Thomas McMahon, senior investment trust analyst at Kepler Trust Intelligence, talks Neil Woodford, rise of passives, and regions and trusts for income in the year ahead.
[Filmed 6th December 2019]
Lee Wild, head of equity strategy at interactive investor:
Thomas, 2019, it's been a pivotal year for investment trusts, thrust into the limelight by the collapse of Neil Woodford's funds empire.
How do you feel about liquidity post the Woodford saga, and is there anything investors should be worried about in 2020?
Thomas McMahon, senior investment trust analyst at Kepler Trust Intelligence:
I think one of the major lessons of what happened with Woodford Investment Management is that investors need to be very wary of cross-holdings between managers, open and closed-ended funds. So, obviously the closed-ended structure itself is a great vehicle for carrying liquid assets, and had Neil Woodford only been running closed-ended vehicles we wouldn't have seen the sorts of events that transpired in the end.
So, I think that's a key lesson to take into 2020 and beyond; to be very clear, where a manager is holding the same companies in different funds and different structures. I think in terms of 2020, as I've said, I think broadly speaking closed-ended funds are a great place to be holding illiquid investments.
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Now clearly stock selection and position sizing are other issues that investors need to bear in mind. But, in terms of areas of concern at the moment, I think the classic one is property funds.
At the time of filming, we've recently heard that M&G have suspended their property fund, and, if you look at the open-ended property sector, those funds are carrying, in many cases, quite an alarming amount of cash on the balance sheet, because they are attempting to protect themselves from redemptions.
So even if suspension isn’t in the offing for those portfolios, there's clearly going to be a significant cash drag, and I think in 2020 we might see that alleviate if the election victory produces a conclusive result, because there may well be more activity in the property market.
But certainly, at the moment, with the property market in particular seeing low levels of transactions, on an ongoing basis, I think this is an area of some concern.
So, in terms of big issues affecting investment trusts and this sector, how has the rise of ETFs and other passive investments affected the investment trust sector. We're told millennials are big buyers of ETFs and passives, but who should be buying trusts and why?
I think that the rise of ETFs and passives has been hugely positive for investors overall. And I think we can see in the closed-ended space, certainly managers have become much more active as a response to the threat of this cheap and easy to understand alternative.
So, I think it has had very positive effects. We've done research over the last year showing that investment trusts have become more concentrated over the last couple of years. We’ve done research showing that the correlation of funds to their benchmarks after a change in manager over the last decade has generally been to see a reduction in correlation, and therefore, more active behaviour.
I think that all investors are benefiting from this trend. I think that investment trusts should suit two types of buyer. Firstly, those who have long-term capital growth goals and aims, and in that case, in particular the gearing that close-ended funds can take on has a huge advantage. Plus the advantage when it comes to holding illiquid investments means that an investment trust can be more fully invested, and in particular, more fully invested in potentially higher returning investments, like smaller companies and so forth.
So, over the long run, if you had a 10, 20-plus year time horizon in investment trusts, obviously you have great advantages. And if you look at the returns over the last 10, 20 years, you'll find consistently that closed-ended funds outperform. I think that another potential appeal, again if you have a long-term perspective, buying something on a discount to net asset value (NAV), could potentially give you a nice kick, although that can be very hard to predict, so you need to be careful there.
I think the second type of investor that investment trusts are really suited for, are those who are looking for high yield. And again, going back to this idea of liquidity, investment trusts can hold a number of assets which open-ended funds really can't.
So, you'll find in the investment trusts universe vehicles which invest in specialist areas that are much higher yielding than your average equity and bond markets infrastructure, renewables, even some very idiosyncratic assets such as Hipgnosis, the recent launch which invests in song catalogues.
There are lots of high yielding assets that you can’t really get in an open-ended fund. So, in short, I think that pretty much describes everyone. You're either a long-term growth investor, by and large, or you're an income investor. So I think investment trusts have something important to offer to almost every investor.
That's interesting, as an income investor should I be favouring trusts over funds, is a question were often asked. There are some very attractive yields, but sometimes investors can find it difficult, especially less experienced investors, to screen out the less reliable dividend payers. So, how do you cope with that?
Well, I think the first thing to say, you know, if we're simply making a comparison between open and closed-ended funds, with open-ended funds, dividend cuts, dividend variability is simply baked in. Because they were going to pay out the income they receive.
So, it's only with closed-ended funds that you get the offer of dividend stability. I think if you're wanting to avoid dividend cuts, if you’re wanting to see how secure the dividend is on your closed-ended funds. The key things to look for are revenue reserves, and dividend cover. So, what is the dividend paid compared to the cash left on the balance sheet which future dividends can be paid out of.
And, similarly, what is the dividend paid relative to the earnings from which it will be paid. So, both those numbers are in the annual reports, but they’re also available in research like ours. AIC website and so forth produce these number.
Those are the key things to look at, and then again, I think look in the annual report and look for what the board says. So, the board controls the dividend policy, the board controls what's paid out to investors, and they are always very clear about what they aim to do. So the board will tell you, they aim to pay out a growing dividend each year, or a dividend that grows in excess of inflation.
So, I think the key things are what is the objective, and what are the reserves and the cover situations? And that's all you can do beyond having a crystal ball. Obviously, with some of the more specialist trusts, it can be harder to get clarity on those numbers. So, you need to be aware of that too.
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For private investors looking for income in 2020, which investment trusts, or where within the sector should they be looking?
I think there are a few interesting areas. One area which is likely to continue to see a lot of investment is renewables, and there's some reasonable yields on offer from the investment trust in that sector. And it's strongly supported by both parties.
I think the shift to renewable energy is an area that provides good potential for many years to come.
I think, at the moment, some emerging market trusts are also looking quite interesting, particularly in Russia and Latin America, markets that have been on low valuations and have some big payers.
And if you think the fundamentals are looking okay in those regions, which generally I do, then that could potentially be an interesting place to look. I think maybe the UK could also be worthwhile looking at. It's been out of favour for many years, well for three years or so, and I think potentially there could be some interesting trusts to look at, with good strong track record of dividend growth in the UK.
Are there any in particular that you would want to highlight?
I think in terms of emerging markets, Baring Emerging Europe is one that we like, so this is paying out a yield of just over 4%, the market is extremely cheap. Now, it tends to be cheap and it has been historically, but the discount has grown since, really since the 2014 Ukraine confrontation.
And there's a lot of reform going on within Russia, which hasn't really perhaps been absorbed by broader investment community, retail investment community at least. That’s probably because it's a relatively small market in terms of the global market capitalisation and, really, the headlines have been dominated by what's been going on between the US and China.
But there's a lot of interesting performance going on there, and a strong yield with some big payers, that's an interesting place to look on a discount too. BlackRock Latin American (LSE:BRLA) is another high payer. Again, Brazil went through a terrible recession a couple of years ago, it now has a reformist President who's very market friendly.
And yet the market is in many cases quite cheap and yields are high. So, I think those trusts are quite interesting. Also, offering you a bit of respite from the US-China trade confrontation.
In the UK, one potentially interesting trust Aberforth Split Level Income (LSE:ASIT). This trust is highly geared, so you need to be aware of that. But it invests in small caps with a value focus, so there's a sort of margin of safety in the valuation of the company it buys, and, if we see a shift back towards UK domestics, towards value over growth, which we may get, then there's a strong wind behind it from a capital performance perspective too.
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