Have trusts investing in alternative assets done a good job of providing investors with protection as a diversifier?
In the last two economic crises – the global financial crisis and Covid-19 pandemic – bog-standard bonds have failed to provide sufficient diversification, so it makes sense that investors are turning to alternatives for their defensive qualities.
Alternative assets accounted for 70% of new investment trust shares issued last year and the size of the sector more than doubled from £35 billion to £80 billion in the six years to August 2019, data from the Association of Investment Companies shows.
So far this year, the renewable energy infrastructure and infrastructure sectors rank first and third respectively for secondary fundraising (by existing investment trusts). Investor demand amid the pandemic has increased the premiums that these trusts trade at – from an average of 10.1% and 7.4% for infrastructure and renewable energy trusts respectively at the end of January, to 15.7% and 14.6% at the end of October.
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Many niche trusts have low correlation to equity markets, and the majority offer higher yields than most equity-oriented trusts – a key factor in their promising outlook, according to Kepler Trust Intelligence.
It recently forecast nominal returns from US equities, the world’s largest equity market accounting for 65% of the MSCI World index, of 6.1% per year over the next decade. That compares to a long-run average of 10.1% between 1970 and 2020. BlackRock and JP Morgan have published similarly muted forecasts.
“In light of these historically low expected returns, infrastructure, debt, private equity and environmentally focused investment trusts look extremely interesting,” says Kepler partner Pascal Dowling.
“These sectors have the potential to generate total returns close to our forecast for equities over the next 10 years. They should, however, have more predictable cash flows and less volatile net asset values (NAVs).”
During a turbulent year such as 2020, however, have such investments done a good job of providing the protection investors seek?
Trusts established to manage the fortunes of wealthy families are usually well diversified and aim to mitigate volatility and preserve capital.
RIT Capital Partners (LSE:RCP) and Caledonia Investments (LSE:CLDN), developed by the Rothschild and Cayzer families to manage their finance and shipping riches (and still 21% and 48% owned by them), are the largest with net assets of £3.1 billion and £1.9 billion, respectively.
Of the two, Caledonia has a higher allocation to equity risk, particularly private equity. Its share price tanked faster than its FTSE All-Share benchmark during March’s stock market sell-off.
“Since then, if anything, it has been more volatile than UK equities, no doubt caused by uncertainty around private equity valuations and the NAV being announced once a month,” says David Liddell, a director of IpsoFacto Investor.
RIT Capital Partners arguably uses more tools to mitigate risk – short positions, absolute return strategies and currency hedging. At its largest drawdown in March, it had also fallen more than the UK stock market, due to seeing its premium vanish and at one point turn into a double-digit discount. This proved momentary, however, and could have been due to profit-taking among its large retail following, says Liddell.
Both trusts have bounced back to significantly outperform UK shares but have lagged global equities. While the MSCI World was down 1.3% in sterling terms in the 10 months to end-October, shares in RIT Capital Partners slid by 11.3% and Caledonia by 11.5%, according to FE Analytics.
Over the longer term, the diversification benefits have shone more strongly with the trusts providing reasonable downside protection, while capturing a good slug of the upside in world markets.
Nick Wood, head of fund research at Quilter Cheviot, points to the connections of Lord Rothschild, which result in RIT Capital Partners having “some relatively unique exposures for most UK investors”. These include investments run by Springs Capital, which invests in China, and Eisler Capital, which runs a macro strategy.
Numis Securities analyst Ewan Lovett-Turner regards RIT Capital Partners as a “great defensive option”, while John Newlands, founder of Newlands Fund Research, hails it a “vehicle of supreme quality, best bought when out of favour – more or less as now – then held on a minimum 10-year view”. He adds: “Caledonia also has some great qualities, being managed again for the very long term and with separate pools of capital that can be monitored and adjusted as conditions change.”
Private equity trusts
Private equity investment trusts succumbed to this year’s stock market-volatility, largely due to the link between private and public equity market valuations.
“Now that the dust has cleared, it is promising to note that several companies have seen valuations recover alongside stronger public equity markets, and in certain cases have navigated the pandemic relatively unscathed,” says Markuz Jaffe, a senior research analyst at N+1 Singer.
Among the standout performers is HgCapital Trust (LSE:HGT), which focuses exclusively on technology. Having fallen by 36.4% in the two weeks to 19 March, considerably more than a 25.2% decline in the FTSE All-Share, its shares recovered sharply to post a 18.4% gain, while the UK market remains down 23% in the 10 months to the end of October. “This surely reflects superior stock-picking, or at least stock-picking attuned to these special times, rather than anything inherent about private equity,” says Liddell.
Vermeer Partners and Numis continue to rate HgCapital Trust, the only private equity trust trading at a premium to NAV, for its managers’ specialist knowledge in software-as-a-service businesses and strong track record.
Given the lag in reporting operating performance of underlying companies and subjectivity around private equity valuations, discounts elsewhere could be a buying opportunity if realisations prove stronger than expected.
Lovett-Turner points to “lots of attractive opportunities in well-managed funds, with high-quality portfolios” and “value opportunities” in funds such Apax Global Alpha (LSE:APAX), which is trading at a discount of more than 20%.
Devon-based wealth manager Philip J Milton & Co, a staunch value investor, rates the discount opportunity in private equity fund-of-funds. It holds Standard Life Private Equity (LSE:SLPE), which is trading at a discount of more than 30%.
“Several private equity trusts, which mainly invest in collective private equity vehicles, seem to trade at comparable discounts to the direct investing ones, which may have most money in just one or two ‘do or die’ ventures, and that is an aberration that should not exist,” says founder Philip Milton.
Social and renewable energy infrastructure have generally proved better diversifiers. Following a relatively brief period of shares trading lower during the peak of the pandemic sell-off, infrastructure trusts have delivered on expectations.
This is largely owing to dividends, which have been maintained or increased due to the reliable cash flows (often government-backed or inflation-linked) that these trusts generate.
“Dividends have been maintained in all cases with many also committing or maintaining prior commitments to grow their dividends,” says Jaffe. “This is, of course, in stark contrast to the wider UK equity market, and indeed other investment company sectors, which have seen large, prolonged drawdowns in share price and high levels of income uncertainty as dividends were reduced or suspended.”
Attractive yields in an increasingly income-scarce world means many infrastructure trusts trade at double-digit premiums. Some solar funds, such as NextEnergy Solar (LSE:NESF), have more modest single-digit premiums.
Dowling highlights US Solar Fund (LSE:USF), which was launched in April 2019. The trust is not yet fully invested, and is trading at the smallest premium in the sector at around 2%. It yields 1%, but aims to achieve its dividend target of 5.5% in the first quarter of next year.
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The closed-end nature of investment trusts also lends itself to investing in more esoteric, less liquid parts of fixed-income markets. While there is huge disparity in performance across the structured finance sector, Lovett-Turner points to the “opportunity in structured credit” exemplified by TwentyFour Income (LSE:TFIF).
It invests in European asset-backed securities, particularly mortgage-backed securities and collateralised loan obligations. It entered 2020 defensively positioned with relatively high levels of liquidity and low duration assets, which provided some protection.
Its managers have ridden out the crisis by using gearing to add exposure to cut-price assets. As a result, the trust’s shares are yielding 6.2%, more than a target dividend of 6p per share or yield of 5.8% based on its current share price. “Investors can take significant comfort in the security of the dividend and ability to meet and exceed the target,” adds Lovett-Turner.
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