Investment trusts: pros and cons

Investing in cutting-edge shares is not for the faint-hearted, writes Warwick Lucas

While the number of listings on the JSE has decreased steadily over the past 30 years, the number of unit trusts has proliferated. The JSE hosts just over 300 companies, with fewer than 100 realistically investible by fund managers.

This makes for tricky slicing and dicing — how many ways can you repackage 100 shares? One way is offshore investing, but stock picking outside a home market is usually a punishing exercise for a fund manager. In my view the most value is added (or subtracted) in the binary decision to either buy offshore or not.

A maelstrom of innovations in investing products has become available, and this is particularly true for SA investors, as liberation from (tight) forex controls is so recent. Collective investments include not only local unit trusts but also global unit trusts and both SA and global passive and active iterations of exchange-traded funds, exchange-traded notes, private equity funds, hedge funds, closed-end funds (investment trusts) and structured products.

These combinations offer a rich range of possibilities to uncover in future.

I will open by looking first at investment trusts. These differ from unit trusts in that there is a restricted number of shares in issue and these shares trade on stock exchanges.

I wish I could talk about SA investment trusts. But sadly, with the exception of the formidable Remgro, there is no such thing left in SA (the other listings such as Reinet, PSG and HCI are really just holding companies) after former finance minister Trevor Manuel decided to torpedo the sector with a hostile tax framework in the late 1990s. Thus, for great investment trusts (also called closed-end companies) one must sally forth into the exceptionally wide and deep pools available on the London Stock Exchange (LSE).

Under the investment trust

The managers have shown willingness to adapt their approach as time goes by and a skill to spot companies of excellent potential

categories on that exchange are more than 400 listings addressing a market cap of £290bn. This is almost certainly a lot larger than the JSE on a free float basis! There are pros and cons for both investors and managers alike:

● Investors do not buy and sell at NAV. Investment companies can trade at both discounts and premiums to their underlyings. For a longer-term investor it’s a chance to buy good assets at a discount, and for the company they can practise capital management in the form of buybacks if the discount gets silly.

● Many active managers find that flows are a tremendous management issue — too many inflows lead to cash drag as new deposits swamp out best ideas, while outflows can be disruptive of long-term strategies (especially forced selling).

● The board and governance structures can allow for some highly original and differentiated strategies as compared with the extremely rigid framework that applies to financial products sold to the public.

● This also applies in regard to the instruments or debt that a company can issue.

● Esoteric holdings might include physical gold.

● Companies can adopt policies that force dividends — this provides cash flow certainty to the investor.

Most investors in investment companies should remember the potential issue of nonresident estate duties on investors. The UK level of £325,000 before situs kicks in is significantly more lenient than the US’s ridiculously low $60,000.

Scottish Mortgage

In opening coverage of LSE investment trusts, I have decided to start with the grandad and big gorilla of them all. With a market cap of £15bn, this fund is bigger than Vodacom.

Scottish Mortgage was founded in 1909 by Baillie Gifford to provide bridging funding to Malaysian rubber companies during a credit crisis. After that crisis, the fund was widened to include global equities and bonds.

Scottish Mortgage is one of the UK’s longest-tenured and most successful investment trusts. The investment philosophy is simple: identify companies that have the potential to change the world, and be patient long-term shareholders, giving the investment time to deliver returns.

The fund is globally orientated and agnostic as to where a company is headquartered and whether it is public or private. This has allowed Scottish Mortgage to invest in worldbeating companies long before they became household names. Prominent examples are Amazon (first invested in 2004), Tencent (2008) and Tesla (2013). More recently, Scottish Mortgage was well positioned during the Covid pandemic, with technology, e-commerce, food delivery and biotechnology investments featuring prominently.

When investing in companies that can “change the world”, one is often going to be investing in “cutting edge”. This type of company is often fashionable when markets are running, and success requires that the manager be both early and patient. It can mean putting up with a lot of noise, so a longterm perspective and patience are key for an investor in Scottish Mortgage. Frankly, 10 years is a reasonable baseline.

Investing in cutting-edge companies is not for the faint of heart. Though the benchmark is the FT all world index, intermediate fund price volatility was double the AWI volatility, and the NAV volatility was eyewatering too. The fund lost 30% over the past three months (24% over a year), driven by the Chinese government’s drubbing of Chinese technology companies and a re-evaluation of the prospects of stocks that surged during the pandemic.

Is Scottish Mortgage now in free fall, or is this an opportunity to buy? The long-term perspective matters. Over the 10 years to December 2021, Scottish Mortgage returned a cumulative 1,147%, well above the benchmark’s 271%. The recent 30% reversal cuts that lead, but still makes for a respectable 750% bottom line. With a management fee of 0.35%, Baillie Gifford costs are certainly not a disincentive.

The managers have shown willingness to adapt their approach as time goes by and a skill to spot companies of excellent potential before they are in vogue. With the ability to act in the way investment companies can, the fund has a net private equity exposure of 25% and a gearing of 11%. Given their high conviction stance, they are NOT shy about taking concentrated sector exposures. As that now entails exposures to the high-beta infotech and biotech sectors, those with the bad habit of watching fund investments too frequently may not be able to tolerate the stomach acid! Position sizing is the order of the day.

An overview of the top 10 holdings (all info- or biotech), left, illustrates the point about conviction bets.

Investment companies trade at either premiums or discounts to their NAV. With the rougher market recently, a discount to NAV has come back into the fund price. Those conditions can persist for a long time, so perhaps the (psychologically more soothing) way to get into bucking broncos like this is to make small moves every few months while the pressure persists.