Funds and trusts tipped to prosper from falling interest rates

For the first time in more than four years UK interest rates are falling, which can only be good news for stretched households and debt-ridden businesses.

But what does it mean for investors keen to position themselves for the prospect of further interest rate reductions over the coming months? While cuts are expected to be gradual, and we’re unlikely to return to the days of ultra-low rates, there are areas of the fund and investment trust universes that could be set to prosper, having struggled over the past three years as interest rates rose.

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High-quality growth stocks

One area that stands out is fund and trust investment strategies that revolve around forward-looking, high-growth businesses. Such strategies have been on a roller-coaster ride since the start of the rate-hiking cycle.

As rates rose, investors suddenly found they could earn decent returns from much less-risky alternatives such as gilts. At the same time, higher rates undermined the potential long-dated future earnings of growth companies with high valuations, impacting those valuations in the process.

The potential of artificial intelligence (AI) has offset much of the damage for tech-focused growth strategies, says Gavin Haynes, investment consultant at Fairview Investing. “But a lower-rate environment should be more supportive generally,” not only improving these companies’ financial situations but also lifting broader investor sentiment.

Haynes picks out the open-ended global equity fund WS Blue Whale Growth, which takes a high-conviction approach to investing in large-cap quality growth stocks in developed markets, focusing on both business quality and valuation.

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Thomas McMahon, head of investment trust research at Kepler Partners, likes Baillie Gifford European Growth Ord (LSE:BGEU) as an option whose time may be coming.

“Markets have bounced since the end of October last year as rate expectations have changed, and BGEU has outperformed the market since then, possibly suggesting how it will do in a falling interest rate environment,” he says.

“As well as a strong growth bias, the trust also has a mid-cap bias and considerable gearing, which could be a powerful combination if rates are cut in any soft-landing scenario.” In addition, around 11% of the portfolio is in unlisted companies, which could provide a further kick.

Andrew McHattie, publisher of the Investment Trust Newsletter, takes a less mainstream tack, suggesting that some of the more unusual growth-focused trusts “could easily capture investor attention if conditions brighten”.

HydrogenOne Capital Growth Ord (LSE:HGEN), which invests in clean hydrogen assets and is currently trading on a -50.7% discount to net asset value (NAV) and space-tech expert Seraphim Space Investment Trust Ord (LSE:SSIT), on a -42.3% discount are his picks. All discount figures are to close of trading on 1 August.

Alternatively, in the biotech growth category, RTW Biotech Opportunities Ord (LSE:RTW), on a -11.8% discount, also looks very promising. “It’s starting to see its net asset value rise impressively,” he adds.

When it comes to the attractions of unlisted growth companies, Peter Walls, manager of the Unicorn Mastertrust fund, highlights the health of the IPO market, the process whereby private companies become public ones, as an important factor alongside the interest rate environment.

“There are signs that appetite for IPOs is improving, although sentiment could easily deteriorate if inflation proves to be more stubborn,” he argues. In the meantime, though, trusts such as Chrysalis Investments Limited Ord (LSE:CHRY) – also picked out by McHattie – and Augmentum Fintech Ord (LSE:AUGM), which invest exclusively in privately owned high-growth businesses, sit on discounts of -43.2% and -34.3% respectively.

“These could narrow significantly if the rate of realisations picks up (as the trust exits its positions in investee companies) and investor confidence in valuations improves,” says Walls.

Renewable energy

Renewable energy infrastructure trusts have also been under the cosh as rates have risen. McHattie notes many trusts in the sector were highly rated on premium ratings before the interest rate hikes reduced their relative attractions.

As investors took flight in favour of lower-risk areas of the bond market, which saw yields rise in response to higher rates, the renewable energy infrastructure sector was de-rated sharply.

However, the climate crisis is not going away and the structural long-term growth dynamics driving renewables remain in place, which will be potentially be bolstered by the Labour Party’s stated green agenda and policies.

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With interest rates falling and cyclical headwinds tending to abate, “the sizeable discounts on offer in the sector look to provide some contrarian opportunities”, observes Haynes.

“On both discount and dividend yield measures, many trusts look attractive at present, including Bluefield Solar Income Fund (LSE:BSIF), Greencoat UK Wind (LSE:UKW), and SDCL Energy Efficiency Income Ord (LSE:SEIT),” McHattie adds.

Walls and McMahon also pick out Greencoat UK Wind, which is on a discount of -9.1%. McMahon says: “Its combination of quality, a well-covered dividend and its discount is highly attractive in the light of a potential falling interest rate environment, given that falling rates should lead to a boost for asset valuations too.”

Haynes, meanwhile, likes the well-established and highly regarded Impax Environmental Markets Ord (LSE:IEM), which invests in a broader portfolio of companies offering solutions in the clean energy space, as well as in waste, water and sustainable food sources. Its discount is -9.8%.

Property

Another area that could be poised for a comeback is real estate investment, which was an obvious casualty of the changing macroeconomic circumstances as debt costs rose over the past three years.

“The turbulence in the sector has been expressed in a number of takeovers and other corporate actions in the closed-ended sector, including an emergency refinancing by Regional REIT Ord (LSE:RGL),” notes McHattie.

However, he believes there are now indications that the worst of the trauma is past. “Much of the corporate action likely to occur here has already taken place, but some trusts still look cheap on a discount basis,” he adds. One example is Picton Property Income Ltd (LSE:PCTN), “a generalist trust on a discount to NAV touching -30%”.

Thomas McMahon’s choice is Schroder Real Estate Invest Ord (LSE:SREI), one of a relatively small number of diversified UK commercial property REITs left after extensive corporate action in the sector.

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Although valuations remain under pressure and it sits on a -23.1% discount to NAV, McMahon points out that “it has relatively low-cost gearing locked in – 3.5% for 10 years – and a distinctive focus on sustainability in its investment strategy”.

Alternatively, the long-running TR Property Ord (LSE:TRY) trust provides exposure to UK and European REITs and is the preferred route for both Walls and Haynes. “It has navigated the market well over many years of ups and downs,” comments Walls.

McHattie also highlights value in some of the niche areas such as logistics, picking out Urban Logistics REIT Ord (LSE:SHED), Warehouse REIT Ord (LSE:WHR), and healthcare, highlighting Impact Healthcare REIT (LSE:IHR) and Target Healthcare REIT Ord (LSE:THRL).

Smaller companies

The other hunting ground to consider is smaller companies, particularly UK minnows. Over the past couple of years stagnant economic growth, high inflation and interest rate rises led investors to reduce risk, which caused share prices and valuations to slump.

Smaller company shares are more domestically focused than the mega-caps in the FTSE 100 index. As a result, this part of the market “tends to be more sensitive to economic slings and arrows”, points out Neil Hermon, manager of Henderson Smaller Companies Ord (LSE:HSL). The investment trust is one of interactive investor’s Super 60 investment ideas.

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UK smaller company-focused funds and investment trusts have been enjoying a good spell of performance lately, but the general feeling is that valuations remain cheap and there’s still plenty of potential performance catch-up with larger company shares. The other UK smaller company option in the Super 60 is WS Amati UK Listed Smaller Companies. Those looking for global exposure could consider abrdn Global Smaller Companies, which is also part of the Super 60.