by Mark Dampier
Should you be put off by the greater complexity of investment trusts? I don’t think so, although it does obviously depend on how much time for research you have at your disposal. Potentially investment trusts are a rich feeding ground for the self-directed investor. There are plenty of pricing anomalies you may be able to exploit. One reason is that professional investment institutions, which once were big buyers of investment trusts, have steadily divested their holdings over the years in favour of managing their investments directly. In a market dominated by individual investors, pricing anomalies do not always disappear as quickly as they would do in the professional institutional market.
In my view their complexity means that investment trusts will never be mass market investment vehicles in the same way as unit trusts were designed to be. That is actually a good thing. If they were to become more broadly owned, it would remove most of the advantages that private investors enjoy with them today. The very first investment trust, Foreign & Colonial, was formed as long ago as 1868. Despite its long illustrious history, after more than 150 years it is still only capitalised at £2.5 billion. By contrast, in the few months since Neil Woodford launched his most recent unit trust in 2015, it has already attracted more than £6 billion of investors’ money. Now that is what I call a mass-market product – simple, easy-to-own and simple to monitor. Investment trusts will never be that, but they do have other advantages instead.
You will see in the media that financial firms are often criticised for not recommending investment trusts more frequently. There is a simple reason for this. Many investment trusts are quite small and that makes it difficult for firms with large numbers of execution-only clients to suggest them. The reason is that buying and selling shares in many investment trusts in size is difficult. The top 20 largest trusts rarely trade more than £2 million in a day. This won’t matter to a DIY investor who is looking to buy or sell between £1,000 and £10,000 of trust shares, or to advisors who can spread client orders over a period of time. But for a firm like ours with thousands of clients, recommending an investment trust could suddenly swamp the market with buy orders, something that could never happen with a unit trust.
Just suppose we recommended an investment trust through our newsletter. What might happen? The market makers, the professional firms that take and implement buy and sell orders, would see the recommendation and mark up the price of the trust before the orders came through. Buy orders on any significant scale could not all be fulfilled, leaving clients frustrated. Worse still, the clients might want compensation for failing to have their orders fulfilled, particularly if that price continues to move up. If our advice was to sell, then the problem would be even more acute. This is why platforms offering execution-only services are wary of investment trusts and is why I also think they are generally unsuitable for the mass market.
That does not mean they might not be right for you. If you can get to grips with understanding how investment trusts work, they can be an attractive way to invest. They can still help you even if most of your money is going into open-ended funds. (As explained in the previous chapter, I own shares in RIT Capital, in part because there is no open-ended alternative.) The premium or discount at which investment trusts trade can also be extremely useful in seeing how investor sentiment is moving. It can be a good indicator of whether a particular sector or market is on the cheap or expensive side. If many more trusts are trading at premiums, it may be flagging up that we are near to a market top, while large discounts across a number of sectors suggest the opposite.
Venture capital trusts
Venture capital trusts are another sector in which I have been able to invest profitably in the last few years. What is a VCT? Well, as its name suggests, it is an investment trust that invests in venture capital – in other words, providing capital for new or established businesses that need cash to develop their business, and are typically either too immature or perceived as too risky to be able to borrow that money from a bank or other commercial lender. Anyone who has watched Dragons’ Den will know how many would-be entrepreneurs find they need both finance and professional expertise to get their fledgling businesses off the ground. Since the financial crisis, banks have been cutting back on their lending to small and medium-sized businesses and venture capital investors have stepped in to help fill the gap. As an investor in a VCT you effectively get a return from both the lending and the equity investment that the manager of the trust has made.
Managing a VCT – picking the right businesses to back and helping them to grow – is a specialist form of investment management. Most of the firms which offer VCTs are small boutiques that are independent of the big fund management companies such as Fidelity and Aberdeen Asset Management. Nurturing new and growing businesses is an important function in any capitalist system and governments of all political persuasion have traditionally tried to encouraged it by offering tax breaks for those who invest in them.
When I started out in investment the main form of tax incentive was called the Business Expansion Scheme, and it wasn’t frankly a great success. Many of the businesses that were backed under this heading were rubbish – more Del Boy than Google – and the charges were quite high. Since then things have evolved a fair bit and today VCTs have become a valuable source of finance for new companies as well as a useful additional home for any spare cash you are lucky enough to have as an investor.
That is because each VCT will invest in a diversified portfolio of companies, some of which will work out well and some will not. With luck the successes will more than outweigh the number that for whatever reason fail. Because they are young and risky, start-up businesses can grow very quickly if things work out and you only need a handful of those to produce overall gains in a diversified, professionally managed portfolio.
Admittedly VCTs are most suitable for those who are lucky enough to have already built up a sizeable amount of savings or are close to using up their lifetime pension limit. Because of the importance that the government attaches to venture capital, the tax breaks can be very valuable, especially for those looking to generate more income from their capital. The main benefit from investing in a VCT has been that your initial investment can be set against tax and will normally give you a tax rebate equivalent to 30% of the money that you have invested. Thereafter any dividends you receive are free of income tax and there will be no capital gains tax to pay when you sell them. The tax relief is withdrawn if you fail to hold the shares in the VCT for at least five years21.
As with an ISA, another benefit of investing in VCTs is that you don’t have to bother including the dividend payments on your annual tax return. The main attraction to me, apart from knowing that money I would otherwise pay in tax is going to help small businesses that the banks won’t touch, is the tax-free income which I know I will need and appreciate when I am older. Assuming that the government does not change the rules about what qualifies for the favourable tax treatment, I expect to be adding to my VCT portfolio for the next few years. My main complaint about VCTs is that their fees can be quite high. Many also charge a performance fee in addition to their annual management fee, a practice which I have never liked.
It is important to remember that the tax breaks only kick in if you buy shares in an initial fundraising, not when you buy them in the secondary market. Because they are illiquid, the prices in the secondary market tend to be volatile. During the financial crisis, a lot of VCTs went to big discounts of 30, 40 or even 50%. As an existing investor, all you can do is sit through those episodes, but if you are on the ball it can sometimes be worth buying more in the secondary market at those heavily discounted prices. Although you don’t qualify for the initial tax relief, you still get the tax-free dividends and the prospect of capital gains on top as the discounts reduce over time.
My VCT portfolio includes funds run by the likes of Northern Venture, Maven and Mobeus. Some VCTs are quite specialised and I prefer to stick with the gene
ralist ones, rather than say the AIM VCTs which invest mainly in quoted stocks in the AIM market, where you always have the option to buy the unit trusts that do the same thing.
By the nature of the business the payouts from VCTs can be quite lumpy. If you are lucky and your VCT has a spectacular success, you may get a special dividend as well as regular interim payments. A good recent example was when Octopus sold its stake in Zoopla, the online estate agent portal it had funded. Because they are more risky, I take a long-term view of my VCT holdings, as you have to do. However, my experience is that VCTs are not as risky as some people seem to think. By and large they are fantastic dividend payers.
The main problem is that VCTs can be difficult to analyse; they are mostly run by teams, and telling the good ones from the bad is not easy. The liquidity can be poor, so selling at the price you want can be difficult. Many VCTs trade at a discount to their net asset value (and the rules and tax reliefs keep changing, which I am afraid is an occupational hazard). However, it seems to me, looking back over the 20 years or so that VCTs have been around, that half a dozen or so companies have emerged from the pack as the best of the breed and rather than trying to cherry-pick the best ones, I aim to hold a cross-section of the proven performers.
Buy-to-let is not all it is cracked up to be
Technically buy-to-let is outside the scope of this book. Yet property has become a near religion in the UK. For many it is the asset class that never fails and it is certainly true that property has turned out extremely well for many. But for me property has always been about a place to live rather than investment. I don’t even think of it as an investment, at least not in the case of buy-to-let, which only really started being a private investor option in the mid 1990s. Buy-to-let is really a business venture, not an investment; the two are very different.
It would be silly of me to suggest that buy-to-let isn’t something to look at. But you should go in with your eyes open. I notice, for example, that its fans tend to place its origins in 1996, which was right at the bottom of the then property cycle, and give all sorts of statistics to prove how well it has done against all other asset classes. It is perfectly true that it has done well since that date, but as I have said elsewhere in this book, be careful of statistics. Start the comparison from other dates in the past and the numbers can look very different.
Property for most is far better understood than the stock market. After all you can see it and touch it. It also appears to be less volatile – but be careful, shares are priced every second, and property only occasionally, so the rises and falls in price are far better disguised. Buy-to-let is a business and you need to approach it as such. It is far more hands-on than an investment and is now beginning to attract more regulatory requirements. For example, 2015 saw the introduction of new requirements on landlords to obtain proof of identity and nationality from their tenants; failure to do so can incur fines of up to £3,000.
Other factors that are extremely important to take note of when weighing up whether to try your hand as a property landlord are the costs of maintenance, agents’ fees and tenancy voids (the gaps that inevitably occur when one tenant leaves and another has yet to arrive). All these will reduce your income return. If you are also gearing up and using a mortgage to buy the property you want to let out, the mortgage payments also need to be taken into consideration. True, the interest payments can be set against tax, but I wonder how long that will last.
In my view buy-to-let is mainly a business to generate income, which is especially valuable today when interest rates are so low. The yield you receive as rental income is very important to making buy-to-let a success. Does a yield of 5% sound enough? That is a figure I often hear talked about on the radio when the subject of buy-to-let comes up, especially in the southeast of England, where capital appreciation has driven prices higher and yields correspondingly lower. It may seem to stack up well against your bank or building society account, but think carefully. My view is that as a buy-to-let investor you should be looking for yields closer to the 7% to 9% mark to make it a sensible business.
It is possible to find properties that you can rent out for that amount, but they are often found in areas far away from where you might live yourself. You are not likely to be buying the house next door. The buy-to-let business, like any other, involves looking for areas with the greatest potential for profit. It requires a huge amount of work to do this properly. Of course, it may be that you will benefit from capital appreciation when you come to sell your property and this will bail you out after a poor income return. This is undoubtedly one of the reasons, along with ultra-cheap mortgages, that so many people have rushed into buy-to-let in the past few years.
But in my view the capital value should be seen as potential icing on the cake, not least because realising it is an all or nothing event.22 The income is what you should concentrate on. There is no certainty that the handsome capital gains of the past 20 years from housing will be repeated in the future. In fact they are highly unlikely to materialise on anything like the same scale. When interest rates start to rise, they will inevitably change the economics of buy-to-let for the worse. With so many young people feeling unhappy about being priced out of housing altogether, the friendly climate for buy-to-let landlords may well change.
The taxation rules that favour buy-to-let are also liable to change23. Property prices could easily fall, as they have done in the past. It would be very unwise to think that in a period of rising interest rates and falling house prices, buy-to-let landlords may not find themselves facing a very uncomfortable financial squeeze. That could be accentuated by the fact that many buy-to-let properties are financed with cheap mortgages. Over the longer term, this leverage does have the potential to magnify potential capital returns, but the flip side is that that can also work the other way round once interest rates start to rise – even if, as I expect, any such rises are gradual and spread over a number of years.
So I say use buy-to-let if you are happy for it to take the time and effort that is inevitable by doing the proper due diligence that you might do on any other kind of investment. Don’t be seduced by headline yields and remember the cost of buying property is very high and this will normally wipe out your first year’s income anyway. Remember too that buy-to-let increases your exposure to property if you already live in a house. Don’t think that property never falls in price. It does. And don’t forget the hassle involved in dealing with tenants, maintenance and all the records you need to keep in order to run a business. Me? I looked at buy-to-let once and decided that equity income gave me far more peace of mind for far less work!
Investing in shares directly
You will have noticed that the book contains very little about buying and selling shares directly. That is because in writing I have relied heavily on my own experience and with the exception of the shares I own in Hargreaves Lansdown, investing directly in equities has never really been a big part of my experience. This is not because I have anything against doing so. I know many people who have been very successful at it. It is mainly because if you are going to do it properly, it requires considerably more time and effort – and also different skills – than I have to offer. I genuinely doubt that most people are willing (or able) to give up that amount of time. But please don’t let me put you off!
With more than 3,000 funds to choose from, not counting offshore funds, I feel that I have more than enough to do to keep on top of my fund research duties. While I enjoy investment, I don’t personally wish to spend all my spare time poring over company reports. I much prefer funds, as they give me instant diversification and a far better spread of investments than I could achieve on my own by buying shares. Another factor is that my job requires me to invest money on a global scale, where stock-picking is even harder to do. I am also lucky to have daily access to fund managers whose ability to pick shares is far greater than mine could ever be. As the old saying goes, if you want a friend
for life, go buy a dog. If you want to pick great stocks, go hire a fund manager to do it for you (just make sure they really are that good!).
I have owned shares from time to time, and like most people in the investment business I am quite happy to tell you about some of my greatest triumphs. Back in the year 2000 I did find a ten-bagger (shorthand for a share that makes you ten times your money) in the shape of a company called Cambridge Antibodies. For a while I thought I had found the secret of how to turn lead into gold. I quickly came down with a bump, however, when I lost virtually everything I had invested in another share, a company called Knowledge Management Software. At the time I thought it was on its way to incredible success. It turned out to be a turkey, or a zero-bagger, instead. Honesty compels me to tell you this.
More recently I have done pretty well with a company called Provident Financial, whose capital value has almost doubled in the past couple of years. It also pays a good dividend. Here at least is a business that I can understand. Whether you approve of it or not, money lending has been with us since the age of man and is likely to still be with us in the future. What I like about Provident Financial is that it is a straightforward business with little in the way of technology or biotechnology to understand. It is also a share that I reckon I could easily see myself holding for the long term, which suits my particular style of investing. It isn’t sexy. It isn’t going to make ten times my money in a year. But equally it is not likely to go bust. I very much subscribe to the view that the best way to get rich is slowly.
