nd
fear, markets driven by, 2nd
fees
different structure
and DIY investors
effect of cheaper fees on performance
funds launched with performance fees
hedge funds, 2nd
hidden charges, 2nd, 3rd
making more transparent
management charges, 2nd
unit trusts
multi-manager funds, 2nd
shareholders’ questions about
structured products
TERs (total expense ratios), 2nd
in the USA
wealth managers
Fidelity
research on timing the market
Fidelity China Special Situations
Fidelity European Fund
Fidelity European Values
Fidelity Special Situations
Fidelity Special Values
Fidelity UK Special Situations
financial repression
government policy of
Financial Services Authority see FSA (Financial Services Authority)
Financial Services Compensation Scheme
Finsbury Growth & Income (FGT), 2nd, 3rd
discount trigger
fixed-income sector
performance
flexibility of investment trusts
Forbes
forecasts, ignoring
Foreign & Colonial (F&C)
Commercial Property
discount triggers
discounts, 2nd
dividends
Global Smaller Companies, 2nd
Managed Portfolio Growth
Managed Portfolio Income
US Smaller Companies
free-falling markets
frontier markets, 2nd, 3rd
and the Investors Chronicle portfolios
FSA (Financial Services Authority) investing into wealth managers
see also Retail Distribution Review (RDR)
FTSE 100 index
and Black Monday
ETFs, 2nd
and structured products, 2nd
FTSE All-Share index, 2nd, 3rd, 4th, 5th
best trading day
and the Investors Chronicle portfolios
and portfolio diversification
FTSE APCIMS
and the Investors Chronicle portfolios, 2nd
FTSE Developed index
FTSE Emerging index
FTSE Gilts All-Stocks index
FTSE World index, 2nd
fund managers
active, 2nd, 3rd
and ETFs
different investment styles
and directors
and discounts, 2nd
change in manager or strategy, 2nd
communication with shareholders
effects of day-to-day management on
picking a manager, 2nd
and gearing
and geographical themes
growth managers
hedge fund managers
management charges
unit trusts
variations in
moving on
multi-manager funds, 2nd
and performance
change in focus
mirror funds
and portfolio turnover
raising dividends from capital
reports
shareholdings
small investors compared with, 2nd
value managers
see also fees; wealth managers
funds of funds
future prospects
and discounts

Galbraith, J.K.
gearing
and discounts
and fund managers’ reports
and fund managers’ shareholdings
and profits
and shareholders
Glaxo
GlaxoSmithKline
global equity funds
losses
US compared with UK
global equity income
performance comparisons with benchmark/OEIC/unit trusts
global sector
categories of investment trusts
growth and income, 2nd
discounts
performance comparisons with benchmark/OEIC/unit trusts, 2nd
see also emerging markets
globalisation, 2nd
and investment themes
and portfolio diversification
goals
reaching investment goals
government bonds, 2nd, 3rd
government policies
and financial repression
Graham, Ben
Greece, 2nd
greed, markets driven by, 2nd

Hargreaves Lansdown effect

healthcare funds, 2nd, 3rd
hedge funds, 2nd
fees, 2nd
and the Investors Chronicle portfolios, 2nd
performance
and portfolio diversification
private
raising dividends from capital
Henderson Asia Pacific Capital Growth
Henderson Asian Dividend Income
Henderson Asian Growth
Henderson European Focus
Henderson EuroTrust
Henderson Far East Income
Henderson Global
Henderson Private Equity
Henderson Smaller Companies, 2nd
Henderson TR Pacific
Henderson UK Equity Income
Herald investment trust
HFRX Global Hedge Fund index
HICL Infrastructure
high-yielding trusts
standing at discounts
household goods sector
HSBC

Ibbotson Associates
IFAs see independent financial advisers (IFAs)
ignoring forecasts
IMA (Investment Management Association)
Active Managed sector
fund categories
UK All Companies sector
unit trusts, fund launches v. closures
income
access to funds
and capital growth
growth
requirements
income shares, 2nd
income tax
independent financial advisers (IFAs)
and asset management
fees and commission charges
and investment trusts
understanding of
volatility of
model portfolio approach
and the RDR
index-trackers, 2nd
India
individual savings accounts see ISAs (individual savings accounts)
inflation
and financial repression
and global equities
and savings
infrastructure funds
discounts
fees and performance
and long-term investment
interest rates
and company profits
and compound interest
and economic growth, 2nd
and emerging markets
forecasting
and investment objectives
and split capital investment trusts
International Biotechnology
internet see websites
Invesco Lev High Yield
Invesco Perpetual
Invesco Perpetual High Income Fund
Investec UK Special Situations
investment trusts
and asset classes
capital changes
compared with structured products
directors
board of, 2nd, 3rd
shareholdings
with discount control policies
discounts and premiums
dividends
enhanced flexibility of
exchange-traded funds (ETFs), 2nd, 3rd
gearing
and long-term investment
market capitalisation
memorandum and articles
net asset value (NAV)
share price
performance
and fees
portfolio turnover
price of
range and reach of
report and accounts
shareholders
size of
and marketability
split capital (splits)
structure and differences
supposed complexity of
ten cheapest (2011)
understanding of
volatility of, 2nd, 3rd
websites, 2nd
see also discounts
Investors Chronicle portfolios
asset classes, 2nd
balancing competing factors
benchmarks, 2nd
and the DIY investor
and ETFs, 2nd
execution-only service
and frontier markets
Growth and Income, 2nd, 3rd, 4th
balancing capital growth and income
balancing risk and reward
geography versus themes
performance
international shares
investment philosophy
investment strategy
emerging markets
going deep
going high
performance
rationale for
rebalancing portfolios
UK shares
and the UK smaller company sector
investors
discounts and investor demand
DIY, 2nd
Irsaelov, R.
ISAs (individual savings accounts)
compared with structured products, 2nd
Ishares Corporate Bond
Ishares DJ Emerging Markets Division
Ishares Gilt
Ishares Japan

James, Kevin
Japanese equity market, 2nd
Japanese investment trusts performance
relative to benchmarks
JEO (Jupiter European Opportunities Trust), 2nd, 3rd, 4th
joint names, portfolios held in
JPMorgan Brazil
discount trigger
JPMorgan Claverhouse
dividends
JPMorgan Emerging Growth
discount trigger
JPMorgan Emerging Markets, 2nd
discount trigger
JPMorgan European Income
discount trigger
JPMorgan European Smaller Companies
JPMorgan Japanese, 2nd
JPMorgan Overseas
discount trigger
JPMorgan Russian Securities
discount trigger
JPMorgan US Smaller Companies
discount trigger
Jupiter European Opportunities Trust (JEO), 2nd, 3rd, 4th
Jupiter Primadona Growth
discount trigger

Keynesian economic policies

Lack, Simon
The Hedge Fund Mirage, 2nd, 3rd
Lang, John
Latin American companies, 2nd
Law Debenture Corporation
Laxey Partners
Lehman Brothers
leveraged ETFs
Liew, J.
life insurance
liquidity
and buybacks
size and marketability
Lloyds
London Business School (LBS)
long-term investment
and discounts
regular rebalancing
reinvesting dividends
Lowland

M&G High Income Investment Trust, 2nd

managed advisory services
wealth managers
managers see fund managers
Marie Curie Global Portfolio
discount trigger
market capitalisation
investment trusts, 2nd
market sell-offs
market sentiment
and discounts
versus fundamentals, 2nd
market timing
market volatility see volatility
marketability of investment trusts
Martin Currie Global Portfolio (MNP)
maximum holding limit
medium-sized companies
Mercantile
Midas
Income & Growth
mirror funds
performance, 2nd, 3rd
mispricing, identifying, 2nd
Miton Worldwide Growth
MNP (Martin Currie Global Portfolio)
Mobius, Dr Mark
model portfolios, 2nd
momentum investing
Montanaro UK Smaller Companies
Montier, James
mortgages
multi-manager funds, 2nd
Murray Income
Murray International Trust (MYI), 2nd, 3rd

NAV (net asset value)

collapse (2011)
discounts to, 2nd, 3rd, 4th, 5th
control mechanisms, 2nd, 3rd
and dividends
and ETFs
and gearing, 2nd
growth, 2nd
and income requirements
and marketability of shares
and share prices, 2nd
net asset value see NAV (net asset value)
New City High Yield
Nigeria
Nimmo, Harry
North American sector
performance comparisons with benchmark/OEIC/unit trusts, 2nd
Norton, James

objectives see deciding investment objectives

OEICs (open-ended investment companies)
and discounts
and ETFs
individual unit prices
and investment trusts, 2nd
performance comparisons, 2nd, 3rd
size of
open market buybacks, 2nd, 3rd
open-ended funds
borrowing restrictions
and closed-ended funds
and discounts
and gearing
marketability, 2nd
performance, 2nd, 3rd, 4th
fees, 2nd, 3rd
and the RDR
size, 2nd
TERs
trading times
and UK financial advisers
see also OEICs (open-ended investment companies); unit trusts
open-ended investment companies see OEICs (open-ended investment
companies)
opportunities
discounts
overseas investments, 2nd
earnings from
emerging markets
income from
income requirements
and portfolio diversification
and smaller companies

peer group indices

pension funds
and government bonds
performance
benchmarks, 2nd, 3rd, 4th, 5th
and discounts, 2nd
judging value of
fees
demise of
funds launched with
and wealth managers
and fund managers’ reports
and gearing
hedge funds
investment trusts
regional sectors
Investors Chronicle portfolios
mirror funds, 2nd
multi-manager funds, 2nd
OEICs, 2nd, 3rd
unit trusts, 2nd, 3rd
tables
permitted investments
Perpetual Income and Growth
Personal Assets Trust
discount trigger
pharmaceuticals, 2nd
and portfolio diversification
physical ETFs
Polar Capital Technology
politics
and currency considerations
government economic policies
portfolios, 2nd
bonds, 2nd, 3rd, 4th
choosing a benchmark
constructing
diversification, 2nd, 3rd
and globalisation
and ETFs
and investment secrets
and investment trusts
fund managers’ reports
range and reach of, 2nd
in joint names
liquidation, 2nd
multi-manager funds
reducing investment risk
regular rebalancing, 2nd
returns and fund charges
selling
size and marketability
and split capital investment trusts
and taxation
turnover
values and gearing
see also NAV (net asset value); performance; shares (equities)
pound-cost averaging
premiums
changes to
investment trusts standing on
judging value of
trading at a premium, 2nd
prices
investment trusts
OEICs
share prices
closed-ended funds
and discounts, 2nd, 3rd, 4th, 5th
NAV (net asset value)
open-ended funds
performance of investment trusts, 2nd
and pound-cost averaging
unit trusts
see also fees
private client brokers and marketability
private equity funds, 2nd, 3rd
private hedge funds
profits
and gearing
property investment, 2nd, 3rd
commercial property and the Investors Chronicle portfolios, 2nd, 3rd
portfolio diversification, 2nd

quantitative easing
RDR see Retail Distribution Review (RDR)
rebalancing portfolios
Investors Chronicle portfolios
recession
and economic growth
regional sectors
performance
reinvesting dividends
report and accounts
research costs
Retail Distribution Review (RDR), 2nd
and discounts
and IFAs
and multi-manager funds
revenue reserves
risks
balancing risk and reward, 2nd, 3rd
of different investment styles
and discounts
emerging markets
of ignoring forecasts
investment trusts
discounts, 2nd
and volatility
Investors Chronicle portfolios
reducing portfolio risk by diversification
risk tolerances, 2nd, 3rd
structured products, 2nd
RIT Investment Trust
Ruffer Investment Company

S&P 500 index

Santander
and structured products
Saudi Arabia
saving
and investing
savers and emerging markets
Schroder Oriental Income
discount trigger
Schroder UK Mid Cap
SCM Private
Scottish Investment Trust
discount trigger
Scottish Mortgage, 2nd
Scottish Oriental Smaller Companies
Securities Trust of Scotland
discount trigger
sentiment see market sentiment
shareholders
agitation
and gearing
powers of
shareholdings
directors’ and managers’
shares (equities)
and capital growth
currency considerations
demand for
equity income
performance comparisons with benchmark/OEIC/unit trusts
exchange-traded funds (EFTs)
income requirements
and investment trusts
split capital (splits)
Investors Chronicle portfolios
performance
long-term investment in, 2nd
and risk tolerances
lump sum investing
momentum investing
portfolio diversification
bond/equity splits
prices
 closed-ended funds
and discounts, 2nd, 3rd, 4th, 5th
NAV (net asset value)
open-ended funds
performance of investment trusts, 2nd
and pound-cost averaging
timing the market
see also portfolios
short-term focus
and portfolio turnover
short-term planning
Siegel, Jeremy
The Future for Investors
SIPPS (self-invested personal pensions)
size
of investment trusts
and marketability
unit trusts and OEICs
SLI (Standard Life UK Smaller Companies Trust), 2nd
small investors
advantages and disadvantages for
compared with professional fund managers
smaller companies, 2nd
asset management, 2nd
and economic growth
Far Eastern
and investment strategy
and the Investors Chronicle portfolios
performance
smaller-sized trusts
specialist areas
Spencer-Churchill Miller (SCM Private)
split capital investment trusts (splits), 2nd
stamp duty, 2nd, 3rd
Standard Life Property Income
Standard Life UK Smaller Companies (SLI), 2nd
discount trigger
sterling
fall in
stock market
and closed-ended funds
crashes
and currency movements
market timing
and risk tolerances
see also deciding investment objectives; shares (equities)
strategy
discounts and changes in
investment strategy and the Investors Chronicle portfolios
structured products, 2nd, 3rd
successful investing
and compound interest
funds to avoid
hedge funds, 2nd, 3rd
multi-manager funds, 2nd
structured products, 2nd, 3rd
getting started
ignore forecasts
importance of staying invested
keep it simple and cheap, 2nd, 3rd
reaching investment goals
regular rebalancing
reinvesting dividends
sentiment versus fundamentals, 2nd
see also Investors Chronicle portfolios
synthetic ETFs

taxation
capital gains tax (CGT), 2nd
multi-manager funds
and investment policy
investors’ marginal rate of tax
and ISAs/SIPPs
TCF
TCO (total costs of ownership)
technology sector
Temple Bar, 2nd, 3rd, 4th
Templeton Emerging Markets, 2nd
Templeton, Sir John, 2nd, 3rd
ten best trading days
tender offers of discounts
TERs (total expense ratios), 2nd
and discount control mechanisms
and ETFs, 2nd
and marketability
multi-manager funds
and portfolio turnovers
Throgmorton
thematic areas
time horizons
and stock market investment
timing the market
total costs of ownership (TCO)
total expense ratios see TERs (total expense ratios)
TR Property
trackers and ETFs
trading days
missing the ten best
trailing commission
elimination of, 2nd
Train, Nick
Troy Income & Growth discount trigger

unit trusts
disadvantages of
and discounts, 2nd
and ETFs
hybrid funds
individual unit prices
and investment trusts, 2nd
and long-term investment
management charges, 2nd
mirror funds, 2nd, 3rd, 4th
performance
compared with benchmarks, 2nd, 3rd
compared with investment trusts, 2nd, 3rd
and fees, 2nd, 3rd
tables
size of
trackers
US mutual funds
United Kingdom
equity income, performance comparisons with benchmark/OEIC/unit
trusts
equity trusts
Finance Act (2011)
global equity funds
investment trusts
categories of
discounts
market in
performance
Investors Chronicle portfolios
smaller company sector, 2nd
UK shares
see also FSA (Financial Services Authority)
United States
Dow Jones index
fund fees and costs
global equity funds
investment trusts
and the Investors Chronicle portfolios
mutual funds
portfolios
Utilico Emerging Markets
utilities sector

value
seeking discount value
value managers, 2nd
Vietnam
volatility
balancing risk and reward
and discounts, 2nd
and emerging markets
and investment risk, 2nd
of investment trusts, 2nd, 3rd
and market losses
and speculation
and structured products

Wall Street Journal

and DIY investors
Warne, Dr Kate
wealth managers
advisory management
discretionary management
and investment risk
and marketability, 2nd
websites
and DIY investors
investment trusts, 2nd
‘white list’ of permissible investments
wills
Witan
Woodford, Neil, 2nd, 3rd
Worldwide Healthcare Trust (WWH), 2nd

zero discounts
zero-dividend preference shares (zeros), 2nd
PEARSON EDUCATION LIMITED
Edinburgh Gate
Harlow CM20 2JE
United Kingdom
Tel: +44 (0)1279 623623
Web: www.pearson.com/uk

First edition published 2013 (print and electronic)

© John Baron 2013 (print and electronic)
The right of John Baron to be identified as author of this work has been asserted by him in accordance
with the Copyright, Designs and Patents Act 1988.
Pearson Education is not responsible for the content of third-party internet sites.

978-1-292-00156-2 (print)
978-1-292-00510-2 (PDF)
ISBN:
978-1-292-00509-6 (ePub)
978-1-292-00797-4 (eText)
British Library Cataloguing-in-Publication Data
A catalogue record for the print edition is available from the British Library
Library of Congress Cataloging-in-Publication Data
Baron, John, 1959-
The Financial times guide to investment trusts / John Baron.
pages cm
Includes bibliographical references and index.
ISBN 978-1-292-00156-2 (pbk.)
1. Mutual funds. 2. Investments. I. Financial times (London, England) II. Title.
HG4530.B335 2013
332.63'27--dc23
2013022344
The print publication is protected by copyright. Prior to any prohibited reproduction, storage in a
retrieval system, distribution or transmission in any form or by any means, electronic, mechanical,
recording or otherwise, permission should be obtained from the publisher or, where applicable, a
licence permitting restricted copying in the United Kingdom should be obtained from the Copyright
Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS.
The ePublication is protected by copyright and must not be copied, reproduced, transferred, distributed,
leased, licensed or publicly performed or used in any way except as specifically permitted in writing by
the publishers, as allowed under the terms and conditions under which it was purchased, or as strictly
permitted by applicable copyright law. Any unauthorised distribution or use of this text may be a direct
infringement of the author’s and the publishers’ rights and those responsible may be liable in law
accordingly.
10 9 8 7 6 5 4 3 2 1
17 16 15 14 13
Cover image © Getty Images
Print edition typeset in ITC Stone Serif 9.5/14 by 3
Print edition printed and bound in Great Britain by Henry Ling Ltd at the Dorset Press,
Dorchester, Dorset
NOTE THAT ANY PAGE CROSS REFERENCES REFER TO THE PRINT EDITION