Is the US a land of opportunity for trust investors?

Given that it is notoriously hard for professional investors in the US to beat their benchmark, Kepler considers how funds and trusts in North American sectors have performed.

America is not only the land of the free and the home of the brave, but also the land of equities. American equities’ returns have far outstripped the returns of other regions’ markets over the last five years, and the US makes up some 50% of the global equity market. Yet the dominance of US equities has not translated into opportunities for active managers, as the US market is a notoriously efficient one, especially in the large-cap space.

However, as we highlight in this note, the investment trust space offers a number of innovative structures and strategies with advantages over their open-ended cousins, providing options for investors looking for alpha or equity income.

Super-size

While the AIC North American sectors carry all the hallmark differences of closed-ended funds, with the average trust using some form of gearing (although with none currently going into double digits) and every trust trading on some form of discount to NAV, in our opinion the more noteworthy differences are at a more fundamental level. The most striking differences between the closed- and open-ended sectors are in the styles of investing on offer. Despite the dominance of US growth investing over recent years, the investment trust universe has a far greater bias towards value strategies than its open-ended equivalent. This bias is not due to managers changing their styles in step with the market, but is instead due to the long-standing biases of several trusts in the peer group, and in particular the strong presence of income-focussed mandates. Three of the seven trusts in the AIC North America sector have an explicit income objective. The investment trust universe also has two dedicated Canadian equity strategies within it, Middlefield Canadian Income (LSE:MCT) and Canadian General Investments (TSE:CGI), with the IA currently having no actively managed Canadian equity strategies present in its North American peer groups.

Investment trusts also have a penchant for investing in smaller companies, with each North American investment trust having a smaller ‘size score’ than the S&P 500, and in aggregate a lower ‘size score’ than the IA sector average (according to Morningstar). This indicates that the average investment trust has a lower average market-cap weighting. Closed-ended funds favouring smaller companies is no surprise, however, as by removing the need for daily liquidity their managers are given more flexibility to pick up smaller, more thinly traded companies. Using BlackRock Sustainable American Income (LSE:BRSA)as an example, its board has recently allowed the managers to tap into the US mid-cap market, to allow the trust to be a better reflection of the full range of its managers’ ‘best ideas’.

The result of this greater range of styles is that the AIC North America sector not only has a greater value bias versus the IA sector but also substantially less homogeneity between its strategies, as indicated by the greater volatility of its value–growth scores. Thus, for better or worse, the North American closed-ended strategies are far more differentiated from one another than from their open-ended peers.

LARGE-CAP INVESTMENT STYLES

Source: Morningstar, as of 31/08/2022.

The below table shows the relative performance of the open-ended and closed-ended universes – based on the AIC and IA peer groups – as well as the performance of the S&P 500 Index. We note that the IA North America sector does not include any dedicated Canadian equity strategies, which are instead placed into the IA Specialist sector. However, the four Canadian equity strategies within the IA Specialist sector are tracker ETFs, and thus we still believe that comparing the two North American sectors remains fair for the purpose of this article. We also note that the AIC North America sector has seen a major degree of upheaval over the last 12 months as one of its strategies, Gabelli Value Plus, was wound up, and the enormous hedge-fund-turned-US-equity-strategy Pershing Square Holdings (LSE:PSH) was introduced.

LARGE-CAP NAV PERFORMANCE

Source: Morningstar, as at 31/08/2022. Past performance is not a reliable indicator of future results.

As can be seen, on average both sectors have failed to outperform the S&P 500 over the sampled time periods.

We believe that the underperformance of the average North American closed-ended fund can be easily explained by the diversity of the sector. Until 2022, the North American market was dominated by US mega-cap companies and growth stocks, where at the height of their momentum the largest technology names contributed over 50% of the S&P 500’s total return in 2020. Then high-growth companies that were smaller than the dominant mega-cap players saw their share prices increase in multiples. Tesla, arguably the poster child for US growth, has seen its current price increase tenfold from its 2019 levels. We believe that the underperformance of investment trusts is not too surprising, given the fact that the average North American investment trust has a structurally minimal exposure to the aforementioned US companies.

AIC NORTH AMERICA SECTOR NAV RETURNS

*JAM was run under a different North American mandate prior to June 2019. Source: Morningstar, as at 31/08/2022. Past performance is not a reliable indicator of future results.

Yet the sector is home to Baillie Gifford US Growth (LSE:USA), one of the most growth-biased trusts in any sector. It has been able to capitalise on the tailwinds behind US growth stocks to such an extent that it reported the single largest NAV return of any investment trust in 2020: an eye-watering 118%. Baillie Gifford American also utilises one of the greatest advantages of closed-ended trusts, as its manager Tom Slater invests in a cohort of unlisted companies alongside his more conventional listed holdings. Unlisted exposures not only set the trust apart from its open-ended peers – given the near impossibility of holding unlisted companies in open-ended structures, thus offering key advantages for diversification – but they also allow Tom to tap into Baillie Gifford’s leading access to unlisted companies. For example, Baillie Gifford American offers investors a rare opportunity to invest into SpaceX, the well-known space exploration company, with the trust currently having a 4% allocation to it.

Despite its value bias, the AIC North America sector does contain one dedicated ‘core’ strategy, that being JPMorgan American (LSE:JAM). However, JAM is not a conventional core strategy as its portfolio is split between large-cap growth and value allocations, run by Timothy Parton and Jonathan Simon respectively, with each allocation representing between 40% and 60% of JAM’s assets at any one time. The trust also has a small circa 5–10% allocation to US small-cap growth stocks. While JAM does eschew major style biases, its structure doesn’t stop its managers from taking clear bets when they have greater confidence in a specific style of investing, these taking the form of major overweights to specific stocks within each style. For example, Jonathan’s companies have represented JAM’s major overweight positions for much of 2022, indicating the team have held an overall greater value-style conviction. By straddling both the growth and value styles, JAM can also capitalise on the full capacity of JPMorgan’s US equity analyst teams. We think this is a positive because extra resources are a particularly important factor for US large-cap investing, given how hard it is to find an informational edge when analysing companies. JAM also has the impressive accolade of having outperformed the US equity market over both one and three years (with the current team having taken over management in June 2019).

While the combination of gearing and the return-enhancing properties of a narrow discount may make investment trusts particularly exciting for capital return-focussed investors, it is actually in the income sector that we find the greater number of truly unique opportunities which are not directly replicated in the open-ended universe. Those which we believe are the most noteworthy are BRSA and MCT. In fact, we think the AIC North America sector offers a superior choice for income-seeking investors because it currently has a 12-month yield far in excess of what can be found in the open-ended space, as can be seen below.

12-MONTH YIELD

Source: Morningstar, as at 31/08/2022.

BRSA stands out for two reasons, the first being that it is ostensibly a value-focussed income fund (as its above-market yield is achieved solely through the underlying revenue generated) with clear ESG-related objectives. This is unusual because value investing of any kind is seldom associated with ESG, given the style’s comparatively poor ESG metrics when contrasted with those of growth stocks. The second reason BRSA stands out is that it is an entirely unique strategy within BlackRock, making it the only way that income-minded ESG investors can access the US equity team of the world’s largest asset manager. BRSA is run by the three-strong team of Tony DeSpirito, David Zhao and Lisa Yang, who utilise an investment process that marries fundamental research (based around three criteria: value, income and income growth) with in-depth ESG analysis. This not only ensures that BRSA meets its strict ESG investment criteria, but also potentially that it benefits from the alpha potential that ESG investing can offer. While BRSA has clearly benefitted from the value-stock rally in 2022, the team have taken a ‘two-pronged’ approach to their portfolio construction, with BRSA holding a variety of companies to ensure it remains well positioned for either a positive or negative economic outcome. This involves holding companies which benefit from rising economic activity, such as banks and healthcare, as well as holding less sensitive companies with more stable earnings which can outperform during a recessionary environment, such as select technology companies or utilities.

MCT is one of only two strategies (open- or closed-ended) which allow UK-based income investors to tap into Canada’s equity market, a market whose structure is naturally suited to income investing. MCT is allocated across financial, energy and real estate stocks, sectors which not only reflect the best income opportunities within Canada’s markets, but often include a number of world-leading companies. In the case of MCT’s bank holdings, many are among the largest banks in North America. MCT has a strong value and cyclical bias, and its positioning in financials and energy in particular makes it well placed to capitalise on both inflation and rising interest rates. Despite the attractiveness of Canada’s high-income stocks, the country is unlikely to be a major exposure for most investors, given the lack of viable investment products for UK investors. This therefore means that MCT offers attractive geographical diversification. The trust’s high exposure to REITs and the strength of the Canadian real estate market are other differentiating factors, while the depth of opportunities across energy producers and midstream pipelines is hard to find elsewhere.

Not everything is bigger in Texas

The AIC North American Smaller Companies sector consists of only two trusts, JPMorgan US Smaller Companies (LSE:JUSC)and Brown Advisory US Smaller Companies (LSE:BASC). These strategies are unified by their focus on high-quality US small- and mid-cap companies, with BASC also having a clear focus on the growth factor, while JUSC follows more of a ‘core’ style of investing. While the notion of an investment process that focusses on quality companies may not seem that unusual, using such a process within the US small-cap universe can lead strategies to differ widely from their benchmark because at the end of 2021 circa 30% of the companies in the Russell 2000 Index were unprofitable. Due to profitability being one of the most basic prerequisites for a company to be considered ‘high quality’, following such a process will place substantial restrictions on a trust’s potential investable universe. However, the below table shows that the two US small-cap trusts currently demonstrate far better returns on their invested capital than the market, and also generate positive free cash flows (albeit trading at a greater premium to the market as a result).

SMALL-CAP CHARACTERISTICS

Source: Morningstar, as at 31/07/2022.

Both small-cap strategies have outperformed the wider small-cap universe over a five-year time horizon, and compared to their open-ended cousins it is BASC’s strategy which has outperformed (see the below table), though we attribute this in part to its greater growth bias. This also likely explains JUSC’s relative underperformance, as the average open-ended fund has a slightly higher bias towards growth stocks. However, this outperformance doesn’t hold over shorter time horizons, with the Russell 2000 having beaten both the open- and closed-ended sectors over three years, one year and year to date, with JUSC edging out slightly better returns over one year thanks to its more modest valuations. The more recent underperformance can be explained by some of the unfortunate headwinds that high-quality companies have faced. During 2020 the best-performing companies were the unprofitable high-growth companies, which faced less scrutiny of their valuations during a period where investors were searching for any source of growth. Conversely, in 2022 the premiums that high-quality companies traded on meant that they were heavily impacted by the rise in US interest rates, which increased the discount rates assigned to companies’ valuations and meant that the higher the valuation, the greater the potential drawdown.

SMALL-CAP NAV PERFORMANCE

Source: Morningstar, as at 31/08/2022. Past performance is not a reliable indicator of future results.

If the US economy is entering a period of slowing growth and rising interest rates, then investors may be best served by paying up for higher-quality businesses: companies whose business models are robust enough, and whose management teams are experienced enough, to navigate turbulent economic periods without their long-term prospects becoming impaired. In the case of JUSC, its highly experienced team of Don San Jose, Dan Percella and Jonathan Brachle have ingrained the quality factor into the trust’s investment process as the overwhelming driver of stock selection, whether through the quality of management or the business model. JUSC is not bound by any other style bias, however, with the team buying high-quality businesses across a range of sectors because they believe that a prudent and balanced approach to stock selection is important as growth and value factors are unlikely to keep dominating returns like they have done in recent years. For example, the team have been increasing exposure to a select few banks which directly profit from rising economic activity and interest rates while still demonstrating quality metrics that are often lacking in their peers.

While there is a clear overlap in the quality factors that the BASC team, led by Chris Berrier, assess and those assessed by the JUSC team, BASC has a clearer focus on high-growth companies. Chris aims to find companies which can display the three ‘G’ characteristics of growth, governance and scalable go-to-market strategies. While technology and healthcare are the two largest allocations in BASC (accounting for circa 40% of its portfolio), Chris avoids the more speculative areas of these industries, such as pharmaceutical companies with drugs in trials or other unproven goods and services. Instead he prefers companies such as Workiva (NYSE:WK), which provides cloud-based reporting and compliance services. While it has huge growth potential given the disruptive and scalable nature of digital services, Workiva is already an established and profitable business, and more mature than the venture-stage small-cap technology companies that often make the headlines. We think technology companies are the best examples of ‘go to market’ scalability, given their margins grow as their business expands while requiring limited capital to be expended relative to the revenue generated.

Cheap as French fries

One thing that does unite every North American investment trust, whether large or small cap, is that they all trade on a discount. With the US arguably being better placed than Europe to weather any forthcoming economic storm thanks to the country’s robust domestic consumption, strong dollar and energy security, investments trusts may be the more attractive opportunity for investors looking to tap into the world’s largest economy. And while the closed-ended sector has lagged the open-ended sector in NAV returns, it does have the potential for higher overall shareholder returns when one takes into account the potential return enhancement of narrowing discounts.

NORTH AMERICAN SECTOR DISCOUNTS

Source: JPMorgan Cazenove, as at 31/08/2022.

Conclusion

Beating the US indices is a tall order, whether due to their informational efficiency or the powerful tailwinds behind select groups of their constituents. While the average investment trust hasn’t outperformed the S&P 500, we think this isn’t due to poor manager decisions, but rather their stylistic biases.

In the case of large caps, the bias towards more attractively valued companies, as well as the presence of Canadian investment strategies, has made it difficult for the investment trust universe to keep up with the growth-stock-dominated S&P 500 or the more growth-orientated open-ended peer group. While the closed-ended small-cap managers have been able to outperform the Russell 2000 over the longer term, their commitment to the quality style has begun to work against them in the near term. Yet we shouldn’t count out the investment trust space because of this, as not only does it offer a number of unique investment opportunities, but it also offers investors the ability to tap into the US equity market at some very attractive discounts. It therefore gives investors an additional way to enhance the returns made from investing in one of the world’s most efficient – and dynamic – equity markets.