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Keeping pace

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25 January 2019

David Prosser asks why long-standing clichés about investment companies persist, and suggests why views on the closed-ended sector may be outdated.

For those who still harbour concerns about the supposedly elevated risk and additional complexity of investment companies, Winterflood Investment Trusts’ review of 2018, published last week, makes interesting reading. The data and trends it identifies suggests some of the anxieties cited by investment company sceptics are now wide of the mark.

Take the question of discounts. Some advisers worry about how the closed-ended structure of an investment company means its shares typically trade at a discount or a premium to the value of the underlying assets. They fear that in difficult times for markets, deteriorating investor sentiment will lead to a widening of discounts, amplifying losses.

Well, that wasn’t the experience of last year. The average investment company ended 2018 trading at a discount of 4.3 per cent, Winterflood reports, little changed on 12 months previously, when the figure was 3.5 per cent. That despite a very difficult year for global investment markets when you might have expected investors to run for the hills.

Or consider gearing. The fact that investment companies can take on borrowing is an obvious boon during periods of rising markets, providing a cheap hit (almost a free one given today’s low interest rates) that boosts returns. In falling markets, however, doesn’t gearing have the opposite effect, exaggerating losses?

Not necessarily. Winterflood reports that the FTSE Equity Investments Instruments index recorded a total return of -3.4 percent last year. By contrast, the FTSE All Share Index fell 9.5 per cent, almost three times’ as much. Over the longer term, moreover, investment companies are miles ahead, up 214 per cent over the past 10 years compared to 138 per cent from the All Share. Gearing, it seems, doesn’t automatically lead to increased losses – not least because investment company managers have the option of reducing it in more challenging periods.

What about the much-repeated claim that investment companies somehow represent a riskier option than other types of collective fund? Well, again, the data doesn’t bear this out. In fact, taken in aggregate, the sector is becoming less risky, offering a more defensive profile for investors seeking diversification from stock market assets. Some 42 percent of the investment companies sector’s assets now have no exposure to listed equities.

Why, then, do the longstanding clichés about investment companies persist? Why do sceptics fear a sector that has outperformed markets in seven out of the past 10 years, seen discounts trend downwards and become less volatile, and increase its exposure to defensive assets?

The short answer is they haven’t kept pace with changes in the sector. If their anxieties were ever accurate, they no longer feel relevant given the recent attempts of the sector to broaden its appeal, particularly since the retail distribution reforms of six years ago. Strategic discount management programmes, renegotiation of gearing terms, cost reductions and innovation in alternative assets – among other initiatives – have all played their part in changing the profile of the sector.

This is not to suggest, of course, that any given investment company is guaranteed to outperform, let alone that it is suitable for all investors. It’s merely an observation that the assumptions some people still make about investment companies look increasingly lazy and out of date.

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