Active investment in global opportunities

As shown in Exhibit 2 (left-hand chart), returns from both equity markets and the investment trust universe have been strong in absolute terms, particularly over the past 18 months. The US-heavy MSCI AC World Index has led the way over the long term, with investment companies largely moving in step with the MSCI AC World ex-US. Meanwhile, average investment trust discounts have narrowed sharply from the spike downwards following the Brexit vote in June 2016, amid a period of positive NAV performance (right-hand chart). While the risks from here may arguably be to the downside given more extended developed equity market valuations, any increase in risk aversion could provide opportunities for discount-aware investors with a focus on quality assets.

Lazard World Trust Fund (WTR), formerly The World Trust Fund, has been managed since launch in 1991 by the Discounted Assets team at Lazard Asset Management, who manage more than $5bn across a range of mandates. WTR is incorporated in Luxembourg and listed in London; its shares are quoted in sterling and it reports in US dollars and sterling. The fund invests for capital growth in a global portfolio of closed-end funds and holding companies that the managers believe are trading at unwarranted discounts to their net asset value, and where the underlying holdings are also undervalued. Over the past 18 months the fund has put in place a range of measures to boost its appeal to investors. It has changed its name to link it more explicitly with its management team; moved its benchmark from the MSCI AC World to the MSCI AC World ex-US, reflecting its low US weighting (up to 20%, currently 12%); appointed a new corporate broker (Cenkos Securities) and introduced a new dividend policy whereby it pays a distribution equal to 3.5% of year-end NAV. The fund is permitted to use short positions and currency hedges to mitigate volatility and boost returns.

WTR lead manager Kun Deng says the current shape of the portfolio reflects the team’s view of where the best global opportunities lie. At the time of the benchmark change in mid-2016, the managers felt there was significant value in Europe, Japan, and emerging and frontier markets such as China, India, Vietnam, Romania and Eastern Europe. In contrast, the US looked less attractive in valuation terms. Deng comments that performance vindicates the fund’s positioning, with the US having been one of the worst performing major markets year-to-date.

The fund’s largest holding is now Fidelity China Special Situations1 (FCSS), reflecting the team’s view that investors continue to undervalue the attractive opportunities available in ‘new China’ companies – in areas such as e-commerce, technology, healthcare and education. The second-largest holding, South African-listed Naspers, also has significant exposure to China. WTR’s strategy of investing in holding companies as well as funds means it is able to access opportunities such as Naspers that may be unavailable to a pure fund of funds.

A key tenet of the investment process is for the managers to gain access to favoured stocks where they are mispriced. For example, Chinese internet company Tencent is the largest holding in both FCSS and Naspers, respectively trading at a 9.9% and a 32.2% discount based on 31 July 2017 figures. This means the team is able to access Tencent’s growth potential at far less than its market value. Deng points out that Naspers’ stake in Tencent is now worth $130bn, compared with Naspers’ own market capitalisation of c $90bn, meaning investors can buy Tencent at a 30% discount as well as getting the rest of Naspers’ global portfolio of best-in-class tech and media companies effectively thrown in for free. Another example is Softbank, a new direct investment for the fund, but also a top five position in JPMorgan Japanese. As well as buying British chipmaker ARM Holdings in 2016, Softbank owns stakes in companies including Yahoo! Japan, Sprint, and Alibaba.

Recent corporate governance initiatives for the team include proposing a new director for top 10 holding First Pacific, participating in a tender offer for Tetragon Financial Group, and introducing a new fund manager to the China Fund.

WTR seeks to invest in listed funds or holding companies that are trading at a discount to NAV or sum-of-the-parts valuations, and whose own investments are also undervalued. The managers look for catalysts for revaluation, the potential for underlying holdings to appreciate in value, and opportunities to narrow discounts proactively through corporate governance initiatives. The aim is to construct a high-conviction portfolio of holdings that have the potential to perform strongly in rising markets, protect capital in falling markets, and outperform the fund’s benchmark and peers. The mainly New York-based Discounted Assets team at Lazard, led by Kun Deng and made up of four portfolio manager/analysts, a client portfolio manager and a dedicated trader, can also draw on the macro and industry views of the wider Lazard Asset Management group globally.

There are broadly four stages to their investment process:

The managers may make use of hedging, usually by taking short positions in ETFs, in order to offset market risk. During FY17 there were short positions linked to the S&P 500 and a Vanguard pan-European index fund and, unusually, a currency hedge, with a short Japanese yen position versus the dollar. There are currently no hedges in place, and no gearing at the fund level.

WTR is designed to express the highest-conviction ideas of the investment team in a concentrated portfolio. At 31 July 2017, the fund had 35 holdings, with the top 10 representing 40.6% of the total (30 June 2016: 49.3%). The change in benchmark has prompted a further fall in US exposure, to 11.8% at 31 July 2017 compared with 20.0% a year earlier. Most other geographical weightings have risen, particularly China, Japan and India, although Japan has moved from overweight to underweight versus the new benchmark. Portfolio changes over the past year have largely been fund-specific or opportunistic, rather than thematic. A fall in closed-end fund (as distinct from investment trust) exposure from 35.6% to 28.8% over 12 months to 31 July 2017 is largely the result of closing out or reducing some US positions where the managers had less conviction, such as Tri-Continental, Adams Diversified and General American. Liberty All Star Equity was added to the portfolio in FY17 at a c 19% discount and sold following strong performance driven by its tilt towards banks.

Changes to the portfolio in FY17 include reductions in biotech and mainstream private equity funds where discounts had narrowed substantially, and a fall in UK smaller company funds exposure, which was trimmed on narrower discounts ahead of the Brexit referendum. The emerging markets weighting has been consistently topped up on market weakness, with Fidelity China Special Situations now the largest holding, and new positions in Africa Opportunity, Brazilian public/private equity fund GP Investment, and the Romanian privatisation fund Fondul Proprietatea (now a top 10 holding). BlackRock Resources & Commodities is a new position that is just outside the top 10, and further additions in FY17 include JPEL Private Equity (now in run-off mode and so insulated from the high private equity valuations that present a risk to funds that need to reinvest) and JZ Capital Partners, focused on US and European micro-caps and US real estate. Since the year-end, new positions have been opened in Japanese holding company Softbank (a similar proposition to the South African tech/e-commerce specialist Naspers), Yahoo! spin-off Altaba, and Wendel, a 300-year-old French public/private equity investor with a global portfolio including exposure to Africa.

WTR has produced strong absolute returns over the past year (Exhibit 4), as well as beating its new benchmark in NAV total return terms over six and 12 months. Share price and NAV total returns are also ahead of the blended benchmark over three years, although the picture versus equity indices, as well as the universe of investment companies, is more mixed over five and 10 years (Exhibit 5). Contributors to strong performance in FY17 include global funds (such as Tetragon Financial Group,1 HarbourVest Global Private Equity1 and International Biotechnology Trust, all since trimmed); emerging Asia (Macau Property Opportunities, Fidelity China Special Situations) and frontier markets (Fondul Proprietatea, VinaCapital Vietnam Opportunity Fund1). The top two contributors to returns in FY17 – Naspers and Jardine Strategic – have continued to perform strongly. Meanwhile, detractors from performance in FY17, such as Marwyn Value Investors, Haci Omer Sabanci Holding, China Everbright, China Fund (both sold early in FY17) and JPMorgan European Smaller Companies1 have all recovered well in local currency terms in 2017 to date.

At 12 September 2017, WTR’s shares traded at a 5.2% discount to cum-income NAV. This is narrower than short- and long-term averages, reflecting a period of very strong share price performance, and close to the five-year low of 4.5%, reached on 8 September 2017. Having drifted wider in a period of heightened risk aversion in the first half of 2016, which culminated in a market sell-off following the Brexit vote, the discount narrowed sharply (from a five-year high of 18.6%) at the end of June 2016 following the announcement of the new dividend policy, and had largely remained in its longer-term range of 10-14% until recently. Tender offers may be proposed each year, giving investors a chance to exit at a price closer to NAV.

WTR is incorporated in Luxembourg as a closed-end fund (SICAF) and listed on the Main Market of the London Stock Exchange. It has one class of share, with 36.4m ordinary shares in issue and a further 10.25m held in treasury. The fund holds an annual continuation vote and may also propose a tender offer; 10% of shares were bought back in the last tender in September 2016 at a 3.2% discount to NAV. Gearing is available via a $25m facility with Citibank. This is currently undrawn but equates to potential gearing of c 13.2% based on 12 September 2017 net assets and exchange rates.

Lazard receives an annual management fee of 0.75% of NAV, calculated and paid quarterly. A performance fee may be paid on a sliding scale of between 5% and 20% of outperformance of the benchmark, measured over a two-year period. No performance fee was paid for FY17 (FY16: nil).

The board of WTR recognises the importance to investors of regular dividend income, and since the start of FY17 the fund has followed a policy whereby it pays a distribution equal to 3.5% of the year-end NAV. This is paid in two instalments, with an interim in January and a final dividend (subject to AGM approval) in August/September. For FY17 the dividend was 10.2p per share, and for FY18 it will be 12.985p, representing a prospective dividend yield of 3.5% based on the 12 September 2017 share price. The distribution is partly funded out of capital; given WTR’s focus on capital growth, its portfolio is relatively low-yielding, with investment income of 0.9% of total net assets in FY17. Dividends were first paid in FY15, when the policy was to pay out substantially all of net income. Since then (including the dividend declared for FY18) the distribution has grown at a compound annual rate of 56%. Because the distribution is set at a percentage of NAV, it may fall as well as rise in absolute terms if the fund declines in value over the course of a year.

WTR is a member of the AIC’s Global sector, although its discount-focused, fund-of-funds investment approach sets it apart from the majority of the peer group. In Exhibit 8 below we have drawn together a selection of comparators, most of which are funds of funds, from the AIC Global (British Empire, F&C Managed Portfolio Growth, JPMorgan Elect Managed Growth) and Flexible Investment (Henderson Alternative Strategies, Miton Global Opportunities) sectors. WTR has outperformed the group average in NAV total return terms over all periods shown except 10 years (reflecting the fund’s difficult period during the financial crisis), ranking first, first and second, respectively, over one, three and five years. Ongoing charges are above average, while the discount has narrowed to below the peer group average. WTR is ungeared, in common with the majority of peers; this is not unusual in a group of funds whose underlying holdings may themselves be geared. Reflecting its new distribution policy, WTR has the highest dividend yield in the group.

There are five non-executive directors on the board of WTR, all independent of the manager. Philip R McLoughlin joined the board at the fund’s launch in 1991 and became chairman in 2010. Duncan Budge became a director in 2006, while James Cave was appointed in 2008. Howard Myles (chairman of the audit committee) has served on the board since 2011, and Tony Morrongiello was appointed in 2014. All of the directors have backgrounds in investment management.