The low interest rate environment that has prevailed since the global financial crisis has led many investors to join the “search for yield”. This has prompted the launch of several specialist investment trusts (funds listed on the London Stock Exchange), which allow investors to gain access to a specific asset class (or classes).
These “new” assets include social infrastructure, specialist property (“big box” distribution facilities and student accommodation), renewable energy, market place lending, secured debt, insurance-linked securities and aircraft leasing. These building blocks can contribute to strong risk-adjusted returns and are important constituents of Aberdeen’s diversified multi-asset funds.
A brief history of investment trusts
Investment trusts have been a feature of the investment landscape since 1868. They were originally launched to provide investors with diversified exposure to the emerging markets of the day such as North and South America and South-East Asia. Indeed, Aberdeen Asset Management can trace its roots back to one such trust, the North of Scotland Canadian Mortgage Company Limited, founded in 1875.
Over time, investment trusts mostly moved away from these early, frontier-style investments and became more mainstream equity-focussed investment vehicles. But in the 1970s and 1980s, investment trusts fell out of favour. Their shares often languished at a wide discount to asset value and several trusts were taken over.
In the 1990s, changes in accounting rules allowed trusts to buy back their own shares and strongly performing funds which traded at a premium to asset value were able to issue new shares to satisfy investor demand. More recently, the focus of share issuance has been away from equities towards alternative asset classes.
The key advantages of investment trusts
Investors in investment trusts can only redeem their holding by selling their shares to another investor via the stock market. This means that investment trusts have access to permanent capital. Fund managers can invest in illiquid asset classes (such as schools, windfarms or aircraft that potentially offer attractive risk-adjusted returns) and do not need to worry about having to sell assets at inappropriate times in order to fund redemptions.
Unlike OEICs or SICAVs, investment trusts do not have to pay out all of their income as dividends but can retain up to 15% of their net income to build up revenue reserves. These can be used to sustain or even grow dividend pay-outs during short term market downturns. Some trusts have been able to use this mechanism to grow their dividends consistently over the past 50 years. In addition, recent changes to tax legislation mean that trusts can now distribute realised capital gains as dividends and several trusts are taking advantage of this flexibility.
Since the global financial crisis, the benefits of the investment trust’s permanent capital structure have been used by an increasing number of specialist fund managers to give investors access to high-yielding assets that are not suitable for open-ended vehicles.
In 2016, the total market capitalisation of the sector increased to over £121 billion as £5.5 billion of new capital was raised by investment trust companies. The bulk of this was in so-called alternatives funds with only £1.2 billion raised by equity-focussed funds. The chart below shows the pattern of share issuance by investment trusts since 2011 with the top three blocks showing the most popular asset classes: infrastructure, property and debt (including loans and market place lending).
The new investment model
How do these new, alternatives investment trusts earn such returns for shareholders? In some cases, they buy an illiquid asset and then use it to provide a service to a third party for an annual fee. The aim is to secure revenue streams from high-quality counterparties that are long-term, inflation-linked if possible, and independent of the economic cycle.
Typical examples would be public sector school or hospital buildings owned by social infrastructure funds, A380 aircraft leased to airlines such as Emirates by aircraft leasing funds and solar energy parks or wind farms owned by renewable energy funds, which sell their energy under contract to suppliers such as Scottish Power. Investments in these areas with secure, long-term cash flows are purchased partly using long term debt. This enables funds to target dividend pay-outs of 5 – 8% p.a. to shareholders.
A variety of debt-focussed funds have been raised which seek higher returns than are on offer from investment grade corporate bonds or from government bonds. These include funds specialising in market place lending via peer-to-peer platforms such as Funding Circle, in mortgage-backed securities and in debt secured on assets owned by sub-investment grade companies.
Funding Circle, for example, has received backing from the UK Government-owned British Business Bank and from the European Investment Bank in order to offer loans to small and medium-sized enterprises at more competitive rates than UK high street banks. It has developed an innovative, technology-based platform that allows it to do this at low cost. In order to take advantage of this, an investment trust, Funding Circle Income Fund (FCIF), raised £150m to invest via the platform. FCIF, which currently earns a gross return of 11% from a widely diversified portfolio of small business loans, is targeting a total return of 8-9% per annum after allowing for potential credit losses.
But be aware of the risks
What are the risks associated with alternatives investment trusts?
The most notable is counterparty risk – that the trust’s “customer” (e.g. Emirates airline for aircraft leasing, or a housing association for a social housing fund) is forced to default on their future obligations when market or economic conditions change adversely. This is the same risk faced by investors in a property REIT when a tenant goes bust. The manager will look to re-lease the asset to a new counterparty but there will be additional costs involved and the new lease may not be on such favourable terms.
On a day to day basis, investment trust volatility is more generally driven by the expected return of the underlying asset and related investor sentiment. Most alternatives trusts aim to spread their risk by investing in a variety of assets within their chosen asset class. However, this does not remove sector-specific risks – such as falling power prices, which impact renewable energy funds or rising long-term interest rates, which can impact “long duration” assets, such as schools or hospitals.
If trusts perform poorly, or their asset class is out of favour, there is likely to be little investor demand for their shares which will therefore trade at a discount to net asset value (NAV). (By contrast, in normal market conditions, OEICs are always priced at close to NAV.) Consequently, many trusts operate discount control mechanisms such as buying back shares from the open market or offering all shareholders the periodic opportunity to formally tender their shares back to the company at close to NAV.
Aberdeen’s diversified multi-asset funds have been investing through an increasingly wide range of alternatives trusts over the past decade. In addition, the Aberdeen Diversified Multi-Asset Team which manages these funds is able to call on in-house expertise on various sectors including property, infrastructure and real assets when assessing such funds. Compared to equities, these asset classes can offer attractive risk-adjusted returns with a low correlation to the economic cycle.
For example, HICL, which started life as HSBC Infrastructure, initially raised £250m in March 2006 to invest in a portfolio of 17 hospitals, colleges and other government assets within the Private Finance Initiative. Since then, it has delivered an annual return of around +10.5% (compared to +6.1% p.a. from the FTSE All-Share index). These attractions have, however, not gone unnoticed and its shares ended 2016 at a 15% premium to NAV. The fund has issued new shares regularly and it closed the year with a market capitalisation of £2.4 billion.
Some of the recently launched funds have similar long-term potential to grow in size as investors become more familiar with new asset classes.
An expanding investment universe presents plenty of compelling opportunities and ideas. But identifying which asset classes offer reliable long-term potential at acceptable levels of risk takes experience, good judgment and extensive resources. We believe investment is best approached through a proven and global investment manager like Aberdeen which has deep research capabilities but can also offer these developing asset classes as part of a highly-diversified and actively-managed multi-asset portfolio.
Investment trusts aren’t new – but the range of investments that they can provide access to has opened up a new universe of opportunities for the multi-asset investor.