Diversification – How Investment Trusts Access Specialist Asset Classes to Reduce Portfolio Risk
Diversification is widely considered the cheapest way to reduce portfolio risk; generally speaking, diversification involves investing in a range of assets, which react differently at different points in the market cycle and to different triggers.
This, in return, should mean that investors reduce their risk of excessive losses in any particular period, because they aren’t entirely exposed to a single risk, such as Brexit.
In the past, for most investors, diversification tended to involve investing in a combination of bonds and different equities from around the world – and this approach has worked. However, in the last few years, the dial has shifted.
‘investing in a range of assets, which react differently at different points in the market cycle and to different triggers’
Over the course of the last decade, the correlation between stocks and bonds has become increasingly positive. That, in turn, means that simply blending stocks and bonds in a portfolio is no longer offering investors the protection they might assume. At the same time, some equity markets have begun to move together too, increasing the risk from this side of a portfolio.
While many retail investors have retained the simple blend of stocks and bonds, big investors like pension funds and endowments have increasingly allocated to alternative assets to reduce the correlation in their portfolios.
‘simply blending stocks and bonds in a portfolio is no longer offering investors the protection they might assume’
Traditionally, these assets wouldn’t have been available to retail investors, because assets like property, infrastructure and private businesses can be hard to sell on to other investors. This means that fund managers may not be able to quickly meet investors’ requests for their money back.
However, with investment trusts this problem is no longer prescient. Investment trusts have what is called a fixed pool of capital, because their investors access them by owning shares on the public markets (normally the London Stock Exchange). To stop investing in the fund, all investors need to do is sell these shares on to others in that market. And where demand isn’t high enough, investment trusts can retain a pool of cash to buy shares off their investors themselves.
This structure opens up a world of opportunity for the individual investor, giving access to the specialist asset classes that institutional investors have long tapped for diversification. Here, we discuss some of the trusts that give this access, and the asset classes they invest in.
The world of investing has changed rapidly in the last half decade; on one hand, growing awareness of the need to protect the planet – and the people that occupy it – has led to the flourishing of the ethical and sustainable investing markets.
‘automated investing, through the use of quantitative algorithms and exchange-traded funds’
On the other side, rapidly developing technology has contributed to the flourishing of more automated investing, through the use of quantitative algorithms and exchange-traded funds.
Although the latter development could be seen as a threat to investors, it has also contributed to some unexpected outcomes. These include dramatic dislocations in the market, when these instruments crowd a single trade, dramatically moving the price of a stock.
But while these are a challenge for busy investors, they also represent potential upside for those investors able to spot where things have gone wrong.
This is just one of the opportunities spotted by Third Point, run by Daniel Loeb, one of the US’s most well-regarded fund managers. UK investors are able to invest with Daniel and his team through Third Point Offshore Investors Limited, a London Stock Exchange-listed investment company that invests directly into the main Third Point fund (LSE: TPOU).
This approach has led to significant success, with the strategy behind the company returning annualised net returns of 14.4% from inception in December 1996 to October this year. This compares very favourably to the equivalent 8.3% return per annum from the S&P 500.
NB Private Equity Partners (NBPE) is unique in the listed private equity (LPE) sector, given that the portfolio consists primarily of co-investments. It is now almost entirely invested in the equity of private companies. Given the range and quality of managers that NBPE invests with, the portfolio can be seen as a good representation of the top tier of US and global private equity deals.
‘a good representation of the top tier of US and global private equity deals’
NBPE is currently invested in a total of 120 companies, accessed through over 55 different third-party private equity sponsors. The team hopes to increasingly focus its investments, making fewer but somewhat larger investments. At the current stage, the portfolio’s top ten equity holdings represent 26% of the total portfolio – not dissimilar to a traditional (quoted) equity fund.
With so many companies and ‘sponsors’, it is unlikely that investors are exposed to significant specific or key man risk. Whilst being diversified, NBPE offers exposure to a number of key industries: including technology, media and telecoms [TMT] (27%), healthcare (16%), industrials (14%) and consumer (16%). NB focuses on partnering with high quality sponsors, looking for specialist and deep industry knowledge from its partners, and an ability to source differentiated investments as well as deliver operational ‘value-add’ to investments.
In September 2018, the company announced a clarified dividend pay-out policy of 3% per annum, or greater dividend yield on NAV. At the 30th September 2019 share price, NBPE’s dividend yield was 4.2%, which compares with a 3.8% weighted average dividend yield for the AIC Global Equity Income and 3.9% for the AIC UK Equity Income sectors.
Greencoat UK Wind (UKW) provides a pure investment exposure to UK wind farms, with the aim of delivering a high, RPI linked, income return for shareholders whilst maintaining capital value in real terms.
Wind is a resource that the UK has plenty of. In 2018 it was a significant contributor to the UK’s electricity supply – meeting 17% of the country’s total demand (renewables as a whole contributed 30%). As such, it is likely to remain one of the central planks of the UK’s strategy to achieve a lower carbon economy.
‘likely to remain one of the central planks of the UK’s strategy to achieve a lower carbon economy’
Greencoat UK Wind (UKW) currently owns a portfolio of 35 wind farms around the UK, which together generate enough electricity to power 940,000 homes and is the largest renewable infrastructure fund listed on the LSE with net assets of £1.9bn.
UKW remains amongst the best performing of the renewable infrastructure funds since it launched in 2013. Since launch, the company has delivered strong total returns comprising the 6p dividend which has risen with RPI, and capital growth of 23.9%.
In share price terms, shareholders have enjoyed a total return of 96.8% in just over six years. Despite the considerably lower volatility that the company exhibits, on a NAV total return basis UKW has outperformed the FTSE All Share Index total return since launch by over 30 percentage points.
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Third Point Offshore Investors Ltd Ord NPV USD – (TPOU) – GG00B1YQ7219
NB Private Equity Partners Ltd Ord USD0.01 – (NBPE) – GG00B1ZBD492
Greencoat UK Wind Plc Ord Shs 1p – (UKW) – GB00B8SC6K54
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