The world is changing fast and to keep up you need local knowledge with global context.
*This content is brought to you by Overberg Asset Management
By Nick Downing*
It is common wisdom that investing in overseas markets is a good idea, not only to diversify risk but to take advantage of the vast array of investment opportunities available across the world. How does one proceed? Constructing a share portfolio around individual companies’ shares is an option but where does one start…. There are 5,000 shares alone listed on India’s largest stock exchange. Another option is to construct a portfolio around Exchange Traded Funds (ETFs), passive tracker funds which mirror the performance of stock market indices. They have done well but investors will never be able to outperform the index and this may become problematic if erstwhile market leaders, which have such heavy index weightings, start to de-rate in favour of cyclical shares in an economic recovery. Does one really want to be forced to own Tesla shares, valued on a +/- 1700 price earnings multiple. There are so many ETFs these days that the choice has become bewildering and some professional advice is recommended when constructing an ETF portfolio. Collective investments such as unit trusts or mutual funds are another option. Again, professional advice is also helpful in making selections due to the vast choice available. A common refrain is that unit trusts can be costly while their open-ended structure and regulatory restrictions can be limiting.
Investment companies (ICs), also known as closed-end funds or investment trusts are described as the “City’s Best Kept Secret”. ICs provide another option for investors looking to build a global investment portfolio. Professionals in London’s financial centre favour ICs for their personal investments. There are numerous compelling advantages.
ICs have been around since the 1860s. They are listed on the London Stock Exchange (LSE) and there are hundreds to choose from so professional advice is recommended. ICs comprise the FTSE Equity Investment Instruments Index, which has increased its weighting over the past ten years from 4% to over 7% of the FTSE All Share Index. They do incur fees, but no more than commercial companies incur overheads. The fees are very low, sometimes as low as 0.2% and seldom above 1%, well below the fees charged by most unit trusts. The fees are low because ICs are controlled by shareholders and so interests are aligned. In fact, if the appointed asset manager of the IC underperforms, the manager will be replaced or in some cases the IC will be merged or taken over. ICs are like commercial companies. They trade as ordinary shares and should not be confused with unit trusts. This is illustrated below.
A very popular feature with investors is that ICs can pay uncovered dividends from revenue reserves and capital reserves. During the Covid pandemic, ICs were a reliable source of income even at the height of the crisis. Global dividends fell substantially in 2020 due to the pandemic while ICs were able to maintain their dividend payments.
The use of gearing can add value. ICs can borrow money to invest. If the IC earns more than the interest paid on the loan, the gearing will boost investment returns. This is one of the reasons that ICs can produce better returns than unit trusts. Not all ICs use gearing and those that do normally borrow less than 20% of the value of the investments.
ICs are the ideal structure for investment in illiquid assets. The IC sector of the London Stock Exchange contains leading companies specialising in alternative asset classes such as renewable energy, private equity, infrastructure, specialised debt, commercial property, royalties, and absolute return strategies. These alternative asset classes, which add so much value in terms of portfolio diversification and improved return prospects, can be freely traded via ICs. The closed-end structure of an IC is perfectly suited to investing in illiquid assets which owned directly may not be as easily tradeable as the shares of a closed-end fund/IC holding the assets. By contrast, due to “liquidity mismatch” unit trusts can run into all sorts of difficulties if they need to exit illiquid investments in a hurry due to a surge in redemptions. There are several examples of unit trusts having to restrict redemptions due to liquidity mismatches, which render them unable to meet their promise of daily dealings.
ICs are closed-end structures, which means they have a fixed number of shares. The share price could move more than or less than the value of the underlying asset value, which means the share could trade at a premium or a discount to net asset value (NAV). This is one of the greatest advantages. Besides facilitating exposure to alternative asset classes, the closed-end structure creates the opportunity of buying shares for less than their worth (discount to NAV) and selling them for more than their worth (premium to NAV).
The average discount of the FTSE Equity Investment Instruments Index started last year at 1.6% and due to the Covid shock widened to 22.5% by the end of March but by the end of last year the discount closed again to the narrowest level on record. Discount changes introduce an additional element of risk to ICs as their price performance can be more volatile than the performance of the underlying assets and so it recommended that you use professionals to construct and manage your IC portfolio.
One of the best-known ICs is Scottish Mortgage, which was founded in 1907 and now has a market capitalisation of £18 billion. It is a constituent of the FTSE 100 index. Total investment returns versus its benchmark, the FTSE All-World Index (in brackets) are exemplary: 1 year 117% (12.7%), 3 years 181% (32%), 5 years 418% (100%), 10 years 895% (188%). Around 30% of its assets are in unlisted companies. The company is actively managed and at low cost, at a fee of just 0.36%, phenomenal value for an investment of this calibre. Since 1907, Scottish Mortgage has increased its dividend every single year except 1933 at the height of the Great Depression.
Overberg Asset Management constructs its clients’ global private share portfolios around ICs, a well proven strategy successfully pursued over the past 20 years. Clients’ portfolios typically comprise 20-25 ICs, quoted on the London Stock Exchange and therefore highly liquid. Underlying exposure provides true diversification across the world’s regions, currencies, industrial sectors and asset classes in an optimally efficient and cost-effective manner. The result is consistent top quartile performance over the past 20 years.
- Nick Downing is the CEO and CIO of Overberg Asset Management.
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