Following the reputational they have received recently investment trusts need to rediscover their entrepreneurial roots if they are to enjoy a long over-due revival
The 19th century was a period of financial boom and bust. The world was full of opportunities, but fraud was rife, so the solution for the rich investor was to build up an enormously broad portfolio of high-yielding but individually risky overseas stocks. In the event of a few failures, the average yield would still be better than that generated by safer domestic investments. Many overseas government securities at that time yielded treble that of British gilts.
However, smaller investors could not hope to achieve this level of diversification as the minimum sum required to invest in each individual stock was prohibitively high. So in 1868 a team of prominent London financiers promoted a scheme, whose objective was 'to provide the investor of moderate means the same advantage as the large capitalist in diminishing risk in Foreign & Colonial (F&C) stocks by spreading the investment over a number of stocks.' F&C's original name was The Foreign & Colonial Government Trust.
The scheme proved so successful it was soon mimicked. Just one of the 18 original investments failed, with the others more than covering this shortfall. The first investment trust was up and running and the concept of the collective investment scheme was born.
While the investment trust movement started in London, many of the early trusts were founded in Scotland. Even today, a significant number of trusts are run from Edinburgh or Dundee.
The second and third trusts were known, confusingly, as Scottish American Investment Trust and Scottish American Investment Company Limited respectively. The first 'Scottish American' was founded in Dundee, which in 1873 was an affluent financial centre engaged in shipbuilding, heavy engineering, Jute, fishing and whaling.
still going strong
Robert Fleming, who started work at the age of 13 as an office boy in a local merchant, by the age of 28 became the personal clerk to the owner of Dundee's largest textile company, persuaded some of Dundee's wealthiest investors to back his idea of forming the first association in Scotland for investing in American railroad bonds, carefully selected and widely distributed.
These Dundee families found Fleming's scheme attractive as a method of putting their investments under full time management. This trust still exists today under the guise of Dunedin Income Growth. The second 'Scottish American,' launched in Edinburgh three months later, retains its original name and is affectionately known in the market as Saints.
By the late 1880s, investment trusts had become distinctly fashionable with boom conditions existing throughout the financial markets. Acceptance of risk rose sharply in exactly the same way as it has in many subsequent cycles, notably 1999-2000.
Between 1887 and 1889, 60 new trusts were launched. Some of the best, and worst, examples of funds were born during this period. Many of the earliest questionable practices such as stock swaps and founders' shares were first seen around this time.
Relatively dull economic conditions in the UK combined with exciting opportunities opening up throughout the empire meant investment trusts became the mechanism by which these ventures were financed, and were truly entrepreneurial enterprises. Many of these trusts exist today. They provide an insight into how such a relatively small country such as Britain retains its importance within global financial markets.
Prominent examples of the time include The Globe Telegraph and Trust which invested in cables enabling global telephony, so diversification was vital as a cable breakage would be financially disastrous for an individual scheme. The development of the Canadian prairies was financed by The North of Scotland Canadian Mortgage Trust, latterly known as Aberdeen Trust and heavily involved a hundred years later in the promotion of split capital trusts. The Transvaal Mortgage & Loan lent money to South African farmers; it subsequently expanded its operations and became known as British Empire. Cordoba Light Power and Traction has moved on substantially during the last century and now goes under the name of Polar Technology. The Duke of Marlborough's Electric & General Trust which originally focused on electricity companies along with trams and buses is now known as Henderson Electric and General. British Steamship has evolved into JPMF Overseas. River Plate Investment Trust, but now goes under the duller name of JPMF Income & Growth.
The early 20th century saw further issues along the lines that had gone before. These included The Western and Hawaii, which later expanded its operations and became Second Alliance, British Assets that was launched as a recovery fund exploiting depressed Australasian bank stocks in the wake of a slump, and Scottish Mortgage where the promoters had, with hindsight, spotted a spectacular opportunity for the use of rubber within the nascent motor industry.
Some of the new arrivals fell into the 'slightly dodgy' category. One new issue, promoted by a Mr Newgass, attracted the following comment in the financial press of the day: 'Whichever way one looks at the scheme, it does not strike one as being any other than a Newgass relief fund. In conclusion, we need only remark that anyone who subscribes to the shares should, after doing so, consult some medical practitioner of repute who makes a speciality of lunacy cases.' Despite this vicious comment, the trust launch succeeded and has made it to the 21st century under the guise of F&C Pacific.
After World War One, the original role of investment trusts was undermined. New world countries such as the US had grown wealthy on profits made supplying old world countries with their war needs. They could now finance themselves and ceased to need funds from investment trusts. This was combined with the abandonment of the gold standard, which led to inflation, undermining traditional fixed interest investments. Therefore investment trusts started to invest more into equities and begun evolving into the vehicles they are today. Reserves built up over many years allowed the sector to come through the 1929 crash and the Great Depression reasonably well, however, The Economist did comment gearing had not served investors well by magnifying losses.
the golden age
The golden era for investment trusts came between 1945 and 1965. Institutions that had previously focused on traditional investments such as deposits, gilts and mortgages started to recognise equities as a valid asset class for the first time. In an inflationary world they could retain their real value. Investment trusts were the practical way for the likes of Equity & Law, London & Manchester and Standard Life to access stock market expertise, effectively subcontracting the management of this portion of their portfolios by building up vast investment trust shareholdings. Over the course of that golden era, institutions came to dominate investment trust shareholders replacing private investors.
In the 20 years after World War Two, equities rose more than fourfold, while investment trusts typically by the end of the period commanded 14 times their 1945 price. However, happy days juddered to a halt with Labour's 1965 election victory. Investment trusts had four new taxes inflicted upon them, not only making them suddenly a highly inefficient method of obtaining exposure to the stock market, but a distortion called the 'half and half rule' meant that investors needing to raise money paid less tax by selling their trusts first.
By 1976 many trusts were trading at a 45% discount by virtue of this unreal tax regime. It was this era that saw the birth of split capital trusts given that 98% of investment income was confiscated by the taxman, it is not surprising some shareholders were happy to forgo all the income generated by the underlying portfolio.
It is the collapse of many of the splits issued during the latest bubble that has led to sentiment of the entire investment trust industry being at its lowest level in the 150 years of their existence. These tax distortions came to an end once Margaret Thatcher came to power. The period from 1965 to 1979 was a dark period for the sector, because not only did it have to cope with tax inequalities but also the severe bear market of 1974.
More recently life has remained tough, as investment trusts have had to face the challenge of their customers transforming into competitors. Over the past 60 years, life companies such as Standard Life have evolved into fund managers themselves. For example, why would Standard Life wish to subcontract the management of international equities to Baillie Gifford, a rival?
The upshot of this situation is that institutional sellers have swamped buyers in the market. A share price must fall to a level where buyers are attracted, therefore the typical trust has sat on a wide discount since this divestment process began. Due to tax and institutional selling, investment trusts have stood on discounts for around 40 years; few in the market have experienced a period where discounts were not prevalent.
Investment trusts are overdue a revival. There is an opportunity to find a niche now that the acceptance of closet tracking is breaking down. Investment trusts are an ideal vehicle for common-sense investment strategies as managers can focus on their conviction bets and take positions without the worry of meeting daily inflows and outflows. If investment trusts can rediscover their entrepreneurial roots, then their future looks bright.
Investment trusts were born out of demand for diversification in what were risky times.
The golden age for investment trusts was between 1945 and 1965 when the focus switched to equities and interest from institutional investors grew.
Investment trusts have had to face the challenge of their customers transforming into competitors in recent times.
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