This year, as stock markets fell, the ability of investment trusts to borrow to invest has proved to be an Achilles heel. Faith Glasgow assesses whether gearing is all to blame for many investment trusts falling behind funds in 2022.
Investment trusts have long had a reputation for being inherently more risky or volatile than open-ended companies. When markets are on the up, the structural factors that cause such potential volatility help them to outperform their open-ended peers. But when times are tough and investment sentiment turns sour, investment trusts may well fall behind.
One of those structural factors is the ability of closed-ended funds (investment trusts) to ‘gear’ or borrow money to invest. The aim is to boost returns by more than the cost of the borrowing. For a full explanation of gearing, check out our investment trusts' beginner guide.
As Annabel Brodie-Smith, communications director at the Association of Investment Companies (AIC), explains: “Gearing has the effect of magnifying performance in both up and down markets, so it's not without risk, but over the long term it can add value.”
So what has happened to trusts’ relative performance in the face of 2022’s rampant inflation, rising interest rates and the investment mood-swing away from the pricey growth stocks that did so well during the pandemic and towards more ‘old-fashioned’ value-focused holdings in sectors such as energy, commodities and tobacco?
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The table below suggests that in the UK All Companies sector at least, investment trusts have fared far worse than funds (also called open-ended funds). Not only does performance trail by more than 12% over the year to 1 December, but it also lags over three, five and – marginally – 10 years.
In contrast, UK equity income funds outpace trusts over one year, but have lost their advantage over a three-year period. Smaller company funds, both open and closed-ended, are hit hard on a one-year perspective – but fund figures are marginally worse, and that underperformance increases over longer time periods.
Funds versus trusts, which has come out on top?
|Sector||One-year performance (%)||Three-year performance (%)||Five-year performance (%)||10-year performance (%)|
|IA UK All Companies||-4.5||5.8||14.9||88.7|
|AIC UK All Companies||-16.6||-1.4||8.7||87.6|
|IA UK Equity Income||2.5||8.9||16.3||88.8|
|AIC UK Equity Income||-3.3||10.5||16.8||93.8|
|IA UK Smaller Companies||-21.3||6.2||12.9||140.8|
|AIC UK Smaller Companies||-19.9||13.5||20.3||176.4|
Source: FE Funinfo. All data to 1 December 2022. IA refers to Investment Association, the trade body for funds or open-ended funds. AIC refers to Association of Investment Companies, the trade body for investment trusts or closed-ended funds. Past performance is not a guide to future performance.
What’s going on? How significant a role does gearing play in these statistics? And what other factors are at work here?
First of all, it’s important to dig deeper into the make-up of the sectors under scrutiny. Gavin Haynes, investment consultant at Fairview Investing, points out that there is a large disparity between the two UK All Company sectors in particular, with 265 members of the open-ended sector and just eight in the closed-ended.
Moreover, he continues: “If you look at the trusts, there is a clear focus towards UK mid and small-caps, which is an area that has been hit particularly hard this year. And none of the trusts is focused on UK blue-chip stocks (particularly oils, tobacco, banks and pharmaceuticals) that have performed the best this year.”
Indeed some, including Henderson Opportunities (LSE:HOT) and Baillie Gifford UK Growth Trust (LSE:BGUK), are clearly growth-oriented and have had a truly torrid time. In such a small group, the fortunes of any one member will have a pronounced impact.
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Peter Walls, manager of the Unicorn Mastertrust fund (an open-ended fund that invests in closed-ended funds), makes the further observation that in practice gearing for equity trusts is anyway pretty modest.
“Some investment trust sectors such as alternatives and REITs tend to be very highly geared as a matter of course, but we work on an average of around 7% gearing for equity trusts,” he says. “That will have an impact on performance in a bear market, but it’s going to be fairly marginal.”
Walls explains that if a trust has borrowed 7% of the value of its net assets, then if the market falls by 20%, the trust’s net asset value (NAV) will decline by 21.4% (calculated as 20% of (100 + 7) = 21.4).
“It’s a significant difference, but not the be-all and end-all,” he adds.
Two other factors influencing performance
Much more important, in his view, are two other factors. First, the share price discount to NAV is almost bound to widen when the market is falling, as worried investors sell their shares and push the price down. That has made a considerable difference particularly for trusts investing in rate-sensitive assets such as real estate and infrastructure.
Second, investment style has made a big difference to the fortunes of most equity trusts in 2022, with growth-focused trusts hard hit by the rotation into value stocks. Walls gives the example of growth-oriented and geared Henderson Smaller Companies investment trust.
“Its NAV is down about 32.5% this year compared with the benchmark [style-agnostic] Numis Smaller Companies Index, which is down 19%. If we assume 10% gearing for HSC at the start of the period and build that into the index’s performance too, then it would have fallen 22.5%, rather than 32.5%. So HSC’s larger fall is mostly about the fact that it’s a growth investment, rather than about its gearing.”
Gearing not usually the main driver of performance
Andrew McHattie, publisher of the Investment Trust Newsletter, agrees that although gearing is a double-edged sword, “beneficial on the way up and a detractor from returns on the way down”, it is not usually the main factor determining performance.
As well as the impact of widening discounts, he highlights the de-rating of smaller and illiquid assets, which are more heavily represented in the investment trust structure because it is better suited to holding these assets.
“Unquoted holdings, property assets and smaller companies have all been marked down heavily over the last year, and it is this structural bias that accounts for the majority of the overall performance differential,” he says.
As mentioned above, the table shows little disparity between open and closed-ended smaller companies funds. The latter have been painfully affected by relative illiquidity and widening discounts, but as Brodie-Smith observes, open-ended peers may find themselves forced to sell assets near the bottom of the market, when investors decide they have had enough and sell their units in the fund.
“This leaves those funds strapped for cash at the very time they might want to be taking advantage of opportunities,” she says. In contrast, closed-ended smaller companies managers are in a position where the brave ones at least can take advantage of rock-bottom valuations and buy.
They may even increase their borrowing to do so. Walls cites the manager of Aberforth Smaller Companies (LSE:ASL) trust, who “has just added to his gearing for only the third time in 30 years because he’s feeling bullish”.
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Similarly, Helen Steers, lead manager of private equity trust Pantheon International (LSE:PIN), explains that although the trust’s balance sheet is not geared, it has have access to an undrawn banking facility of £500 million. “This provides us with the flexibility to meet outstanding investment commitments while continuing to invest in compelling investment opportunities,” she explains.
The broad consensus is that gearing is not a leading influence on performance, but over the long term it tends to work in shareholders’ favour.
But it can depend on the manager’s capacity to adjust the level of exposure as circumstances change. At Mercantile (LSE:MRC) Investment Trust, for instance, manager Guy Anderson reduced gearing earlier in the year, but broker Kepler reports he is set to deploy it tactically as markets recover.
It can also depend on your perspective on the current market, says Haynes. “As an investor, gearing is a key consideration when assessing a trust; if you’re feeling bullish then you may be more inclined to buy a geared trust, and if you’re more bearish then an un-geared trust or open-ended fund is likely to be more prudent.”
Finally, its attractions are likely to depend on interest rates. JPMorgan Cazenove research highlighted the fact that a number of leading trusts - including Mercantile, Scottish Mortgage (LSE:SMT), Witan (LSE:WTAN) and F&C (LSE:FCIT) among others – have successfully locked in debt at ultra-low interest rates over the past few years; but in general gearing becomes less attractive to managers if they’re going to have to pay more to borrow.
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