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Investors face a constant battle to keep their emotions in check. Just as fear is causing paralysis for many would-be buyers of shares in today’s bargain basement stock market, greed can prompt an excess of exuberance during periods of rampant gains.
A simple checklist should not be viewed as a silver bullet that will suddenly turn anyone into a cold-hearted, ruthlessly effective investor. But it will help them to focus on logic, rather than emotions, when investing their hard-earned cash. It will also help them to avoid common mistakes that will seem obvious with the benefit of hindsight.
When it comes to investment trusts, past performance is usually the first consideration for most investors (and is the first entry on our checklist). Comparing a company’s record with its benchmark and rival trusts provides valuable insight into whether its managers are skilled investors who are worth backing.
Understanding why a trust has outperformed, or lagged, its benchmark and peer group is also important. For example, its benchmark may be a “multi-cap” index dominated by larger companies (the FTSE All-Share index would be an example), while the trust in question may have held mostly smaller stocks that have underperformed their larger counterparts because of temporary weakness in the economic outlook. In such a scenario, the trust’s manager may be more skilled than their track record initially suggests.
On the topic of fund managers, it is crucial to check when they started to run the trust and if they plan to leave (point 2 on our checklist). Basing an investment decision on a trust’s 10-year record when the manager has been in place only for six months is illogical. Likewise, investing in a trust on the basis of its sound record when its manager is shortly to retire is far from ideal.
Some investment trusts focus on income, while others are only interested in capital growth. It is therefore crucial that its aim be checked before purchase (point 3). Likewise, it is always worth double checking the geographic exposure of a trust (4). Sometimes, a trust that claims to be “global” is in fact highly concentrated in stocks listed in a very limited number of countries to which an investor may already have significant exposure.
On the topic of concentration (5), some investment trusts are “closet trackers”: they hold such a large number of stocks that it is very difficult for them to generate any material outperformance of their benchmark. Conversely, some trusts have as few as 20 holdings and their largest 10 positions may account for the vast majority of net assets. This may appeal to some investors. But many will deem it too risky.
It is always worth checking the main holdings of an investment trust (6). They may be stocks that an investor already holds directly in their portfolio, or, more worryingly, they may not be fully aligned with the trust’s aims.
Indeed, some trusts are, in Questor’s view, misnomers. For example, they may contain the description “mid-cap” or “smaller companies” in their name but, on further inspection, straddle the two arenas.
As a result, drilling down into the market value of a trust’s holdings is a worthwhile exercise which ensures that its positions match its stated aim and name (7). This also helps to ensure that risks are not higher than expected by, for example, investing in a multi-cap trust that in practice holds a large number of smaller stocks.
Trusts can be “overweight” or “underweight” at a sector level relative to their benchmark. For instance, some trusts currently have far more exposure to cyclical sectors than the index they seek to outperform. This can be a positive if the market rises, but can lead to relatively large losses amid a weak economic environment. Therefore, it is always worth checking that sector exposure aligns with an investor’s standpoint (8).
Likewise, gearing (9) can have a significant impact on a trust’s performance. Since Questor inherently takes a long-term view, it generally views borrowings in a positive light. Debt can also prompt greater share price volatility in the short run.
As a result of downbeat investor sentiment, many investment trusts currently trade at a discount to net asset value (10). This means they offer good value for money and could deliver greater returns should their discount narrow over time. Although buying a trust that trades at a premium can be justified, most investors are likely to prefer a discount.
Clearly, no checklist can guarantee investment success. And the suggested areas to include in a checklist within this column should not be viewed as exhaustive. But, since many investors struggle to put emotions to one side, a checklist could prove a worthwhile starting point to ensure any future purchases are made on the basis of a logical, structured approach.
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