At the annual general meeting of Scottish Mortgage Investment Trust on June 16, I retired as the senior independent director after a 12-year stint on the board (I remain a shareholder). During that period, the share price had increased tenfold, making Scottish Mortgage by far the largest investment trust in the UK with assets approaching £15bn.
In a world where investors are increasingly drawn to low-cost passive funds and ETFs, where do investment trusts fit in? After almost 40 years as an investor and board director of investment trusts, reflecting on my own experiences may help readers answer that question.
Investing through history
The world’s oldest example of a collective investment vehicle, investment trusts came into being before the first world war. They allowed middle-class investors in the UK to benefit from British imperialism — economic and political — in Asia, Africa and Latin America. That history survives in the name of the oldest investment trust, Foreign and Colonial, which celebrated its 150th anniversary in 2018 and now prefers the more discreet title F&C.
Scottish Mortgage Investment Trust was formed in 1909, just as Henry Ford was launching his Model T, to raise funds for what seemed attractive opportunities in Malaysian rubber plantations. These would provide materials for the nascent automobile industry. Evidently the demand for rubber plantation finance was more limited than had been thought, so the company broadened its remit. The connection to automobiles remains, however. Scottish Mortgage’s largest holding today — and the one every shareholder and financial adviser wants to talk about — is Tesla.
Investment companies were culpably implicated in the Wall Street crash of 1929. The Goldman Sachs Trading Corporation, launched in 1928, was only one of a dizzying range of leveraged investment companies promoted by that bank and others as the roaring twenties roared. By 1931, it had lost 99 per cent of its value. The anxiety of small investors to be part of the boom had also led to the creation of the first US mutual funds. These also fell in the crash, but did retain some value. US investors have preferred mutual funds ever since.
The mutual fund format was copied in the UK with the brave establishment in 1931 of the first unit trust by M&G. The key difference between an investment trust (a closed-ended investment company) and a unit trust (an open-ended investment company) is that an investor in a closed-ended fund must buy from or sell to another investor. By contrast, the investor in an open-ended fund deals directly with the manager, who must then buy or sell shares from the underlying portfolio. An investment trust may therefore be priced at a discount or (less often) a premium to its net asset value, while an open end fund is, in principle at least, always worth its share of the underlying assets.
Unit trusts historically had two marketing advantages over investment trusts — they could be advertised to potential investors, and they could pay commission to intermediaries. Subsequent regulatory changes have largely addressed these anomalies. The advantages were to the promoter of the trust rather than to the investor. But as a result, far more money is today invested in open- ended vehicles.
However, this apparent vote of confidence is not necessarily to the investor’s advantage. Retail investors frequently get trapped in daily-traded funds that invest in illiquid assets, such as commercial property or early-stage companies, which cannot easily be sold. This is a problem that regulators have been grappling with for years.
Investment trusts have proved a better structure for holding more esoteric assets — and furthermore, a variety of studies have suggested that closed-ended funds outperform similar open- ended equivalents.
Nevertheless, for much of the postwar era, the investment trust seemed to be a dying vehicle. Insurance companies and pension funds had once used investment trusts as they began to add equities to the bonds in their portfolios, but they reduced their holdings as they took over direct control of their funds and the shares of most investment companies traded at a discount to their net asset value (NAV).
The investment trust discount tends to reflect the popularity or otherwise of the fund manager — mainly a reflection of relative recent performance — and the fashionability of the sector in which the trust is invested.
Currently, Scottish Mortgage stands at a small premium to its net asset value and so do most trusts specialising in infrastructure or renewables which are both in vogue with investors. Investment trusts with an Asian focus, however, have recently traded at large discounts to NAV, reflecting Covid-19 fears. There are also yawning discounts on most real estate investment trusts (commonly known as Reits) particularly those exposed to retail property as online sales surge. These discounts may reflect scepticism about reported asset values in the commercial property sector.
Some investment trusts now profess “discount management policies” which involve buying back shares when a significant discount emerges and issuing shares when it is possible to do so at a premium. Scottish Mortgage is one of the few to have implemented such a policy successfully, with the result that for several years now the shares have traded close to asset value. This is true even though a significant proportion of the portfolio is illiquid.
So what is the secret? For any investor, successful stockpicking requires the pursuit of a group of related investment themes, and the construction of a concentrated portfolio focused on these themes.
In the case of Scottish Mortgage’s fund manager James Anderson and his co-manager Tom Slater, the key investment theme is that the centre of growth in the world economy has shifted to Asia. Everyone understands that a large proportion of the manufactured goods we buy today come from China. But the corollary is the evolution of a Chinese middle class with demand for consumer goods and more importantly services. The investment opportunity is in the emergent companies which meet these needs.
During my time on the board, early-stage investment in businesses such as Baidu and Alibaba proved very rewarding. Newer companies such as ByteDance (creator of TikTok) have products which will certainly appeal to the grandchildren of readers of this article, though perhaps not to the readers themselves. Hence, investors rely on fund managers to spot these opportunities.
Fifty years of financialisation produced an emphasis on “making the numbers” in corporate quarterly earnings reports which did not, over the long term, create the “shareholder value” which executives purported to seek. Twenty-five years ago, you might have thought a portfolio containing shares in General Electric and General Motors, ICI, Marks and Spencer, Barclays Bank and Sears Roebuck represented a low-risk, conservative approach to investment. And you would have been spectacularly wrong.
Stock market growth over the period has been considerable, but largely driven by new companies, not established market leaders. This was always true, but a more rapid pace of corporate change has made the dependence of aggregate performance on a small number of outstanding stocks more obvious.
Capitalism, as it emerged in the 19th century, is dead. Businesses have long ceased to finance their investment through equity markets. Net capital raising in public markets is negative. New issues have been smaller than the amounts taken out in share buybacks and acquisitions for cash, and tangible assets, less important than they were, are typically fungible; they need not be owned by the company which uses them and typically are not.
This year and next there will be a revival of new equity issues by established companies — not to finance new activity, but to restore balance sheets depleted by Covid-19 related losses. I predict this with confidence as the same thing happened after the 2008 financial crisis, although most of that fresh equity that time came from government.
The result is that the principal need for new equity capital is to fund the operating losses of new businesses. And if asset management is to mean something more significant to the economy and rewarding to investors than outguessing other fund managers on what AstraZeneca’s next quarterly earnings will be, that is in such funding that opportunities are to be found.
Scottish Mortgage is not a venture capital fund, but it has become a provider of capital to growing businesses which are not yet cash generative and which are not yet — and may never be — interested in a public market listing. That is why a quarter of the fund is invested in unlisted securities.
Such a strategy is only realistically achievable in a closed-ended fund. The failure of the Woodford funds, following the earlier gating of open-ended property funds, provides a warning that the promise of immediate redemption at asset value is only possible if the portfolio is confined to a range of highly marketable securities — shares in highly liquid companies such as AstraZeneca, Unilever, HSBC, and Shell (I also hold Shell in my portfolio). Yet if that is your choice, you will be limited to index returns and be better off in a tracker or ETF (exchange traded fund).
The Woodford episode is also a warning of the dangers of running a closed-ended fund alongside an open-ended fund with a similar portfolio, as redemptions in the latter will affect values in the former. In the case of Scottish Mortgage, that required a review of the overlaps between the trust’s portfolio and other funds managed by Baillie Gifford.
There are far too many investment funds in the UK. The ordinary retail investor has a choice of more than 3,000 open-ended funds — there are more funds than London-listed stocks. And in addition there are more than 400 closed-end funds, or investment trusts. Although charges have fallen in the past decade, they are still too high.
In a previous article I provocatively explained the reason; as with brain surgeons and estate agents, price competition is not very effective in these markets because it is well worth paying more for a product that is even slightly better, yet very difficult to judge whether the product is in fact better. Combine that observation with the existence of economies of scale in managing money — it isn’t 10 times as expensive to handle a portfolio of £1bn as it is to manage one of £100m — and you understand why the fund management industry is so very profitable.
Should you contribute to that profitability? You should not pay active management fees for a “closet indexed” fund. If the largest holdings are AstraZeneca, Unilever, Shell and HSBC you are effectively paying active management fees for an index tracker, and will you do better to buy the indexed tracker.
It is instructive to divide the quoted management fee by the “active share” — the total of deviations from the benchmark index. If that active share is 20 per cent and the management fee is 0.75 per cent then you are effectively paying 3.75 per cent for the manager’s (very limited) stock selection on that slice of your holdings. They will have to be very good indeed to recoup that for you. Since most managers are hesitant to move very far from their benchmarks — and regulation tends to discourage them from doing so — that criterion rules out many of the trusts competing for your money.
There are two compelling models for an investment trust. One, followed by a few companies, with the Personal Assets Trust as the standout example — is to offer a complete investment portfolio, designed to be the only security you need. That trust’s holdings are conservative and diversified across asset categories, and an investor would have experienced few sleepless nights and earned returns well ahead of those you could expect from a building society.
The other approach — of which Scottish Mortgage has become the standout example — is to pursue a style derived from a well articulated investment philosophy. Importantly, such a strategy is based on a view about business, rather than a view about assets or markets, and on a view about the future of particular firms and products, rather than a macroeconomic prediction about the future policy of the Federal Reserve Board.
Such thinking is, I believe, the future of asset management in the 21st century. However, it will require skills rather different from those which chartered financial analysts currently obtain — it’s less about the capital asset pricing model and more about models of product pricing. I recall a conversation with a well-known fund manager who, when I began to talk about business strategy, said: “I don’t want to know about competitive advantage, I want to know which stocks are going to go up.” I wouldn’t place my own money there, or bet on the long-term future of his firm.
The Scottish Mortgage strategy which I describe stood up well to the current crisis; the large holding in Amazon has paid off, and the much smaller holding in Zoom was taken long before anyone imagined that in 2020 it would become the business tool of choice. And for different reasons, Tesla has achieved an all-time high. But there might have been a very different existential crisis — a cyber attack, or a “Carrington event” which knocked out much of the world’s electricity network (the last one was in 1859, just before there was a world electricity network to knock out). These crises would have disproportionately damaged the Scottish Mortgage portfolio.
The lesson I will leave investors with is that the only safe — and then only relatively safe — investment strategy is one which emphasises wide diversification. There should be fewer investment trusts, and many fewer unit trusts. The ones worth investing in are those with a well argued investment philosophy that chimes with your own. After doing your own research, you will find there are some managers who fall into this category, but too many who simply boast of their prowess at stock picking. A robust equity investment portfolio might be based on a selection of the former — and for the rest, a tracker will do.
This article was first published in the Financial Times on 28 August 2020.