Three specialist fund areas that are due a recovery

10th July 2023 09:40

by David Prosser from interactive investor

Share on

For investors prepared to think long term, these bombed-out areas offer potential value opportunities. David Prosser explains why these specialist funds are out of form, and why a recovery could be on the cards. 

Three fund areas 600

As is so often the case, Warren Buffett puts it best. “Be fearful when others are greedy and greedy when others are fearful,” he once said.

The point Buffett was making is that the crowd often gets it wrong – they keep buying assets even when they’re over-valued, simply because others are doing the same; and they shun cheaper investments because no one else wants them either.

What if you could break out of that mentality, which inevitably means getting burned when an investment bubble pops, or missing out on the opportunity to get into an asset class at close to the bottom of the market? Where would you put your money to bet against the fear and the greed of other investors?

There are no risk-free answers to these questions. However, below, we look at three specialist fund areas that have struggled in recent times, but where experts think there is now the potential for recovery.

1) Growth capital investment trusts

Growth capital investment trusts invest mostly in privately owned businesses – often early stage and modestly sized – rather than stock market-listed companies. Unlike private equity funds, which fish from a similar pool, growth capital investment trusts take minority stakes. They’re investors in the businesses, rather than owners with a controlling stake.

The rationale for these funds is that getting into businesses with potential for high growth at an early stage could deliver stellar returns as they take off. Unfortunately, it hasn’t worked out this way in recent times. The six investment trusts in the growth capital sector fell by an average of 31% over the year to the end of June according to the Association of Investment Companies (AIC). Shares in these funds trade at an average discount to the value of their underlying assets of 51%, underlining just how out of favour they are.

That dismal record reflects widespread anxiety about unquoted investments in the current uncertain economic environment. Fund managers revalue their portfolio holdings periodically, so investors have to make some assumptions about what might be to come – unlike with a fund that holds publicly listed shares that provide a constant read-out on valuation.

In these tough times, investors are assuming privately owned businesses are struggling and that in time, managers will mark down their value. Their appetite for growth capital investment trusts has fallen accordingly.

The question is whether the downgrades have been overdone. There are good reasons to think they may have been. Portfolio managers have revalued their holdings several times over the past year without making the downgrades investors expected.

Indeed, research published by analyst Numis Securities on the private equity sector recently pointed out that funds selling out of unquoted holdings last year managed to secure an average uplift of more than 30% on their portfolio values.

Several growth capital investment trusts have published positive updates in recent months. At Chrysalis (LSE:CHRY), for example, the fund points to a six-fold increase in profitability at Starling Bank, which comprises 16% of its portfolio.

Iain Scouller, an analyst at Stifel, points out: “The managers say the portfolio is deliberately concentrated with high-conviction investments. They believe a number of companies will be in an IPO-ready position by late 2024.”

Similarly, Schroders Capital Global Innovation Trust(LSE:INOV) has just announced an uplift in the valuation of its portfolio holding Back Market, a company that runs an online marketplace for refurbished devices.

There are no guarantees, but the poor run of growth capital investment trusts over the past year appears to reflect investor perceptions as much as what is actually going on in these funds’ underlying portfolios. If those perceptions shift – as investors become less risk-averse, say – there is potential for a revaluation.

2) Index-linked bond funds

Index-linked bonds, largely issued by governments, pay income and return capital with an explicit link to inflation. So, you would expect such bonds to have performed strongly over the past 18 months given that inflation has spiked higher all around the world.

Sadly not. In the UK, for example, index-linked gilts fell by a third in 2022, a remarkable decline for a supposedly safer asset. Morningstar data suggests the average fund invested in these assets is down around 14% over the past year. Other bond funds are down too, but not to the same degree.

The problem is that while these bonds offer some protection from inflation, that can be overshadowed by the negative impact of increases in interest rates. Higher interest rates are bad news for bonds because the yield on the latter looks uncompetitive; investors sell bonds until yields rise to a more attractive level.

This is true of all bonds, but the effect is particularly pronounced on longer-maturity assets – bonds not due for repayment until many years into the future. And most index-linked bonds fall into the longer-maturity category.

“Shorter-dated index-linked bonds have actually done okay, as the interest accrued from high inflation has offset the downward pressure on bond prices,” explains Stephen Snowden, head of fixed income at asset manager Artemis.

However, the same cannot be said for index-linked bonds with longer lifespans, of 20 years-plus.

“But longer-dated index-linked bonds have essentially fared no better than conventional bonds, with interest rate risk and duration dominating their return profile,” adds Snowden.

What about the future? The important part here is that it is expectations of future inflation and interest rates that drive bond prices, rather than the current levels. And the good news here, paradoxically, is that inflation fears have become so pronounced that the markets are now pricing in a very pessimistic outlook.

So much so, argues Snowden, that “the prospects for bond funds are good”. In the UK, he points out, the markets are now pricing in a base rate of 6% for the end of the year, well up on the current level of 5%.

Snowden notes: “There’s a lag between interest rates going up and the impact being observed in the economy, and 6% is a large margin of error on inflation from where base rates are today. For bonds to sell off meaningfully from here, we would need market expectations for UK base rates to rise well above 6%, and this feels very unlikely.”

3) Biotechnology funds and investment trusts

The biotechnology sector has always been volatile. In theory, the promise of biotech companies – to deliver blockbuster drugs badly needed by people all around the world – should make them hugely attractive from an investment perspective. That’s true, but research and development is risky and unpredictable; new drug projects can and do fail.

In addition, biotech firms rely on investors’ capital to keep them going through the drug development process, so when that capital becomes more expensive or difficult to find, the sector suffers.

Last year saw this clash play out in real time. Risk-averse investors dumped biotech stocks as their anxiety increased; higher financing costs hit many biotech firms hard. In particular, publicly listed biotech shares suffered as equity markets fell, with valuations of privately owned businesses following them down.

By the autumn of 2022, biotech indices were down by around 50% from their previous highs. Performance has stabilised since then, but there has not been a bounce.

Some analysts think that could be about to change. “The sector has just come through the second-worst bear market in its history,” points out a recent note published by the investment companies team at Numis Securities.

It adds: “Valuations are highly attractive, and are just modestly above global financial crisis lows, with a record number of companies trading below cash. However, fundamentals have started to turn around.”

Numis points to better news in areas such as gene and cell therapies, previously dogged by safety fears. Plus, a wave of M&A has been sweeping through the sector – pharmaceutical and biotech companies worldwide spent $85 billion on acquisition in the first half of 2023. The large pharma companies, in particular, are desperate to deal with a looming “patent cliff” – the point when their currently exclusive drugs can be replicated by competitors offering generic versions.

“We think the sector is desperate to break out,” says Woody Stileman, managing director and head of strategic partnerships at RTW Investments, which runs RTW Biotech Opportunities (LSE:RTW). “Our view is that we are in a golden age of biotech innovation.”

Stileman’s view is that M&A – and a return of biotech IPOs, where the market now seems to be reopening – can propel a recovery in the sector in the coming months. Regulatory intervention give pause for thought, he concedes, with the US Federal Trade Commission having just announced that it will try to block the $28 billion takeover of Horizon Therapeutics (NASDAQ:HZNP) by Amgen. “That could put a bit of a dampener on M&A, but we would still expect to see more smaller deals,” he says.

Dzmitry Lipski, head of funds research as interactive investor, is also upbeat. He says: “Long-term trends for the sector remain intact. The growing demand for age-related disease treatments, along with technological advancements such as super-quick development of vaccines and, most recently, the adoption of artificial intelligence, have the potential to speed up discoveries.”

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

Related Categories

    Investment TrustsFundsIPOs

Get more news and expert articles direct to your inbox