David Stevenson: Ideas for untapped trust markets in 2024

Looking at competitor segments – open-ended funds, hedge funds and ETFs – several ideas could turn into trust IPOs next year, including Bangladesh- and AI-specific trusts.

I thought I would finish the year with some upbeat thoughts about new ideas and strategies that might just work in an investment trust format.

Most of 2023 has been a fairly dispiriting experience for investment trust investors but much of the pain has been self-inflicted – the closed-end funds space overdosed on alternative and infrastructure strategies and needed a course correction. Sure, bond proxies serve a valuable purpose but I’m not sure we needed quite so many funds investing in alternative income, infrastructure, renewables and Reits – the process of winnowing these funds is now under way and is likely to accelerate in 2024.

It’s a bit ambitious for me to say this, but at some point next year fund managers might start to think about bringing new funds onto the market. Given we had only two new funds IPO in 2023, that seems a distant prospect but we can only hope.

Looking at competitor segments – open-ended funds, ETFs and hedge funds – there are several ideas for untapped markets.

Fixed income

The first is perhaps the most obvious: fixed income. It will probably come as a surprise to most readers but some listed funds do actually trade at a premium – hard to believe in today’s brutal markets. Many, if not most, are focused on providing an income, with a small number of bond funds such as CQS New City High Yield (NCYF ) and Invesco Bond Income Plus (BIPS ) in the lead.

For the past few years, bond fund managers have had a difficult time as interest rates rose tenfold. However, given we are probably at a pivot point, with rates coming down soon, the asset class is more attractive.

If we look at exchange-traded fund (ETF) flows, a huge wall of money is flooding into everything from near-cash ETFs through to some corporate credit vehicles. Ironically, a fair chunk of this money is flowing into actively managed ETFs, vehicles that by rights should be investment trusts.

There are, of course, good reasons why UK closed-end fund investors haven’t traditionally been keen on fixed income investment trusts and, according to Ewan Lovett-Turner at Numis, there were also tax issues making the asset less likely to end up in the trust structure.

‘The launches that happened were generally offshore (Guernsey/Jersey) domiciled funds,’ the analyst pointed out. ‘The rules changed for UK investment trusts so this is less of an issue now, and a number of funds came back onshore.’

Lovett-Turner also notes that attracting demand for debt-based investment companies can be tricky because debt investors don’t want to buy the equity wrapper and suffer share price volatility. As a result, the sector has tended to focus on less liquid areas of the debt markets such as private credit, where the benefits of the investment company structure can be utilised.

However, I would argue that everything has now changed and that some of those traditional concerns are melting away.

One driver is a structural shift in demand. As wealth firms back away from investment trusts, the sector will come to rely more and more on private investors and their platforms. These investors could do with active managers who know their way around the various nooks and crannies of the fixed income space, and it is not obvious to me that unit trusts have satisfied all that demand.

Top of my list would be funds focused on distressed debt, index-linked securities and multi-strategy multi-asset (debt and credit and loans) vehicles.

Useful US

Back in the mainstream of equity investing – the traditional heartland of investment trusts – some niches aren’t massively well served by the existing funds.

Take US mid-caps. Arbrook, a US equities specialist that spends a great deal of time looking at mid-caps, observes that the stocks are having their worst year relative to large caps in 30 years.

It reckons the only year to come close in underperformance was 1998, during the ‘heady days of the tech bubble and the year some upstart Seattle-based online book retailer’s stock returned 966%’.

Ironically, the few US equities funds that are in the listed, closed-end fund London market are either focused on large-cap growth stocks or small-cap minnows – missing out on the entire mid-cap range the S&P 400 comprises.

Burgeoning Bangladesh

Emerging markets (EMs) are an area where the London investment trust market has traditionally excelled – note the IPO in 2023 of Ashoka WhiteOak Emerging Markets (AWEM ).

Many investors – private and professional – are reluctant to allocate too much to global emerging markets because they are worried about funds investing in China. We all know the challenges of investing in the world’s favourite Marxist superpower, so I won’t bother labouring the downsides.

ETF issuers have started responding to this by launching permutations of indices that exclude China and even Taiwan. Country-specific funds can help fill this gap, and the London market has lots of choice when it comes to India, Vietnam and even Latin America, not to forget frontier markets courtesy of BlackRock.

But where are the funds that invest in tomorrow’s EM darlings, countries such as Indonesia or even Bangladesh?

That last South Asian upstart has been grabbing investors’ attention with record growth rates and low valuations. The export powerhouse has a thriving local stock market with comparatively low price-to-earnings ratios for a fast-growing economy. Bangladesh equities trade at an average of about 14.4 times earnings, with Indonesia only a little higher at 15 times earnings, compared with nearly 25 times Indian earnings. That represents a 40% discount to the main alternative to Chinese equities, India.

On this subject, it’s worth pointing out that the manager behind London-listed Vietnam fund Vietnam Enterprise (VEIL ) has just launched a joint venture with a local Bangladesh insurance company that offers access to local equities via an open-ended mutual fund that is accessible to UK investors. Expect more activity in this space.

Attractive AI

Sticking with equities, there’s also everyone’s favourite topic – AI.

ETF issuers are making hay by coming up with ever more ingenious iterations of indices that invest in AI and its various spinoffs – robotics, data centres and so on. These thematic ETFs have caught the imagination of younger investors and those with a tech bias.

Investment trusts such as Polar Capital Technology (PCT ) and Manchester & London (MNL ) have a very definite AI bias – Ben Rogoff at Polar waxes lyrical about AI and reckons most of his portfolio is in some way AI-based.

But there’s no getting away from the fact that these are generalist tech funds that tend to steer into benchmark indices, even if only indirectly. An AI-specific thematic investment trust that could embrace both listed securities and venture capital might go down a storm and offer more value-added than the passive fund alternatives.

Hedge funds

I’ll finish with one last alternative suggestion: hedge funds. We’ve already been through one iteration of listing hedge funds on the London market and, bar Brevan Howard’s BH Macro (BHMG ), it didn’t end well.

But the need for alternative sources of diversification hasn’t diminished and it is noticeable that many private client wealth advisers are still funnelling large amounts of money into hedge funds but outside a closed-end fund wrapper.

I’d also suggest the sustained interest in funds such as the Ruffer Investment Company (RICA ), Capital Gearing (CGT ) and Personal Assets (PNL ) is in part because investors want an absolute return approach with careful management of downside risk. This is where a new generation of hedge funds could come in handy.

Former Société Générale analyst Dylan Grice, who now runs an investment firm focused on hedge funds, put out a paper recently that suggested a fresh strategy. He doesn’t downplay the concerns many investors have with hedge funds but observes that the real value of hedge funds lies in those that are equity beta neutral with smaller amounts of money under management.

In his view, too many of the big hedge funds are equity alternatives that offer little protection in downside markets. Looking at the data sets on hedge fund returns, he observes that ‘if we remove all funds with high equity correlations and remain biased towards smaller managers, some interesting properties emerge’.

‘Returns surpass those of equity markets, even during the boom of the last 25 years, with less than 25% of the volatility and a fraction of the drawdown. When looked at this way, perhaps hedge funds aren’t so bad after all.’

Call me an optimist but I would have thought investment trusts and closed-end funds offer the perfect vehicle for these smaller, equity beta-neutral shops to offer access to a wider investor community.

Even better, maybe someone could offer a fund-of-fund multi-strategy approach that follows some of the smaller, more innovative, equity-neutral shops and gives investors real diversification and downside protection.

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