Specialist funds and trusts: the risks and rewards

Investors can add spice to their portfolio through funds and trusts that invest in specialist assets.

Periods of strong or weak performance are a characteristic of specialist funds, and the past six months have highlighted an even greater chasm than usual between the top and bottom performers.

The leading specialist fund Nikko AM ARK Disruptive Technology Innovation fund returned 108% over the year to October, and LF Ruffer Gold, Allianz Oriental Income and Smith & Williamson Artificial Intelligence fund all made over 50%. However, losses of around 25% were sustained by other funds, particularly those focusing on Latin America and Global Energy.

So while there are hundreds of specialist funds to choose from, clearly the rewards and risks for getting it right or wrong are great.

The Investment Association classification of specialist funds includes Property and Technology & Telecommunications, but there are many other funds focusing on specific geographies, styles (such as growth and value), and absolute return funds that aim to protect capital, not to mention the panoply that invest in real assets, from warehousing to wind farms.

Core and satellite approach

Specialist funds are perfect for the satellite funds in a core and satellite strategy, where the majority of a portfolio (70% to 80% typically) is invested in developed market equity funds, often low-cost index trackers and ETFs, to keep a lid on overall management costs. The remainder, the satellite part, is invested in racier high-risk, but potentially high-reward satellite funds in the hope of generating higher growth.

Pension funds, which have huge amounts to invest, have long viewed the core and satellite approach as a way of maximising equity returns while keeping costs and risk at acceptable levels. It works well in an environment like today where future returns are likely to be limited by low inflation, low interest rates and geopolitical risks, particularly as a traditional portfolio construction of 60/40 equities/bonds looks unappealing as bond opportunities are scarce. Recent strong global growth has been led by tech stocks, but as we move through the pandemic into the recovery phase, the broader market is likely to become more range-bound, and the approach also works well in this kind of environment. 

The core/satellite ratio will be a finely tuned balance between curtailing risk (specialist sectors tend to be volatile) while having sufficient exposure in the satellites to make a meaningful contribution to the portfolio’s overall performance. Depending on your risk appetite, this could be a percentage split of around 80/20, but it could be 70/30 for aggressive investors or 85/15 for the more cautious.

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Two types of specialist fund returns

Broadly, there are two types of returns from specialist funds: beta and alpha. Beta is where the returns are little correlated with traditional asset classes, such as infrastructure, which has less sensitivity to the economic cycle. For example, renewable energy assets often derive much of their revenue from government subsidies. This grouping includes niche property, such as logistics and student housing, where valuations can differ from the broader market.

Alpha is where performance is based on the fund manager’s specialist skill, such as long-short equity and credit strategies. This includes global macro, event-driven and equity long-short funds, which can deliver returns independent of the direction of equity markets, and specialist strategies offering protection against market downturns. Funds and trusts worth considering include Personal Assets (LSE:PNL), Troy Trojan and Ruffer Total Return.

Beta is frequently found in real assets, which are currently benefiting from low interest rates. “These strategies offer attractive diversification away from traditional equity and fixed income, as well as potential protection from inflation,” says Ayesha Akbar, a multi-asset fund manager at Fidelity International. “Of course, infrastructure strategies will often come with idiosyncratic risks, including around liquidity - so require rigorous research. Our team likes FP Foresight UK Infrastructure Fund, which provides a one-stop exposure to renewable energy and infrastructure trusts, with a repeatable investment process. It aims to deliver annual income of around 5%.”

Infrastructure funds look well placed in current climate

In the current climate, it may be sensible to focus on infrastructure assets with low economic sensitivity, and reduce exposure to port, railways or airports should the recent aversion to globalisation persist. First State Global Listed Infrastructure offers protection investing in essential services as water and electric utilities, and oil and gas storage. Darius McDermott, managing director of FundCalibre, recommends VT Gravis UK Infrastructure Income for a domestic play, or First Sentier Global Listed Infrastructure for global exposure. 

For alpha exposure, Fidelity International sees opportunities in specialist “long volatility” investment strategies, which are designed to perform positively during periods of high volatility. “One such strategy is Assenagon Alpha Volatility, which we hold across some of our portfolios for its ability to generate positive returns in periods of market stress,” says Akbar. “While these types of strategies had seen a period of negative performance before markets turned in 2020 (given low levels of volatility in markets before this year), they did their job in portfolios during the Covid-19 sell-off, and generated positive performance. These types of strategies are good diversifiers, providing a buffer in an overall portfolio during periods of heightened volatility.”

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Tap into fast-growing companies

Smaller-company funds may also have something to offer as the pandemic accelerates “Corporate Darwinism” on an unprecedented scale. Well-managed smaller companies with agile structures can adapt to changing market dynamics better than many larger companies that lack the flexibility, given their sprawling, complex structures.

“Covid-19 is simply bringing on an acceleration in many of the structural trends happening in various industries over a number of years,” says Roland Arnold, manager of the BlackRock Smaller Companies investment trust (LSE:BRSC), “whether it’s the shift to more agile or remote ways of working or falling footfall for bricks-and-mortar retailing as more people shop online”.

Companies driving this accelerated digital shift in areas such as digital marketing and data analytics, cloud-enabled video and audio communications, online learning tools, digital payments and software-as-a-service are well placed to capitalise. Polar Capital Technology Trust (LSE:PCT) and Allianz Technology Trust (LSE:ATT) are trying to tap into such fast-growing companies.

Samuel Meakin, analyst at Morningstar, says the Polar Capital “team believes that it possible to add significant value by identifying disruptive new technologies early and finding the companies best placed to benefit, while avoiding the ‘blue-sky’, pre-revenue hype stage”.

He adds: “The approach attempts to identify core themes and technology inflection points, identifying groups of stocks likely to be winners or losers. The unconstrained approach and smaller-cap bias means that volatility is higher, but the strategy’s superior risk-adjusted returns demonstrate that investors have been compensated for this volatility.”

Other types of specialist funds

Biotech is a hot sector, and volatile, but there are compelling long-term demographic drivers. International Biotechnology Trust  (LSE:IBT)has the additional attraction of a bias towards treatments for rare diseases where there is more control over pricing. Worldwide Healthcare Trust (LSE:WWH), which invests in both healthcare and biotech, mostly in the US and emerging markets, similarly has an overweight in patented specialty medicines for small patient populations.

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In the financial sector, there is a huge divergence between banks that have performed poorly and payments processors such as Paypal (NASDAQ:PYPL), Visa (NYSE:V) and Mastercard (NYSE:MA) that have done brilliantly. McDermott recommends Jupiter Financial Opportunities and Rathbone Global Opportunities. The latter, which although more generalist, has a high weighting to the payment business chain.

Specialist funds can rapidly fall from grace, so when should you cut your losses if there is an unexpected disappointment in an investment story? The golden rule is to cut your losses and run your profits. However, the typical investor is reluctant to cut their losses, and conversely they often bank their profits prematurely. The volatility of specialist funds makes it even more critical to behave dispassionately, moving swiftly to quit a losing position, while keeping an eagle eye on your winning positions and running them for as long as you can.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.