Capital Gearing Investment Trust

Important: What follows is not a recommendation to buy or sell shares in any company. I am just sharing my notes for general interest. Please read my disclaimer.

Long time readers may recall my fascination with investment trusts.

It’s true that index trackers and ETFs have made such trusts redundant for most investors (with the debatable exception of income seekers).

If you want to grow your nest egg with little fuss and the best odds of success, you’re probably best off investing passively and avoiding complications such as:

• The wide choice of investment trusts

• Their higher fees and running costs

• The lack of correlation between a trust’s name and its activities

• The pick-and-mix approach of many trusts towards benchmarks

• The risk of a trust still underperforming whatever benchmark you or they deem appropriate

• Discounts and premiums (oy vey!)

• Debt, buybacks, and the issuing of stock

• Their colourful history, which stretches back to the glory days of shipping and railroads, and which sees you able to run your money with the 1% with some trusts like Caledonia and RIT Capital Partners

But for an investing nerd like me, all this is catnip.

Indeed, even if I went heavily passive again1 I’d probably still follow investment trusts.

After all, I read books about hedge funds, despite hedge funds usually2 being about as welcome in my portfolio as Jeremy Corbyn busting out of a cake dressed in lingerie at the annual gathering of the Bullingdon Club.

Spectator sport

I enjoy seeing how hedge funds try to outwit and profit from the market (and from their own clients…)

Similarly, I’m always curious about how investment trusts go about their business, and I’m always looking for tips for my own active investing (as well as occasionally buying into opportunities in trusts, of course).

Indeed even some passive investors might benefit from occasionally seeing what professional fund managers are up to, if only for ideas about asset allocation.

And they don’t get much more interesting than Capital Gearing Trust (Ticker: CGT).

Let me be clear: This article is not a recommendation to invest this trust.

I’m also not saying its strategy – with its market timing, leftfield asset allocation, and general active fiddling – is above reproach.

Capital Gearing’s strategy would be an anathema to my co-blogger The Accumulator, and to many Monevator readers.

However this site isn’t just about splitting your money between a cheap global tracker fund and a bond ETF, rebalancing every Christmas, and coming back in 30 years to tell us how you did (though there’s a lot to be said for it – and a postcard would be nice…)

And I am not one of those who dismiss fund managers’ efforts with a wave of the hand and a blithe “it’s all just luck.”

What I am is someone who says that in the majority of cases any outperformance they achieve is indistinguishable from what might happen through luck, and also that active investing is a zero sum game.

Given the cost of paying for what is probably luck is prohibitive, and seeing as you likely can’t tell the very few who are going to be skillful/lucky in advance, you might as well just invest passively, keep costs low, accept the market’s return, and avoid the whole kerfuffle.

But that’s very different from arguing you should avoid active managers because they’re charlatans or morons.

On the contrary, I believe lots of hard work, goodwill, and brainpower goes into achieving their existentially troubling results.

There’s a reason why so many UK fund managers are Oxbridge graduates, even if that intellectual arms race means they’ve nullified their respective edges to zero – which in turn again implies we might as well invest passively.

(Though as you should know by now, I personally still try my best to beat the market by investing actively. But that’s my problem, not yours!)

You don’t have to like it…

So, yes:

• You could probably roughly replicate the past returns of the Capital Gearing Trust with some split of equity trackers and bond ETFs.

• You could make the case that it’d be better for you to do that in the pursuit of future returns, too, rather than buying into the trust.

Agreed.

But let’s now examine what the trust’s manager Peter Spiller actually does that makes it so much more interesting than that.

(Not least because like all active managers, Spiller is acting without the benefit of hindsight – unlike academic exercises in replicating past returns through passives.)

You see, whereas many active funds are closet index trackers, Capital Gearing is most definitely not.

Gosh is in the details

Here’s how Capital Gearing Trust manager Peter Spiller had distributed its roughly £95m in assets as of the end of August 2015:

Source: Capital Gearing Trust

A few comments on this rather esoteric allocation:

• Equity-light: The trust benchmarks itself against the FTSE All Share, but there’s barely one-quarter in ordinary shares.

• Investment trust-heavy: Capital Gearing has bought stakes in dozens of other investment trusts. It aims to buy when they’re discounted and sell when the discount closes, to boost returns. In the last financial year, for example, Capital Gearing’s trust portfolio beat the FTSE All-Share.

• You can see the investment trusts it holds at the end of its year in the annual report. Even a quick glance will reveal massive diversification.

• Cash heavy and low duration: Around 45% of net assets are invested in low yielding, short duration assets. Cash, nominal bonds, zero dividend preference shares, and convertible debt securities. Some of these assets may be unfamiliar to you, but the point is nearly half the portfolio is not set to earn much of a return. Capital preservation is the key for now. The manager thinks of such assets as “dry power” to invest in a correction.

• A big weighting of index-linked government bonds: Again, these aren’t likely to shoot the lights from current valuations. But they could help to compensate for the low weighting of equities if (or rather “when”, in manager Peter Spiller’s mind) inflation takes off again.

• Little gold: I think it’s interesting that a trust focussed on capital preservation has only 1% in gold. Not because I think it should own more, but because that’s what the doomster consensus has been for years. Clearly we’re dealing with a subtler mind than your average gold bug. (Not you, dear gold bug reader. You’re an above average gold bug.)

All told it’s quite a strange portfolio, not made any more immediately appealing by the paltry dividend yield of less than 1%.

There are other concerns too, that Monevator-trained investing guerrillas will immediately spot, especially related to costs.

Not only is an investor in Capital Gearing paying a fee for Mr Spiller’s talents, his assistants, office equipment, and trading fees.

An investor is also effectively paying twice for the management of that investment trust portfolio, since they obviously all have their own fees, too.

Indeed on some parts of the portfolio I’d imagine total annual costs – that is, Capital Gearing’s fee and running costs added to the underlying trust’s fees and costs – might approach 5% or more.

Ouch!

Disaster not discounted

All these comments probably sound quite negative, so I should be clear I quite admire this trust, the manager, his record, and how he backs his convictions.

I’m also always surprised when I see Capital Gearing’s long-term record.

It highlights that there’s more than one way to skin the investing cat.

This is a trust that is doing something very different compared to so many me-too funds out there, and yet it is delivering over the long-term.

It thus offers a genuine reason for certain investors whose thinking accords with the manager to consider owning it.

That said, investors are typically their own worst enemies, and that’s likely true for some investors here, too.

I am thinking of the shifting discount/premium over the past five years:

Source: AICStats

This graphic (which unfortunately is spat out without dates on the X-axis) shows how the discount/premium fluctuaed from early October 2010 to end of September 2015.

As you can see, the trust typically traded at a big premium to its net assets – as much as a 20% premium back in 2011.

In other words, investors at the peak were prepared to pay 20% in excess of what the trust actually owned to buy its shares – presumably either because they felt that fairly reflected the cost of assembling a similar portfolio for themselves or because they wanted access to Spiller’s expertise in managing that portfolio.

Neither one is a very good reason to pay such a huge premium.

It’s true that it would cost a lot of money to exactly replicate Capital Gearing’s asset allocation as a private investor, assuming that was feasible or desirable.

Yet most of the trust is not invested in otherwise inaccessible asset classes (as might be the case with, say, a private equity or frontier market fund).

As I alluded at the top, I think you could get something similar to the net exposure of its portfolio using a far smaller and more manageable selection of ETFs, with only its convertibles and zero-dividend preference shares being tricky to duplicate.

It wouldn’t perform exactly like Capital Gearing, to be sure.

But it also wouldn’t cost you a 20% tip for the privilege of buying in!

Of course Capital Gearing’s portfolio is a movable feast, and monthly snapshots only give you so much information about how it’s actually allocated.

Which of course brings us to the second point – paying for Mr Spiller’s talents for managing it for you.

I’m not going to duplicate what I’ve already said – or indeed what most of the Monevator website is all about.

Clearly, we don’t believe it’s worth paying 20% as an entry price for the unlikely chance of outperformance.

And before somebody protests as they usually do that “It’s not just about outperformance, there’s also risk and volatility!” please remember you can cheaply dampen volatility by owning fewer equities and more bonds and cash.

What you were really paying for with Capital Gearing’s 20% premium was outperformance (/lower volatility/a better Sharpe Ratio/whatever) in excess of what you could get cheaply via index tracking products and cash.

Crash tested dummies

So while I said earlier there might be a rationale for certain investors to own Capital Gearing Trust’s assets and to employ the manager on their behalf, I don’t think there was a case for paying 20% to do so.

Why did others think it was okay to pay that 20% premium for the trust’s assets?

Well, why do they ever?

Past performance, of course!

Back in 2010 and into 2011 many investors feared the financial crisis had not really ended. (Some still have their doubts.)

Fear still stalked the market. Anyone reading financial blogs at the time will remember how bearish everyone was. Few seemed to believe the rally was real.

I remember when I posted a suggestion back in 2010 that after such a steep bear market shares might rally by double-digit percentages for a decade, it felt almost more contrarian than saying it was a good idea to buy during the crash!

The point is this was the prevailing mood among many investors – particularly the more, err, venerable old men whom I imagine make up Capital Gearing’s shareholder base.

(If you’ve ever been to a company AGM you’ll know spotting any shareholders under 60 is a novelty, but even so I suspect Capital Gearing’s AGMs are full of Victor Mildrew clones rather than the rosy-hued OAPs you see in Saga adverts.)

I heard investors applaud the trust and Mr Spiller on bulletin boards, saying he had the defensive mindset to see them through the all-but-fake rally.

And uppermost in their mind was how well Capital Gearing had survived the bear market, as this graph indicates:

Source: AICStats

No chart is perfect (all can mislead) but essentially this one reflects how Capital Gearing did far better than most rivals in the crash period from mid-2007 to early 2009.

You can see you might have lost 45% of your money in the average trust – but you barely lost a night’s sleep in Capital Gearing.

Surely that was worth paying a 20% premium for?

Well, perhaps if the market had crashed again in 2010 or 2011 it would have been.

But the market didn’t crash, so we don’t know.

Run away! Run away!

What did happen is shares kept rallying – especially international shares such as US and emerging markets – and so some of the people who’d put their money into Capital Gearing began to feel short-changed.

This wasn’t exactly Spiller’s fault – he stuck to his guns, and like all of us asset allocators he has been working with an extremely limited toolset, with interest rates stuck at zero and yields collapsed nearly everywhere.

On the other hand it was Spiller’s fault in that he was bearish, and being bearish meant being wrong between 2010 and into 2015.

The following chart tells the tale:

Source: AICStats

Other trusts left Capital Gearing behind as it stuck to its safety first return of capital rather than return on capital approach to the market.

Let’s remind ourselves of how this was reflected in the premium over the past five years, by repeating that chart:

Source: AICStats

You can see that as Capital Gearing fell behind, investors decided it wasn’t worth over-paying for its intricate portfolio and/or Mr Spiller’s special insights after all.

The premium even dipped into a discount (so you could buy it for less than it was worth in terms of net assets), which accounts for much of the falling share price over recent years (the net assets, the grey line, can be seen holding up better than the value of the fund in the chart I shared just above this one).

Which is all to say the so-called Behaviour Gap swallowed another bunch of victims.

Just another ride on the investor sentiment cycle.

Too clever for their own good

The irony is that as the market rose and shares – especially US shares – started to look somewhat expensive, the justification for owning Capital Gearing (or otherwise de-risking your portfolio) actually rose with it, if you were minded to try to be clever about all this.

That’s because short-term momentum issues aside, owning shares get riskier when the market rises and safer when it falls – because you’re paying correspondingly more or less for the earnings and dividend stream they deliver3.

Yet as these risks increased, the premium on Capital Gearing actually fell.

For me, it’s another illustration that most investors have no business trying to be cute about investing at all.

They should instead just weight their equity/bond allocations according to their risk tolerance, and avoid indulging in recruiting hired guns, chasing the winners of yesteryear, or trying to time the market.

Holding on to your hero

That said, there is another approach to investing with active managers.

You can buy and hold something like Capital Gearing Trust for the very long-term – multiple decades – and bet on it outperforming over the cycles, rather than adding your own (likely flawed) performance chasing into the mix.

And for all my fun above, I’m sure that’s what most of Capital Gearing’s shareholders actually do.

As always the marginal buyer sets the trust’s price. I suspect it was a relatively small number of Johnny-come-lately buyers who’d been freshly acquainted with the risks of owning shares back in 2008 and 2009 who were responsible for most of that crazy premium that developed.

It’s they who were the foolish ones. Long-term holders probably sat pat. Perhaps some even sold on that unsustainable premium and aimed to buy in when it subsided (like now) – though that kind of game has its own clear perils, too.

Most people who want – for whatever reason – exposure to an active fund will probably do best to choose well, invest, and then file and forget.

As you can see in the following chart, buying and holding Capital Gearing for the past 30 years has done very well (although Spiller wasn’t the manager for this entire period, and we should remember all the caveats about survivorship bias and past performance versus future performance and so on):

Source: CG Asset Management Ltd / 2015 Annual Report

Over the past ten years you can see a similar dynamic in play:

Source: Capital Gearing Trust

It’s clear this trust makes its gains by not falling in bear markets, not by doing well in bull markets.

As such, if you’re the sort who dismisses all this talk of passive investing and cheaper alternatives and wants to own this trust then – given that you’re likely not the next undiscovered hedge fund manager able to trade in and out of it at opportune times – you’re probably best off simply buying and holding.

That’s what Mr Spiller does, and he owns £10 million worth of the £100m trust’s shares.

You probably think he’s a better investor than you, if you’re buying into his fund.

If so, then I’d suggest you’re likely best off doing what he does.

Changing gears

A few takeaways to close:

• You can overpay through fear as well as greed

• When the average person least feels the need for safer assets is probably when they need them most. We suffer from recency bias, and forget most things are cyclical

• Don’t buy an investment trust on a 20% premium

• There’s a lot of weird and wonderful assets out there

Good hunting!

Note: I don’t own any Capital Gearing Trust shares, but someday I might.

 

1. I had most of my money in trackers a decade or so ago. [↩]
2. There are exceptions, at exceptional moments. I may write more on this one day. [↩]
3. I am ignoring growing earnings here, which offset the growth in asset prices over the long-term. I am also talking about real risk, not academic risk! [↩]