The paradox of investment trusts is that demand is often at its highest when performance is almost certain to decline
HAS THE investment trust sector had its day? The analysts at BT Alex Brown are too diplomatic to put it quite so bluntly, but it is the question which underlies their latest annual review of the sector.

After a glorious first half of the decade, when funds under management soared and discounts narrowed, investment trusts have spent most of the second half of the Nineties on the back foot, beleaguered by indifferent performance, restless shareholders and rapidly widening discounts.

There is no doubt that Daniel Godfrey, the new director general of the Association of Investment Trust Companies, faces a stiff task as he sets about trying to bolster the image and credibility of the sector. The Nineties have, as BT Alex Brown's Simon Colson points out, been favourable environment for the retail savings market: marked by favourable demographics, rising asset prices and as benign a set of economic conditions as one could hope to see in a lifetime's investment experience.

Yet it is the unit trust business that, by and large, has walked away with most of the competitive rewards. Assets of investment trusts have risen by 150 per cent over the last decade, but those of the unit trust business are up by 250 per cent, and the gap between the two sectors is widening, as my chart shows. For the last two years, the investment trust sector has seen a net outflow of funds.

As so often happens, the sector's annus mirabilis of 1994, when pounds 8bn of new money flowed in, mostly into specialist trusts, proved to be the peak of the market. Almost ever since the performance of the sector has been in relative decline, though the bull market in both bonds and equities means that shareholders with exposure to the right markets have mostly done all right in absolute terms.

One particularly doleful statistic is that of the 50 new issues which have raised more than pounds 50m in the last 10 years, 30 are currently below their issue price. And 20 of those are down by more than 50 per cent. This mostly reflects the fact that most of the new money which has been raised has gone into once fashionable sectors which have since performed terribly - with the Far East and emerging markets to the fore.

In one important sense, this is not the trust sector's fault. Any business can only supply customers with things that they demand, and the flow of money into poor performing sectors in part only reflects the fact that investors ultimately make their own asset allocation decisions.

The longstanding paradox about investment trusts - as with many financial market products - is that demand is often greatest at the point in time when performance is almost certain to decline. This in turn reflects the broader paradox that investors nonsensically want to buy funds which are in markets or sectors that have done best in the recent past, rather than those which have done less well and which can be expected to do better in future.

While widening discounts have been a problem for all investment trusts, BT Alex Brown's data suggests that, on closer analysis, the underlying performance of the fund managers themselves has not been that bad. Measured against the Footsie index, the asset value performance of the sector has rarely been as poor as it is now. But once you allow for the fact that investment trusts have always had a greater international exposure than other retail market funds, the relative performance is not so bad.

However, nobody can deny that any business which seeks to sell its customers investment funds, and loses them money on half its new product range, faces a serious marketing problem. This is exacerbated by the fact that investment trusts have been unable (or unwilling) to pay commissions to independent financial advisers, and are not getting the sales push from intermediaries that unit trusts capitalise on.

This is a pity, since the evidence continues to show that many traditional investment trusts are still exceptionally good value. Overall, total expense ratios for investment trusts are markedly lower than those of equivalent unit trusts (though emerging markets trusts and other specialist funds are more expensive, producing a uniquely unfavourable combination of lousy performance and high charges).

It is true that there are far too many indifferently-managed investment trusts around, and a cull is urgently needed, but the quality of investment management is generally superior to the competition.

What is not in doubt is that the future of investment trusts can lies in the retail investment market. Institutional investors no longer have any need or desire to gain international exposure through the sector, and are actively looking for opportunities to divest their remaining holdings as soon as it is timely and tax-efficient to do so.

So the investment trust sector will sink or swim by its ability to find effective ways to reach the retail investment public. BT Alex Brown make the forceful point that the arrival of index tracking funds and OIECs (effectively single price unit trusts) faces the sector with an even bigger competitive challenge than in the past.

Can the sector pull itself out of its current rut? I still think so. Any solution has to involve at least two things.

One is the willingness of fund management groups to try and exploit the distinctive capabilities that investment trusts still have, which include their lower costs, the ability to borrow, and the scope to offer distinctive capital structures (an unsung success story of the past few years, for example, has been the market niche established by zero dividend preference shares).

The second requirement is the boards of investment trusts start to earn their crust. Discounts will never be eliminated completely, but they show the failure of many investment trusts to take their responsibilities to shareholders seriously.

It doesn't help that a number of fund management companies run unit trusts and investment trusts. Until boards stiffen demands on the fund managers, to make them more accountable and more performance conscious, the risks of Darwinian extinction will continue to hover over this venerable, but fascinating, sector.