Higher exposure to more defensive funds

The performance of UK and global stock markets over the last decade is shown in Exhibit 3 (LHS). For the sterling-based investor, overseas equities have delivered significantly higher total returns than UK equities over the last four years, particularly over the last two, where performance has been hindered by ongoing Brexit negotiations and sterling weakness. While global stock markets enjoyed a period of particularly low volatility in 2017, this year has seen a return to sharper moves in share prices as investors have become more risk averse. Markets sold off in early 2018 before recovering and are again in a downtrend as there is more attention focused on macroeconomic factors, such as a strong US dollar, and the risks to economic growth from rising interest rates and trade tensions as a result of President Trump’s ‘America First’ strategy. While the recent pullback in share prices has led to more attractive company valuations, the forward P/E multiple of global equities, led by the US, remains above its 10-year average (Exhibit 3, RHS), suggesting investors may benefit from being more selective when deciding on their equity exposure.

Since launch on 16 April 2008, BMPT has been managed by Peter Hewitt at BMO Global Asset Management (BMO, formerly known as F&C). Through its two portfolios, he aims to generate an attractive level of income with some capital growth (BMPI) or capital growth (BMPG) from a broad spread of investment companies diversified by manager, geography and sector. BMPT is intended to appeal to regular savers and investors with smaller investment portfolios; it currently has c 15k shareholders and assets of c £130m (compared with £42m at launch); this includes £13m from the rollover of Cayenne Trust, which was liquidated in December 2015.

A unique feature of the trust is that any income generated by BMPG is transferred to BMPI in exchange for an equal amount of capital, which boosts the income potential for BMPI and the capital growth potential for BMPG. Both portfolios are benchmarked against the FTSE All-Share index. The trust’s investment guidelines state that BMPI and BMPG must each contain at least 25 investment companies (typically c 40, primarily invested in equities). At the time of investment, a maximum 15% of each portfolio may be in a single holding, and up to 20% may be invested in other funds managed by BMO. There are no geographic or sector restrictions. Derivatives are permitted for efficient portfolio management, including to protect the portfolios during periods of stock market weakness. Each fund is permitted to gear up to 20% of total assets; at end-October 2018, BMPI had net gearing of 8.2% and BMPG had a net cash position of 1.3%.

Hewitt’s view is that, while we are closer to the end of the current investment cycle and economic growth is slowing, he does not expect a recession. He says that rising interest rates in the US are putting pressure on equity valuations, and the UK economy and stock market are challenged by uncertainties surrounding Brexit. The manager believes that positive developments in negotiations with the EU could lead to a relief rally in UK shares, and some areas of the stock market look attractively valued, such as small-caps and companies with domestic operations. However, to have a positive view on UK equities, Hewitt believes the Brexit situation needs to be clarified.

The manager notes a large pipeline of UK investment companies aiming to list on the stock market; he suggests that so far, the quality of these companies has been ‘okay’, but the sheer number of potential initial public offerings (IPOs) suggests that not all of them will be successful. Regarding two recent IPOs, Hewitt comments that Smithson Investment Trust, which invests in global small- and mid-caps, smashed its initial £250m fundraising target, by raising in excess of £820m, while Mobius Investment Trust only raised around half of its indicated £200m, as emerging markets are out of favour. However, the manager backed Mobius Investment Trust with a £5m position in BMPG, partially funded by the sale of Genesis Emerging Markets Fund. Hewitt says that the Mobius Investment Trust is a good example of successful managers leaving a large company to set up a fledgling business and committing their own capital; he believes these actions are a recipe for success. The manager argues that it is an opportune time for a long-term investor to consider emerging markets exposure, given their relatively weak performance in recent months.

The manager takes a long-term approach to fund selection. He aims to grow both capital and income, while offering a level of portfolio protection in periods of stock market weakness; hence, both BMPI and BMPG have a number of more defensive positions. Funds are selected on a bottom-up basis, with Hewitt using his extensive industry experience to seek out managers who are able to outperform their respective benchmarks (as well as the FTSE All-Share index). Meeting investment company management is a key part of the investment process, which is supplemented by the use of third-party research. While Hewitt takes account of a fund’s discount/premium at the time of purchase, this is not a primary consideration.

Over time, there has been a broadening of the opportunity set for equity-based income trusts; BMPI now has exposure to Asia Pacific, emerging markets, smaller European companies and the biotech/healthcare sector, along with its traditional holdings in developed markets. BMPG focuses on companies with good capital growth prospects, such as the flagship funds of boutique investment houses, emerging markets, private equity, and the technology and biotech sectors. UK exposure in both portfolios has declined in recent years, as the manager believes that overseas equities generally offer potential for higher long-term total returns.

BMPI: recent new positions include: Aberforth Split Level Income Trust (UK smaller companies); Allianz Technology Trust; Hipgnosis Songs Fund (royalty income); and The Scottish American Investment Company (global equity income). Allianz Technology Trust, along with BMPI’s position in Monks Investment Trust, are not typical income stocks, but were purchased because a large special dividend from 3i Infrastructure means that BMPI is replete with income, but these two positions could be sold, if this position changes. The fund also has positions in BB Biotech and BB Healthcare, which both pay dividends out of capital. These four highlighted trusts provide around 10% exposure to the secular growth in the biotechnology and technology sectors. Hipgnosis Songs Fund had its IPO in July 2018. The company’s strategy is to buy the royalty streams from well-known music artists. Hewitt explains that copyright income is now growing, following years of stagnation, due to the rapid growth of streaming and the increased inclusion of songs in advertisements and films. Hipgnosis is targeting a 5% dividend yield, and the manager believes there is also the potential for capital growth.

Recent sales include BMO UK High Income Trust (UK equity income); GCP Infrastructure Investments (asset-backed debt); HICL Infrastructure Company (private finance initiative infrastructure); and Securities Trust of Scotland (global equity income).

BMPG: recent new positions include Aurora Investment Trust and Baillie Gifford UK Growth Trust (both UK all companies), while River & Mercantile UK Micro Cap Trust (UK small companies) was sold. Aurora Investment Trust is managed by Phoenix Asset Management Partners, who run a very concentrated fund of undervalued, primarily large-cap UK equities. It only initiates a position when a company is trading at a 50% discount to its perceived intrinsic value. Hewitt initiated a position in the Baillie Gifford UK Growth Trust following the change in manager from Schroder Investment Management to Baillie Gifford.

Given the manager’s more cautious view on global stock markets, he highlights that there are a number of holdings in BMPI’s portfolio that are not equity related, such as Hipgnosis Songs Fund and The Renewables Infrastructure Group, which should perform relatively well on an NAV basis in an equity market downswing. Hewitt has also been building up BMPG’s portfolio protection by increasing exposure to the fund’s more defensive holdings (exposure is now up to c 12%) such as Personal Assets Trust and Ruffer Investment Company. While his longer-term view is that it is beneficial to be exposed to secular growth themes, he believes that more caution is warranted in the near term given the current macroeconomic backdrop.

It is interesting to note that in FY18 (ending 31 May 2018), the difference in total returns for BMPI and BMPG was the widest since BMPT was launched in April 2008. This reflected investor appetite for growth over value stocks, with particularly strong performance from the technology sector. Data from BMPT show that from launch to end-FY18, BMPI’s NAV total return of 117.7% outperformed the benchmark’s 97.9% total return by 19.8pp, while BMPG’s NAV total return outperformed by 12.5pp. In the 10 years since launch, BMPI has outperformed the benchmark in seven financial years, performed in line in one (FY17), while underperforming in two (FY14 and FY18); BMPG has outperformed in eight years, while also underperforming in two (FY09 and FY12). The manager highlights the benefits of his long-term investment approach, citing BMPI’s holding in Lowland Investment company, which has delivered a total return in excess of 200% since purchase in September 2009, and BMPG’s holding in Allianz Technology Trust, which has delivered a total return in excess of 500% since purchased in May 2008.

BMPI: in FY18, BMPI’s NAV and share price total returns of +3.0% and +2.7% respectively were below the benchmark’s +6.5% total return. The best contributors to performance were CC Japan Income and Growth Trust (+24%), which benefited from good stock selection and has rapid dividend growth, and BB Biotech (+21%), which built on its positive investment track record. The largest detractor was HICL Infrastructure (-13%), which de-rated during the period, moving from a premium to a discount.

BMPI’s relative performance is shown in Exhibits 6 and 7. Its NAV and share price total return have outperformed the benchmark over five and 10 years but have lagged over one and three years.

BMPG: in FY18, BMPG’s NAV and share price total returns of +11.0% and +10.6% respectively were meaningfully ahead of the benchmark’s +6.5% total return. The best contributors to performance were Syncona (+47%), whose life sciences businesses are making good progress, and Edinburgh Worldwide Investment Trust (+42%), which has a bias to the technology and healthcare sectors. The largest detractor was Woodford Patient Capital Trust (-21%), whose largest holding Prothena suffered from negative clinical trial data.

BMPG’s relative performance is shown in Exhibits 9 and 10. It has outperformed the benchmark in both NAV and share price terms over all periods shown, with the exception of the last month.

BMPT’s board seeks to ensure that BMPI’s and BMPG’s shares trade close to NAV (aiming to limit the discount to 5% in normal market conditions). BMPI is currently trading at a 2.8% share price premium to cum-income NAV, which is higher than the 0.8% to 1.3% range of average premiums over the last one, three and five years.

BMPG is currently trading at a 3.0% share price premium to cum-income NAV, which is higher than the 0.6% to 1.3% range of average premiums over the last one, three and five years.

BMPI has 42.9m and BMPG has 35.6m ordinary shares in issue (there are no shares held in treasury). BMPT has a £7m debt facility with the Royal Bank of Scotland, comprising a £5m five-year loan at a fixed rate of 2.03%, and a £2m two-year unsecured revolving credit facility. Gearing of up to 20% of total assets is permitted in both portfolios; at end-October 2018, BMPI had 8.2% net gearing and BMPG had a 1.3% net cash position.

BMO is paid an annual management fee of 0.650% pa of total assets in each portfolio, reducing to 0.325% pa on any BMO-managed investments; the fee is split 60:40 between the capital and revenue accounts for BMPI and 80:20 respectively for BMPG. A 10% performance fee is payable based on the excess total return of BMPI and BMPG versus the benchmark (capped at 0.35% of the total assets of the relevant portfolio). In FY18, BMPI’s ongoing charge was 1.07%, which was 5bp lower than in FY17, and 44bp lower than the 10-year high in FY10. BMPG’s ongoing charge was 1.03%, which was also 5bp lower than in FY17, and 56bp lower than the 10-year high in FY12.

Each October, shareholders have the opportunity to convert their income shares into growth shares and vice versa, in a ratio based on each portfolio’s NAV per share; the conversion is subject to certain minimum and maximum thresholds. The first conversion took place on 1 November 2018 (based on 25 October 2018 closing NAVs): 242,448 BMPI shares were converted into 155,065 BMPG shares, and 37,172 BMPG shares were converted into 58,118 BMPI shares.

A unique feature of BMPT is that any net revenue generated by BMPG passes to BMPI in exchange for an equal amount of capital. BMPI pays quarterly dividends in October, January, April and July. In FY18, the regular dividend of 5.70p was 4.6% higher than 5.45p in FY17, an increase broadly in line with the 4.4% five-year compound annual growth rate (annual dividends have grown for the last seven consecutive years). The FY18 regular dividend was c 1.3x covered by income, which was boosted by receipt of a special dividend from 3i Infrastructure. As a result, the BMPT board also declared a special dividend of 0.8p for FY18. At the end of the financial year, after providing for the fourth interim dividend, the revenue reserve was c £1.4m, which is equivalent to c 60% the FY18 regular dividend, providing a buffer for years where income is lower. Barring unforeseen circumstances, the first three FY19 interim dividends will be 1.35p per share, while the fourth interim dividend will be dependent on the level of income generated throughout the financial year. Based on its current share price, BMPI offers a dividend yield of 4.4%, which compares favourably with the majority of its peers.

With effect from 1 February 2018, BMPI and BMPG are both classified within the AIC Flexible Investment sector (they were historically in the AIC Global Equity Income and Global sectors respectively). Given the broad mandates of the portfolios, Hewitt believes that the current classification is more suitable. In Exhibit 13, we show the funds in the Flexible Investment sector with track records longer than 12 months. While the 17 peers have different investment remits, a comparison has some relevance. BMPI’s NAV total return is above average over 10 years (ranking fifth out of 16 funds – 53.4pp above the mean), while lagging over one, three and five years. BMPG’s NAV total return is above average over three, five and 10 years, ranking fifth and fourth out of 17 funds over three and five years respectively, and third out of 16 funds over 10 years (69.1pp above the mean). BMPI and BMPG are currently both trading at a modest premium, in a peer group where some of the trusts trade on significant discounts. Their ongoing charges are below average. BMPI’s dividend yield is the second highest in the group (1.9pp above average); this is partly due to the income transfer (in exchange for capital) from BMPG.

Historically, there were four independent non-executive directors on BMPT’s board, who were appointed shortly before the trust’s launch in April 2008: Richard Martin (chairman of the board and the nomination committee); David Harris (senior independent director); Colin McGill (chairman of the audit committee); and Alistair Stewart (chairman of the remuneration committee). On 9 July 2018, the board announced the appointment of Sue Inglis as another independent non-executive director. She is a qualified lawyer with a corporate finance background and is the senior independent director of The Bankers Investment Trust and an independent director of Baillie Gifford US Growth Trust.