Five investment trusts treading a tightrope

Recent market gyrations have served as a vivid reminder that even well-managed companies and trusts can see their share prices fall if investors start to lose their nerve.

The October plunge proved shortlived in most regions - with most markets recouping most, if not all, of the 10%-plus losses - and the winter months have historically been relatively rewarding for investors.

However, with the macro-economic situation so uncertain and shares in the US in particular on demanding valuations, it will be surprising if there is not another sizeable and possibly more sustained correction in 2015.

On this basis, it is sensible for investors to look through their investment trust holdings and take some profit on those that look most vulnerable to a downturn.

Warning signs

Substantial gearing is one warning sign that a holding may be vulnerable. This gearing may have boosted returns in the rising markets of the past few years, but it will exacerbate any falls in future. Significant exposure to smaller companies is another red flag, as they tend to underperform during setbacks.

Trusts with shares quoted on big premiums to net asset value (NAV) and without firm discount controls could prove vulnerable, as their share prices could fall a lot faster than their NAVs when investors pull in their horns.

However, Brierley reckons the five-year bull market has led to the opening up of a significant gap between valuations and fundamentals, and that tactical investors should "introduce a degree of caution".

"Buoyant markets represent a timely opportunity to review portfolios and, given underlying liquidity, we would not wait for the music to stop," he says. "We would focus on reducing exposure to companies with elevated ratings - particularly where returns have been driven more by the market than by stock-picking - higher-risk characteristics and poor marketability."

Peter Hewitt, who manages F&C Managed Portfolio, a fund of investment trusts with income and growth shares, also believes a degree of caution is warranted.

He says: "Markets could be higher in a year's time, but they may not be, so it is sensible to be a bit cautious, especially of anything with too much gearing and a tight discount. But we would not want to avoid everything in the higher-risk category, as we would want some offsetters. Also we would not be too worried about higher levels of debt in non-equity sectors such as property and infrastructure."

Vulnerable trusts

The five trusts highlighted here all have characteristics that might lead them to underperform should there be a global correction in stock markets.

JPMorgan American is a large, liquid, low-cost trust that has been managed by Garrett Fish since 2003. He focuses on larger US companies, but he has benefited over the years from investing up to 8% in smaller growth companies.

Helped by its smaller company exposure (which is currently down to around 3%) and by its mix of long- and shorter-term gearing, the trust's NAV returns have been modestly ahead of the benchmark S&P 500 index over 10 years. But they have lagged the index over the past five years and barely matched the benchmark over the past year, despite gearing of around 10%.

JAM's returns look impressive against those of its closed-ended sector peers, which has helped eliminate the discount and facilitate the issue of a lot of new shares.

However, they look less impressive when compared with those of a number of open-ended funds, whose investors don't have to worry about gearing turning sour in a downturn or a widening discount. A fund such as Old Mutual North American Equity looks a better option for those worried about further bouts of volatility in the world's largest stock market.

Merchants Trust has the highest gearing into equities in the UK equity income sector - around 20%. This has played a key role in enabling the Allianz Global Investors-managed trust to raise its dividend every year since 1982. As a result, it offers an exceptionally high 5.1% yield and its shares trade on a 1.2% premium.

The problem is that manager Simon Gergel has struggled to keep the dividend moving steadily up, as demonstrated by average annual dividend growth of just 1% over the past five years.

At the same time, growth in Merchants' NAV per share (excluding reinvested dividends) has been among the lowest in the sector. This will make generating future dividend growth more difficult, while its high gearing exacerbates its vulnerability to setbacks.

Lower yielding trusts

Investors could sleep more comfortably holding a trust with a lower initial yield but a better five-year record for both dividend and capital growth. Candidates include Perpetual Income & Growth Trust, City of London and the defensively managed Troy Income & Growth Trust.

Fidelity Special Values enjoyed an annus mirabilis following the September 2012 appointment of the youthful Alex Wright as manager, but it has substantially underperformed the benchmark FTSE All-Share index in the year to date. As a result, its discount has widened to mid-single figures.

This looks undemanding relative to the UK all companies sector average. However, FSV has a 58% positioning in medium to smaller companies; investors should be aware of the higher discounts on several well-run trusts with high mid-cap weightings and less gearing, such as JPMorgan Mid Cap and Henderson Smaller Companies investment trust.

FSV's gearing is exceptionally high at 27%. It is achieved through derivatives, and is claimed to be both cheap and flexible. It can include short positions (betting that the price will fall) as well as long, so actual exposure to equities is liable to be much lower than the headline rate. However, many highly experienced active managers avoid calling market moves in the way Wright is attempting to do with derivatives.

His January 2014 appointment as manager of the similarly oriented £2.7 billion Fidelity Special Situations fund may inhibit his ability to actively manage his smaller company holdings. If so, that is a pity, as this is where he built his reputation.

F&C Global Smaller Companies has a great long-term record: it ranks among the top performers in the global sector over five and 10 years and its shares frequently trade at a premium. However, its returns over the past 12 months have been below average for its sector. There are several reasons why the loss of form might prove more than temporary.

Manager moves

One is that Robert Siddles, who had managed the trust's sizeable US portfolio since 2001, moved to Jupiter at the start of 2014. Siddles delivered market-beating returns for much of his tenure and also assisted FCS's manager Peter Ewins with asset allocation decisions. So too did Jeremy Tigue - who has also left F&C, after retiring as manager of Foreign & Colonial investment trust at the start of July.

Another concern is that the trust recently issued £40 million of convertible unsecured loan stock, equal to gearing of nearly 9%. It is tempting providence to increase the trust's gearing when markets are so demandingly valued.

Like JPMorgan American, F&C Global Smaller Companies has boosted its returns by issuing plenty of new shares at a premium in recent years. The boards of both trusts have indicated they will be willing to buy back shares if their discounts start to widen, but in FCS's case it appears the discount could widen to around 5% before it takes action.

The premium rating on Henderson Far East Income could also prove vulnerable if shareholders start weeding out their weaker performers. Its main attraction is a yield of 5.5% that has grown by an average of more than 6% a year over the past five years.

This compares well with a yield of under 4% from its two peers, Aberdeen Asian Income and Schroder Oriental Income. However, HFEL's NAV per share has grown by less than 20% over the past five years, compared with nearer 60% growth from its rivals, so what investors have gained in income they have sacrificed on the capital front.

Brierley at Canaccord Genuity says the managers of the Aberdeen and Schroders trusts "appear to have much greater portfolio flexibility and depth of resource" than HFEL's manager, Mike Kerley, and consequently has a "sell" recommendation on the trust.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.