How I learned to stop worrying and love the boom

After the party comes the hangover. That’s an abridged version of the Annual Review published two weeks ago by Winterflood Investment Trusts, which warned that after the closed-ended fund sector enjoyed a stellar year in 2017, 2018 could prove very different.

First the good news.  While many investment analysts 12 months ago were predicting a difficult year for financial markets – not least due to Brexit and the President Trump effect – equities actually performed very strongly over the course of 2017. Closed-ended funds did even better: the FTSE All Share Equity Investment Instruments index was up 18.4 per cent on a total return basis last year compared with a rise of 13.1 per cent for the FTSE All Share. Performance was boosted by the fact that the average discount at which investment companies’ shares trade relative to the value of their underlying assets narrowed from 5.1 per cent to 3.1 per cent.

Moreover, that strength encouraged investment company managers to raise new money, both for their existing funds and for completely new launches. Last year’s £9.8bn fund-raising was the highest annual total recorded since the global financial crisis of a decade ago and included 19 IPOs that collectively raised £2.9bn.

Enter downbeat Winterflood. “With the bull market now in its ninth year, there will no doubt be speculation that a setback is imminent,” the firm’s analysts caution. “The investment trust sector has enjoyed a strong period of growth and while this could continue in 2018, we believe that current discount levels present a risk should or when the market sees a downturn.”

It’s a very reasonable argument, of course. We know that in the short term at least, investors tend to overreact to bad news – and that this over-reaction tends to be larger when they’ve got themselves comfortable. It does seem likely, therefore, that even a small market setback would prompt a larger sell-off of investment company shares; that would mean discounts widening and investors in closed-ended funds racking up more sizeable losses as a result.

Still, it’s worth making just a couple of points before investors sell up and head for the hills. First, there is nothing written in the stars that says a market reverse is inevitable in 2018; there certainly are market commentators who believe the bull run is out of steam, but others point to valuations that do not look excessive by historical comparisons.

Second, while we will see discounts widen in the event of a market tumble, discount volatility has been considerably lower in recent times, with boards ready to step in to prevent valuations slipping to levels seen in the past. As share buybacks and discount control mechanisms have become the norm, average discounts have fallen. The long-run average discount in the sector, going back all the way to 1990, is 9.5 per cent; by contrast, over the past 10 years, the average stands at 7.4 per cent.

This is not to suggest there is no reason to be cautious over the year ahead. As ever though, trying to call the market is fraught with difficulties – run a profit and cut a loss by all means, but don’t miss out on further growth to come.

Looking for a compromise option? If so, investment company regular savings scheme will have more appeal than ever in 2018. Drip-feeding your money into the market with a fixed cash sum each month provides continued exposure if the markets keep rising, plus the benefit of pound-cost averaging in the event of a fall, when your monthly investment buys more shares.

It is time to be circumspect, in other words. Winterflood’s Annual Review is a timely reminder that what goes up generally tends to come back down. But not necessarily yet – and not necessarily so dramatically as in past corrections.