Kepler’s top-rated investment trusts for 2021
This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.
We update our annual quantitative ratings for investment trusts…
Kepler’s investment trust ratings seek to identify the top-performing closed-ended funds in the growth, income & growth and alternative income categories. Previously presented only on our retail site, today we can unveil for both professional and retail readers the winners of the ratings for 2021. Our ratings are designed to capture attractive and persistent performance characteristics and to reward long-term success. Like all quantitative systems they are backward-looking, but we have attempted to reward those trusts which have done well in the context of their own goals and benchmarks, and which have done so for a sustained period. As the selection system is entirely quantitative, it allows us to set aside all personal biases and views – and all commercial relationships – and look at the universe in a purely objective way.
The information ratio is a key metric in our rating system. The information ratio looks at the outperformance of a trust versus its benchmark. It then relates this to the extent of divergence from the benchmark, or the extra risk taken.
In other words, it seeks to identify whether the active risk taken by the manager relative to the benchmark has been rewarded with outperformance. We also look at the performance of a trust in rising markets versus the performance in falling markets – the upside/downside capture ratio.
We think this has two attractions. The first is it reflects the ‘loss aversion’ of the average investor. Behavioural finance teaches us that investors prize avoiding loss more than they do achieving a quantitatively equivalent gain.
This is captured by an upside/downside capture ratio above 1, which means that the trust has a tendency to avoid losses by more than it makes gains in rising markets. The second attraction is that it allows us to consider more defensive and more aggressive strategies on a more level playing field.
A trust which does exceptionally well in rising markets and is level in falling markets could rank the same as a trust which protects very well in falling markets but only keeps up in rising markets.
In order to create fair comparisons between trusts we have divided our universe into ‘super sectors’ of asset classes: large- and mid-cap equity trusts, small-cap trusts, fixed income or equivalent trusts, and property trusts.
This is intended to reflect the fact that generating alpha in particular is much easier in small caps, so comparing small-cap managers with large-cap managers is unfair. It also overlooks the risks that small caps bring – volatility, liquidity – which mean that small-cap investing is not inherently superior to large-cap investing, despite the advantages with regards to alpha.
We rank trusts within their ‘super sector’ on all quantitative metrics. In order to reward persistence we review performance over a five-year time period, which makes it much harder for a single year to distort results. We also exclude trusts which have had a change of manager in the past three years.
It perhaps goes without saying that all our analysis is based on NAV performance, which reflects strategy and managerial decisions, rather than share price, which can reflect many other factors.
We would never envisage a quantitative rating being used on its own to determine investment decisions, and clearly with investment trusts the discount level (as well as volatility) and the quality of the board all need to be considered too.
As importantly, given that quantitative studies are backward-looking, investors need to make a judgement about the likelihood of past performance patterns persisting in ever-changing markets.
For our income and growth ratings, the main metrics are the same. We have also looked at current yield, and at dividend growth over five years. A trust needs to have a 3% yield and 3% five-year dividend growth as a minimum, giving us a meaningful ‘wedge’ above inflation and allowing for high-yielding trusts and dividend growth trusts to be considered together.
Given the lower number of trusts which hit this boundary, we have been more relaxed in our total return screens, not insisting on minimum targets for information ratio and upside/downside ratio as we have for the growth picks but simply scoring the trusts in the relevant ‘super sector’. We apply the same manager tenure screen.
We haven’t previously rated alternative income trusts. This is chiefly due to the problem that NAVs are reported infrequently. This makes a quantitative analysis of these returns of dubious use.
However, given the relentless expansion of this area and the proliferation of new trusts investing in new asset classes, we have set out to identify those trusts which have indisputably walked the walk. We have looked at those alternative funds which have been running for five years under the same management team.
We have then looked for those which have managed to maintain their raw NAV over that time, while also growing their dividend. This proved to be a high bar to beat, with only nine trusts managing the feat, making any further attempts to narrow the field down superfluous!
How did our 2020 rated trusts do?
It is interesting to look at how last year’s winners did over the course of 2020, although it is worth stressing that just as we look over a longer time period in our screens, we would expect the typical holding period for an investment in any of these trusts to be much longer than one year.
2020 was a remarkable year for reasons that we are all probably sick of discussing. From an investment point of view it saw one of the most vicious stock market crashes in history, yet overall, global equity markets finished the year in positive territory.
We also saw almost an entire credit cycle play out in spreads and treasuries over nine months. Comparing the 20 growth-rated trusts to their own benchmarks, they generated an average outperformance of 10%, with the median being 7.7%. JPMorgan China Growth & Income (JCGI) outperformed the FTSE China Index by 55.5%, Montanaro European Smaller outperformed the FTSE Europe Small Cap ex UK by 26.9% and BlackRock Greater Europe (BRGE) outperformed the FTSE AW Europe ex UK by 22.5%.
The worst individual performer was European Opportunities Trust (JEO), which underperformed the Europe index by 9%. Only two other trusts underperformed, one of these by less than 1%. The trusts started the year on narrow discounts in absolute terms.
The 1.1% average was slightly narrower than the investment trust universe average of 1.5%. The trusts ended the year on a 1.9% average discount, compared to 1.1% for the universe.
Given the strong outperformance of their benchmarks, we think this illustrates that investment trusts can offer exceptional returns even when there is a minimal discount angle to play.
An equally weighted investment in the 20 growth-rated trusts for 2020 would have returned 15% in NAV total return terms over the year. This compares to a gain of 12.7% in the MSCI ACWI Index and a loss of 10% in the FTSE All-Share Index.
However, neither of these are great benchmarks for this set of trusts. The FTSE was one of the worst-performing major markets in 2020, while the MSCI ACWI is over 60% invested in the USA, one of the best-performing markets.
Given there wasn’t a single US-focussed trust on the list last year and only one trust benchmarked to the MSCI World, in our view this is an outstanding result.
As for the income & growth-rated trusts, it was a much tougher year for obvious reasons.
We would expect a quantitatively selected list of growth trusts to have done well in 2020, given that the outperformers in that year were generally sectors, stocks and indices which have had momentum behind them for some time. As a result of their dividend requirements, income trusts are led more towards value sectors which have been out of favour for a few years. These areas remained out of favour in 2020 – at least until Q4.
Relative to their own benchmarks, the picture for the income & growth trusts was more mixed than with the growth trusts, with an overall average underperformance of c. 1% (median -0.6%).
However, this was largely caused by the significant underperformance of Utilico Emerging Markets Trust (UEM), which underperformed the MSCI Emerging Markets Index by c. 25% (in sterling terms). Utilico is extremely active in its approach, and invests largely in utilities and basic infrastructure, with no exposure to the growth sectors which have massively outperformed in emerging markets.
Temple Bar (TMPL) underperformed the FTSE by 16.9%, while JPMorgan European Income (JETI) underperformed by a similar amount on the Continent. Temple Bar in particular suffered from having a marked value approach which was extremely unhelpful. It also saw a change of manager during the year due to the sad withdrawal of Alastair Mundy for health reasons.
On the positive side, the two strongest outperformers were Aberdeen Asian Income (AAIF) and Schroder Oriental Income (SOI), both of which outperformed the Asia Pacific high-dividend index by over 15%. Again there was little of a discount angle to play on average at the start of the year.
The trusts were on a 2.8% average discount and ended the year on a 4.5% average discount. As the graph below shows, this represents something of a recovery, with share prices falling more than NAV during the crash and being slow to recover as growth trusts remained in favour.
Out of the 20 income & growth-rated trusts, 11 were UK-focussed, so the FTSE All-Share is possibly the least unfair benchmark. An equally weighted portfolio of the income & growth-rated trusts outperformed the FTSE, but lost 6% in total return terms, compared to the FTSE All Share’s loss of 9%.
Our 2021 growth-rated funds
Below are the 20 trusts to have won the growth rating for 2021, ordered by raw score. While there have been a number of changes (see old shortlist here), it is worth remembering that these are the best of the best – and many trusts which have not made the list this year score highly versus the universe as a whole.
This year we have created a quantitative scoring system to map trusts by style. Our first metric looks at how trusts behave on a growth/value axis, and the second ranks them in terms of ‘quality’.
We have used Morningstar’s raw value growth score, inflated or deflated for style consistency and for style dispersion, to place the trusts on the value-versus-growth spectrum.
A negative score indicates a tilt toward value and a positive score indicates a tilt toward growth.
For quality we have looked at the underlying portfolio’s long-term forecast earnings growth, historical profitability and balance sheet strength (the last using Morningstar’s financial health score). This is scored out of ten, with a higher score indicating a higher tilt to ‘quality’.
Clearly there is a strong tilt to growth on our shortlist, and it has been extremely hard for trusts tilted towards value to outperform over the past five years. BlackRock World Mining (BRWM) and Murray Income (MUT) are the two with meaningful tilts to value on our shortlist.
BRWM has benefitted from a strong rally in commodities after the March crash, and operates in a typical value sector. Murray Income is a more interesting case: its strong quality score perhaps indicates how it has managed to buck the trend for value-tilted trusts to struggle.
Looking over the universe as a whole, there was a correlation of 0.36 between the growth score and the total quantitative ranking. The below scatter chart with value-growth on the x-axis and quality on the y-axis shows the importance of high growth (to the right) and relatively low importance of quality, with BRWM the obvious outlier in the lower quality/value quadrant.
One interesting thing to note regarding the quality scores is the low score for Scottish Mortgage (SMT). This reflects its low historical profitability score, as the trust scores highly for balance sheet strength and long-term earnings growth.
This is also true for Polar Capital Technology (PCT), which scores low for quality, while BRWM’s low score reflects the cyclical nature of a commodities business. It is notable too that the average score of the rated trusts for quality is almost perfectly neutral at 5.1, while the average on the growth/value axis is significantly towards growth, with a score of 2.9 relative to a neutral score of 0.
Our 2021 income & growth rated funds
The income & growth-rated trusts below unsurprisingly display a strong tilt towards value, with an average score of -1.8. Lindsell Train (LTI) is the outlier here, while Henderson Far East Income (HFEL), with its historical tendency to invest in higher-yielding state-owned enterprises in China, has the most extreme value score of -4.2. Interestingly, the average quality score is very high, at 7 out of 10, and significantly higher than that of the growth-rated trusts.
This is perhaps a second indication that those value-tilted strategies that have done better in a tough market for the style are those with a concomitant tilt towards quality. Certainly, strong balance sheets should help companies in economic periods that are disadvantageous for their businesses.
A look at the scatter chart for the selection reinforces the importance of quality for these funds, in distinction to the growth-rated funds. Lindsell Train is a clear outlier on the value-growth axis, although Schroder UK Mid Cap (SCP), Troy Income & Growth (TIGT) and TR Property (TRY) also have a slight tilt to growth.
For these ratings we require a minimum yield of 3% and dividend growth of 3% annualised over five years. One question for us has been how to handle the dividend cuts in the light of the pandemic.
We decided the only fair and useful way to treat the matter was to overlook dividend cuts that had been caused by the lockdowns and government decrees.
The alternative would be to effectively exclude UK equity income trusts, making the ratings much less interesting and relevant, while we would also have been penalising managers for what is an ‘act of God’ – no matter what the insurance firms say.
We also note that many boards maintained the dividend for 2020 while a guided cut is possible in 2021, so simply going by 2020’s figures would be creating an unlevel playing field, considering that differing financial year ends also complicate the issue.
By the time of the next rebalancing in a year’s time, hopefully the sector picture will be clearer and economies will be on more even keels, meaning we can adjust our screens accordingly.
Presenting the 2021 alternative income rating
In the past we have baulked at presenting a rating for alternatives, given the nature of the NAVs which means that quantitative analysis is largely inappropriate.
However, with the growing maturity and importance of the space, and the esoteric nature of some of the assets, we believe it is valuable to identify those trusts which have a long-term track record of generating a high and consistent income while maintaining or growing their NAV.
We believe one reason the alternatives space is expanding is the need for sources of income in a world where interest rates and the yields on government bonds are very low by historical standards.
The attractiveness of annuities, priced off government bonds, has fallen year on year, and increasing numbers of those living off their assets will be seeking higher-yielding alternatives to either in whole or in part replace those products.
Using Morningstar data, we have screened for those trusts in the alternatives or fixed income space which have managed to maintain their NAV over five years while growing or maintaining their dividend.
There are relatively few trusts with a track record that long, but with those that have such a track record, these proved to be hard marks to beat, with the below nine trusts being the only ones to have managed the feat.
Were it not for the impact of the pandemic there would have been more trusts to make the cut, but the property trusts in particular have been forced to make harsh dividend cuts.
Starwood European Real Estate Finance (SWEF)did make the list, however. SWEF lends against property, meaning it is higher up the capital structure and its investee companies are much less likely to miss payments (as this would amount to a default).
SWEF, like the credit funds on this list, may face a fight to maintain its dividends in the coming years given the secular decline in rates we have seen. Notably three of the trusts to receive the rating operate exclusively in the renewables space.
This includes Greencoat UK Wind (UKW), the first trust to be established in the renewables sector. UKW was launched in March 2013, four months before The Renewables Infrastructure Group (TRIG), which also makes the list. Finally, three conventional infrastructure trusts have also made the cut; notably HICL Infrastructure (HICL), which was launched in 2006, has returned investors’ original investment in dividends alone.
2020 was a very challenging year for investors, but the recovery in markets by the end of the year was remarkable. Our ratings are set up to focus the mind on the long term, which is sometimes difficult to achieve given the proliferation of real-time data and the fallibilities of human nature.
A year like 2020 is probably a reminder that underneath all the noise, long-term trends continue to work their way forwards. While we would never pick trusts solely based on any quantitative rating (just as no managers would solely pick stocks that way), we think managers who have persistently achieved risk-adjusted outperformance should be recognised with a rating.
It is pleasing to note that the growth-rated trusts from last year did so well. We also think the performance of our income and growth-rated trusts is very good, given an extremely disadvantageous environment for managers with a yield mandate.
In our view investment trusts (whatever their investment objective) are at an advantage relative to open ended funds, in that they allow managers the freedom to express their investment views consistently – especially in years like the one we have just had – without concerns about investor flows influencing their investment behaviour.
At the same time, an objective and independent board is able to hold manager’s feet to the fire, boards can also represent a good source of reassurance to managers when things are looking as bleak as they were at the end of March.
We continue to believe that appropriately selected investment trusts will suit investors of all types – particularly over the long term. While discounts can be an important consideration, over the long run even the most egregious premiums should be less important than NAV returns to performance.
However, on a series of updates through the year we will be highlighting the short term ups and downs of these rated funds and which look cheap or expensive.
Notably while a number of the growth funds are trading on significant premiums, SMT is currently trading around par, while Polar Capital Technology is trading on a 7.5% discount (as of 18/01/2021). Investors are more likely to find a bargain on the income & growth shortlist: Aberdeen New Thai (ANW), TR Property and Schroder UK Mid Cap all trade on double digit discounts.
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