Money: Survival of the fittest in a struggling sector

Investment trusts are facing a tough time. The class acts will come into their own but the less competent will stumble
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The Independent Online
When it comes to analysing investment trust performance, there are few wiser or more entertaining voices than those of Hamish Buchan and his colleagues at NatWest Securities in Edinburgh. Although his team suffered some surprising defections a short while ago, he and his colleague Robin Angus are still the act to beat if you are an investment trust watcher.

A couple of weeks ago, the NatWest duo delivered their latest update on the investment trust sector, which - as I mentioned a couple of weeks back - seems to be going through an uncertain patch. In so far as it makes sense to generalise, discounts in the sector this year have generally widened, to the point where you can once more buy a general trust like Alliance or Foreign & Colonial on a 10 per cent discount (and some of the more exotic species on much bigger discounts).

In the short term, part of it has to do with the fact that the market, after its strong recovery in the summer, seems once more to have relapsed into pre-electoral uncertainty. Sterling's strength has not helped much either. And the fuss over Kepit, Kleinwort Benson's unhappy European privatisation trust (now liquidated), has done little for the image of investment trust managers. Overall, the sector gives the strong impression of drifting rather uncertainly.

However much the marketing men may try to convince you otherwise, investment trusts are an industry like any other, with the same cycles of supply and demand, and fluctuating degrees of competition. The sector has grown furiously in the last 10 years. Today there are something like 100 different management companies and 350 different trusts to choose from. In 1985 there were barely half that number.

The flood of new entrants and new products reached something of a climax in late 1993 to early 1994. At the time, discounts on many trusts had disappeared altogether, and for a while, says Hamish Buchan, you even had the bizarre spectacle of investors buying new issues in the hope of making an instant profit, as if they were privatisation stocks. (Bizarre, since as investment trusts normally trade at a discount to net assets, hopes of a significant immediate premium are by definition improbable.)

Some correction after the boom period of 1993-94 was inevitable, and what we are seeing now, in NatWest's view, is a necessary process of digestion. Whether you look at three-year, one-year or three-month data, it is no accident that investment trusts collectively have underperformed the All- Share index over the recent past, reversing the trend of the previous years.

Not only are there too many trusts around, but too many of the funds in the list today are failing to take advantage of their investment trust status to do the things that they alone can do. That is to say, they are neither using their gearing power - their ability to borrow additional cash to increase investments and enhance returns - nor investing in unlisted securities. To all intents and purposes, they are behaving like ordinary managed funds which just happen to be investment trusts.

As many as 100 of the 350 current trusts, reckons Mr Buchan, have never used gearing at all in their lives. He thinks it is time that investment trusts woke up to the competitive threat which OEICs may pose when they are finally introduced next year. (OEICs, or open-ended investment companies, are the new hybrid form of investment fund - half way between an investment trust and a unit trust - which the Government is legislating to create to offer more variety to investors.)

Most commentators so far have worked on the assumption that OEICs were more likely to take business away from unit trusts than from investment trusts. But this may be a false assumption. A trust like Kepit, which invested conventionally, with zero gearing, might well have been better suited as an OEIC. Rather than having to suffer a large and persistent discount, investors would then at least have had the chance to get out at any time without an added penalty.

Also on the horizon looms the spectre of changes in capital gains tax. The tax threat comes in a number of different forms, but none of them is likely to be good for the market or the investment trust sector. (One fear is that many of the big insurance companies will want to sell their chunky holdings in investment trusts if the accumulated CGT liability which currently locks them in is removed).

As it happens, Mr Buchan and his colleagues are doubtful whether either the tax or the OEIC threat will in fact materialise and do much damage in the short term, whoever wins the election. I am less sanguine about that than they are. But the underlying argument that investment trusts are facing a period of "financial Darwinism" seems spot on to me.

Those investment trusts who fail to manage their discounts, or put the interests of the fund management company above those of the shareholders/investors (as many are wont to do), face a tougher time.

Management fees in particular are likely to come into the spotlight once more. Note, says NatWest, how new issues in the investment trust sector typically charge up to 1.5 per cent of assets under management as an annual fee, compared with the more typical 0.3-0.75 per cent range for existing generalist trusts.

After several years of growth, there is a fair chance, reckons NatWest, that the investment trust sector will see a net outflow of investors' cash for the first time next year. It is when industries start to contract after a period of rapid growth that the class acts tend to come into their own, and the less competent stumble. Investment trusts are no different.

So a period of consolidation, here as elsewhere in the fund management business, seems inevitable. And where will that leave investment trust discounts? Well, it will vary from sector to sector. NatWest likes a number of trusts in the Income Growth and Smaller Company sectors, for example.

But, overall, the odds must be that discounts will not narrow greatly in the short term. If so, the implication is that performance will continue to drag for those who are already fully invested, but that those looking to invest new sums should be able to find bargains - assuming they know where and how to look.

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