Investment: It's the new retro fashion for investment trusts

ARE WE seeing the start of a fresh dawn in the investment trust sector after several dismal years? I have asked this question more than once in the past three years, and mostly concluded that the sector would indeed come back into favour one day - but not for a while yet, given the many structural issues which the industry has to sort out first.

Most stem from the excessive oversupply of new investment trusts in the glory days of 1993 and 1994 when more money was raised for new issues than before or since, proving again that buying any investment on grounds of fashion rather than fundamentals is a proven route to indifferent returns.

The arguments against investment trusts have been rehearsed many times. Some have not changed, but there have been encouraging signs this year that the outlook is improving, helped in large measure by the industry's belated realisation that it has to do a lot more to put its own house in order if it is to launch a credible attempt to win new retail investors.

For example, many trusts are taking advantage of the abolition of advanced corporation tax to buy back their shares. The spate of reconstructions in the sector is further evidence that many trust boards - for years effectively in the pockets of the fund management groups - are giving the idea of shareholder value more than lip service.

More importantly, there are signs that the long run of underperformance which has dogged the sector may be ending. Investment trust analysts at Credit Lyonnais Securities, say over the five years to the end of 1998 investment trusts as a group achieved capital growth of 18 per cent, compared with capital growth in the FT All Share Index of 59 per cent and of 63.3 per cent in the World Index. This is not the kind of performance of which growth industries are usually made.

One reason why investment trusts have done so badly over the period is that the sector as a whole is not weighted the same way as the main market indices. Investment trusts have always been underweight in the United States - only 10 per cent of their assets are in North America, which has been an expensive drag on performance, given the strength of Wall Street.

What Credit Lyonnais call the "new issue binge" of 1993 and 1994 has also exerted a heavy price: a good deal of the money raised then was for the fashionable sectors of the Far East, emerging markets and smaller companies, all of which subsequently fared poorly.

Compound this with the inevitable widening of discounts as performance stumbled, and it is little surprise that many shareholders in investment trusts have had a sorry time. At the end of last year, the average Far East investment trust had seen its share price decline 68 per cent in five years, and the average emerging market trust one of 52 per cent over the same period.

At the height of the market turmoil last autumn, the average investment trust discount had widened to 17 per cent, and in the case of Far East and emerging markets the damage was worse, discounts reaching as high as 25 per cent to 33 per cent. But this year the picture has become much more positive. Not only have the out- of-favour sectors such as Japan and smaller companies come back into favour, but the discount has started to edge back in the opposite direction.

The average discount on all investment trusts is now down to 11 per cent. The discounts on Far East and smaller company trusts have also started to narrow, giving a powerful extra push to a strong underlying improvement in performance. Most specialist Japanese investment trusts are up by between 50 per cent and 100 per cent in share-price terms, and those specialising in Japanese smaller companies have doubled or even trebled.

For those who like a highly volatile ride, the way to cash in on these trends has been to buy the warrants many investment trusts issue. Warrants are essentially options and provide a highly geared play on movements in the underlying asset class. They are most definitely not for widows and orphans.

A look through the performance figures to the end of July provides powerful indications of their potential and risks. Some of the top performing warrants have more than trebled this year. Despite this impressive recent performance, many of these warrants are still trading below the price they were three and five years ago. (Here is one extreme example - warrants in Baillie Gifford's Shin Nippon investment trust, one of the best Japanese funds, have risen 411 per cent in the past 12 months, but are still 50 per cent down over five years.)

As always, the key to picking investment trusts lies in more detailed analysis than most investors are comfortable with. In addition to picking the right asset class, you need to find a manager with a clear and consistent methodology.

You also need to analyse the behaviour of the discount and look at how much gearing (borrowing) the trust has. This has become even more important since the introduction of new accounting rules which requires trusts to report the market value of any debt they have taken on.

Traditionally, many investment trusts have borrowed money in the form of long-term fixed rate debentures, a policy that looks less than ideal now that interest rates have fallen so far. It also makes sense to analyse how well a trust has performed, not just in absolute terms, but relative to its chosen benchmark.

Recent analysis by the team at Deutsche Bank (formerly NatWest Securities, and before that - a long time before that - the investment trust gurus at Wood Mackenzie) demonstrated what a wide disparity in performance there is in these terms. In spite of the investment trust industry's claims that they have superior investment management expertise, the evidence suggests several well-known trusts have consistently failed to keep pace with their benchmarks.

The table highlights the main under- and overachievers on this measurement in the period to the end of June 1999. Emerging markets show this disparity at its extreme: Templeton Emerging Markets (the best investment trust in this sector) has outperformed its relevant benchmark by 47 per cent over three years, and the troubled Foreign & Colonial Emerging Markets trust has underperformed on the same basis by 17 per cent. Of course, this one measure does not make one investment trust better than another, but over time it is certainly a potential indicator of management skill.

This kind of analysis certainly suggests that picking investment trusts will always require a degree of added skill and effort, compared to the average unit trust or Oiec. On the other hand, investment trusts generally are cheaper and more sophisticated vehicles for gaining stock market exposure than other types of mainstream fund.

For those who understand and can live with the discount movements, in many cases they may be a better option for an ISA than a conventional fund. My guess is that, aside from a major market correction, which will inevitably lead to a widening of discounts once more, investment trusts are through the worst of the tribulations of the last five years and are worth looking at more seriously.

If you want to gain some exposure to any recovery in the sector's fortunes, without having to do the analysis yourself, you may want to take a look at Scottish Value, a trust which only invests in investment trusts. Pick carefully and steer clear of the fashionable.

davis@aol.com