Investment Trusts: opportunities in all market conditions

The UK investment trust industry has prospered for more than 150 years.¹ During this time, it has endured depressions, wars, pandemics and other major crises. Today’s market conditions bring their own unique challenges, but history suggests the UK investment trust industry is well-positioned to deal with them. Here, we take a look at how the current market conditions are impacting the opportunities that lie ahead for Schroders investment trust range.

What’s happening in financial markets?

It’s been a tough year for investors in most asset classes. Against a backdrop of high inflation, slowing global growth and a significant change in monetary policy from the world’s major central banks, equity and bond markets have suffered widespread declines. As the chart below illustrates, references to recession in company conference call transcripts recently hit an all-time high, and our economists currently expect recession in the UK, US and Eurozone economies in 2023.

Source: Schroders Economics Group, Schroders Data Insights Unit, Sentieo, 30 September 2022
Note: The data is smoothed using a three-month moving average

With powerful global economic forces at play, it is worth spending some time looking at how the opportunity that lies ahead for the Schroders’ investment trust range is evolving in these volatile conditions. Schroders runs investment trusts in five different sectors: private equity, impact, UK, Asia and real estate. We take a look at each of these areas in turn below.

Private equity – differentiated opportunities from structural growth

Schroders runs two private equity investment trusts: Schroder British Opportunities Trust, which as the name suggests, focuses on the domestic market, and Schroder UK Public Private Trust, which targets an increasingly global opportunity set.

Investment trusts are a very appropriate structure for private equity investments. Their closed-ended nature provides a permanent source of capital, which can be deployed in less liquid assets. The risks involved in individual private equity investments may be higher, because it typically involves investing at an earlier stage in a company’s development. But a diversified portfolio of private equity assets offer the potential to deliver a premium long-term return to compensate for this higher risk.

Meanwhile, although private equity is clearly not immune to the global economic headwinds, it is relatively well-placed, because the asset class represents one of the best ways of accessing structural long-term trends, such as digitisation, disruptive innovation and the energy transition required to reduce the global economy’s reliance on fossil fuels.

We can therefore remain confident in the enduring long-term opportunity that our private equity investment trusts are targeting. As Rory Bateman, co-portfolio manager of the Schroder British Opportunities Trust, recently said:

“We invest in high quality, high growth businesses with strong management teams. Valuations may ebb and flow but the growth in these businesses can drive long-term value. The portfolio is not immune to the forces which are buffeting the full spectrum of financial assets at the moment but, in this environment, there is opportunity.”

Impact investment – addressing the UK’s most pressing social challenges

Schroders partnered with one of the UK’s leading impact investors, Big Society Capital (BSC) to launch the Schroder BSC Social Impact Trust in December 2020. There is a growing private impact investment market in the UK, providing solutions that aim to alleviate some of the country’s most pressing social challenges, while also targeting a sustainable financial return.

As is the case with private equity, many of these investment opportunities are illiquid, which means they are not easily accessible to other investors without specialist expertise and deep networks. This makes investment trusts an ideal structure for delivering social impact.

Already, the portfolio is benefiting more than 160,000 disadvantaged and vulnerable people and almost two-thirds of committed assets benefit from inflation resilience.²

More broadly, this part of the Schroders investment trust range is less impacted by the current global financial market volatility, due to these types of investments historically having low correlation to traditional asset classes. Indeed, the current economic challenges make the social issues they aim to address even more pressing.

“This environment is creating significant cost of living challenges for many low-income groups in the UK. Many of the Company’s investments in areas such as affordable housing and fuel poverty are directly tackling this challenge and are seeing significant additional demand. Across our activities we are seeing an increasing opportunity set where investment can be part of the solution in addressing social issues.”
Jeremy Rogers, Portfolio Manager

UK equities – dividend income and potential takeover activity

For much of 2022, asset prices have been influenced by global headwinds, but in recent weeks, domestic events have contributed to the volatility, triggered by the new government’s mini-budget in September. The mainstream media narrative has suggested a loss of confidence in UK plc, but although one can question the timing, communication and logic of the policies that were announced, it is interesting to note that the UK stock market is still outperforming most other major stock markets this year.

Meanwhile, the weakness of sterling has been the subject of intense media scrutiny, but this is not just a reaction to UK political developments, as Sue Noffke, Head of UK Equities and manager of the Schroder Income Growth Fund explains.

“It’s important to put the pound’s weakness into the context of a global dollar crisis. The US dollar has been extremely strong in 2022 versus nearly all other major currencies. This is due to two factors. Firstly, because of steep interest rate rises from the Federal Reserve and secondly the flight to safe assets given the energy crisis and uncertainty around the Russia-Ukraine conflict. As the world’s reserve currency, the dollar has benefited here.”

The UK is home to many large, global businesses that derive most of their revenues and profits from overseas. The sterling value of their international (primarily dollar-based) earnings, is therefore enhanced by a strong dollar. From the perspective of dividends, this is making the long-term income opportunity that Sue aims to capture even more enticing.

“The dividend yield on UK equities remains high and attractive versus other regions. At nearly 2.5x earnings, dividend cover is stronger than it has been for 10 years. Meanwhile, it’s important to note that 45% of UK dividends are paid from US dollar denominated earnings, so dividends are aided by weak sterling.”

Source: Koyfin to 18 October 2022, on a capital return basis in local currency
Past performance is note a guide to future performance and may not be repeated

Mid-sized UK companies tend to be more focused on the domestic economy, so the Schroder UK Mid Cap Fund is not as exposed to this dynamic. Nevertheless, there is another aspect of sterling weakness that could continue to unlock future value for its shareholders. Co-portfolio manager Jean Roche expects the continued undervaluation of many UK businesses to attract the attention of private equity investors and other corporates.

“We see US private equity players in particular attempting to profit from this situation. It’s been a very busy period for merger and acquisition activity. Plenty of UK small and mid-caps have been acquired or approached recently and we can expect more of this. Management teams have not failed to notice the value presented by their own shares, and this is reflected in the plethora of share buybacks which have been announced.”

Asian equities – attractive valuations and a brighter outlook for Japan

Schroders runs four Asian investment trusts, each of which targets a specific opportunity within this diverse and attractive region. The Schroder AsiaPacific Fund offers exposure to high long-term growth potential across Asia’s diverse equity markets, while the Schroder Oriental Income Fund has an additional focus on increasing dividend income. The Schroder Asian Total Return Investment Company, meanwhile, aims to preserve and grow wealth through all market conditions.

Dollar strength is typically seen as a headwind for Asia’s economies and stock markets, and that does appear to have weighed on returns recently. The prospect of sustained inflation across a number of commodities, as well as headwinds to global growth and therefore exports from the region, pose further challenges for the region. Meanwhile, China's struggles with Covid and its associated zero-Covid policy, continue to weigh on sentiment.

Despite this seemingly gloomy prognosis, there are reasons for optimism, as Richard Sennitt, manager of the Schroder AsiaPacific Fund and Schroder Oriental Income Fund explains:

“All of the above paints a pretty negative backdrop. However, this has in part been reflected in market action with valuations today looking much more attractive, particularly versus global equities. Although earnings downgrades may continue, aggregate valuations for the region are now trading below long-term averages and at the lower end of the range versus the rest of the world.”

The fourth Asian offering is Schroder Japan Growth Fund, which seeks attractive investment opportunities in the world’s third-largest economy. Here, the investment outlook is perhaps brighter now than it has been in many years, thanks to continued improvements in corporate governance and a relatively benign economic outlook. Consensus forecasts continue to point to modest growth for the Japanese economy in 2023, at a time when much of the rest of the developed world is increasingly at risk of recession. After many false dawns, this could finally be Japan’s chance to shine brightly once more.

Source: Schroder, Eikon as at 27 September 2022

Real estate – a diversified potential inflation-hedge

Like private equity, real estate is another asset class that is highly suited to the closed-ended investment trust structure, because of the illiquidity of the underlying assets. Property has many attractive investment characteristics. It has traditionally been seen as a good way of introducing more diversification to a portfolio, with low correlations against equities and bonds and less volatility than equities. Furthermore, rents tend to rise in line with other prices over the long term, providing the potential for a partial hedge against inflation and, because it is a physical asset, there is more opportunity for skilled managers to add value through delivering operational excellence for occupiers, redevelopment schemes and other initiatives, such as improving a building’s sustainability performance.

However, despite these strengths, real estate is not immune to the economic headwinds which have hit financial markets in 2022. Higher interest rates have a direct impact on the ability of debt-backed investors to buy real estate and they may also deter institutions who allocate capital between real estate and bonds. Although real estate yields are not mechanically tied to interest rates, they are likely to increase in the short term, depressing capital values. In addition, weaker economic growth is likely to reduce occupier demand, particularly in sectors such as retail and office which are already under pressure from structural changes such as e-commerce and home working. By contrast, there are a number of other real estate types which are benefitting from structural change including warehouses, data centres, student halls and laboratories.

That is why investing with experienced specialists that are capable of focusing on the most attractive parts of the market makes sense. The Schroders real estate investment trust offering consists of three funds. The Schroder Real Estate Investment Trust invests in UK commercial real estate, with a portfolio that fund manager Nick Montgomery describes as “a good quality, diversified portfolio that is weighted towards higher growth parts of the UK real estate market”.

Similarly, Schroder European Real Estate Investment Trust focuses in on the opportunity in Europe’s “winning cities”, such as Berlin, Hamburg, Stuttgart and Paris. These offer higher levels of growth, exposure to higher-value industries and well-developed infrastructure. In short, winning cities represent places where people want to live and work, which should correspond to a sensible long-term investment strategy.

Conclusion

These are clearly challenging times economically, and the near-term outlook is perhaps as inscrutable as it ever has been. Despite this considerable short-term uncertainty, it is worth reiterating the long-term perspective and discipline that is required for successful investment outcomes.

One of the interesting characteristics of investment trusts is the gap that can emerge between share prices and net asset values. Often, we see discounts widen during times of uncertainty, and the current environment is no exception. The average UK investment trust is currently trading at a 15% discount to the value of its underlying assets (source: Bloomberg as at 30 September 2022), which is the widest discount in at least a decade.

In other words, investors can currently buy a pound’s worth of assets for just 85p. Irrespective of the current uncertainty, therefore, there are attractive long-term opportunities to be found, and UK investment trusts remain a highly valid structure for unlocking value for investors.

¹ Source: The Association of Investment Companies as at 31 October 2022

² Source: Schroder BSC Social Impact Trust – Investor Update July 2022