Beware! Trusts can fall on a double-edged sword

Are investment trusts always to be preferred to their unit trust and mutual fund counterparts?

Over the years that I have been writing this column, I have given precedence to investment trusts over open-ended funds for private investors.

Their long-term performance is on average notably superior, they are able to invest in a wider range of securities, they enable investors to acquire a portfolio of shares at a discount to their unit trust counterparts, and governance is more transparent and accountable.

So game, set and match for investment trusts? Well, not quite. For they have a hidden double-edged sword on which investors can find themselves impaled. And seldom has the damage inflicted by this weapon been more visible than in the Covid-19 pandemic and the notable volatility in market volatility.

The double-edged sword is in investment trust gearing – unlike their fund counterparts they are able to borrow to purchase more shares for the trust portfolio.

When markets are rising, this can be a great bonus for trust investors: the expanded portfolio is thus able to display a stronger performance than funds where no such borrowing is permissible.

But just as gearing can enhance gains in a rising market, it can magnify losses when markets are falling.

Research released in the past week by the Interactive Investor website compares the performance of funds and comparable investment trusts – and the results sound a timely warning that what, over long time periods can be a blessing can prove to be a bane when markets are in retreat.

It found that for eight of the ten “mirror” portfolios, the fund version outperformed over its investment trust twin. For six of the ten mirror portfolios, the investment trust has underperformed the fund by around 5 per cent or more.

For example, in the year to 10 August, the UK Smaller Companies investment trust run by Standard Life has fallen by 16.7 per cent, while its mutual fund counterpart – the ASI UK Smaller companies fund – has declined by just 5.2 per cent.

Similarly, the Janus Henderson European Focus investment trust is down by 8.7 per cent; its mutual fund counterpart by less than 1 per cent.

The pendulum swings the other way over a longer time period, with investment trusts outperforming in six out of ten mirror portfolios over five years and nine out of ten over ten years.

However, the variability in performance can be unsettling for investors working on shorter time-scales and who can be smarting over initial losses on an otherwise well-regarded investment trust.

And while markets have recovered a large portion of the initial losses suffered in March and April, we are not yet at the end of this pandemic – and its full devastating economic consequences, in particular, have yet to be felt.

The severity of the stock market selloff over a five-week period in February and March has played a major role in the performance of most funds that have outperformed comparable trusts.

When re-running the five-year performance numbers prior to the selloff (from 1 February 2015 to 1 February 2020) nine of the ten investment trusts performed better than the fund version. The only exception was Henderson European Focus Trust, which lagged Janus Henderson European Focus (41.5 per cent versus 48.3 per cent).

When looking at a longer time period of ten years, a period that for the most part (prior to the coronavirus sell-off ) was the longest bull market in history for equities, investment trusts have the edge, outperforming nine times out of ten.

The one exception is Edinburgh Worldwide investment trust versus Baillie Gifford Global Discovery (a gain of 441.09 per cent versus 503.50 per cent). It should be pointed out that it was not until January 2014 that Douglas Brodie took over management of the trust, so therefore the trust has not been following the same strategy and approach for the full ten years.

Brodie has managed Baillie Gifford Global Discovery since May 2011.

Says Dzmitry Lipski, head of funds research at Interactive Investor, “Investment trusts have proven to be a terrific vehicle for long term investing and there is a growing body of evidence that shows they tend to outperformance over the long term.

“The ability to gear, borrow money, is a structural advantage investment trusts have over funds which, for many, has turbo-charged returns during the recordbreaking bull market spanning over a decade.

“Then Covid-19 pandemic happened, and the subsequent unprecedented lockdown measures enforced by governments over the globe sent markets into freefall.

“In falling markets, gearing, even a small amount, has the reverse effect: enhancing losses on the way down.

“Investing is intrinsically a long-term game, and as long as you have time on your side, you can ride out the inevitable bumps in the market for a smoothed return,” Lipski added.

As long as you have time on your side, you can ride out the inevitable bumps