F&C Managed Portfolio Trust — Diverse exposure with income and growth options

Exhibit 3, left-hand side, shows the performance of the FTSE All-Share and FTSE All World ex-UK indices over the last 10 years. While posting a strong performance in 2016, the 16.8% total return of the FTSE All-Share index lagged the 30.4% total return of the FTSE All World ex-UK index in sterling terms; for UK investors, the value of overseas equities was boosted by significant sterling weakness during the year. In recent years, the relative strength of US equities has also contributed to the outperformance of the FTSE All World ex-UK index and the US now represents more than 55% of the entire index. Despite a degree of positive revaluation during 2016, equities remain supported by robust consensus earnings growth estimates for 2017. In a continued low interest rate environment, equities have appreciated further so far this year; the market for merger and acquisitions and initial public offerings is buoyant and major equity indices have been hitting new highs both in the UK and US. For investors wishing to have exposure to global assets, funds offering widely diversified exposure with either a focus on income or capital growth may appeal.

FMPT aims to provide income and growth, while spreading risk by investing in a wide range of investment companies, diversified by geography, sector and manager. The majority of shareholders are regular savers and investors with smaller investment portfolios, so the manager is mindful of not taking undue investment risk; the trust now has more than 14,000 individual shareholders.

During FY15, FMPT was increased in size by c 20%; the majority of share issuance was to shareholders of British Assets Trust, who elected to stay invested in an F&C product when British Assets Trust moved to an external manager. During FY16, the size of FMPT was increased by a further c 20%, primarily following its selection as the rollover option for the winding up of the Cayenne Trust.

FMPT comprises two distinct portfolios, which are listed in London – FMPI aims to provide an attractive level of income (FMPI is currently yielding 3.9% versus 3.5% for the FTSE All-Share index) plus capital growth, and FMPG aims to generate long-term capital growth. The unique feature of FMPT is that any net income generated by FMPG is transferred to FMPI in exchange for capital. Both portfolios are managed by F&C, a wholly owned subsidiary of Bank of Montreal. Manager Peter Hewitt has more than 30 years’ investment experience specialising in investment companies and has run FMPT since launch, as well as having managed the predecessor managed portfolio service.

FMPI’s and FMPG’s investments are primarily in listed closed-ended funds, which gives investors access to a very broad range of underlying investments. The majority of holdings comprise equity investments although FMPI and FMPG are permitted to invest in other securities issued by investment companies. There are no geographic or sector restrictions, and both FMPI and FMPG are concentrated portfolios holding a minimum 25 investments (generally c 40). No holding at the time of investment may exceed 15% of NAV and a maximum of 20% in each portfolio may be invested in any other F&C fund. Derivatives may be used for efficient portfolio management, including protection against market falls. Gearing of up to 20% of NAV is permitted for both FMPI and FMPG. The benchmark for both of the discrete portfolios is the FTSE All-Share index; FMPI’s NAV total returns have outperformed the benchmark in seven of the last eight financial years, while FMPG’s NAV total returns have outperformed the benchmark in six of the last eight years.

Last year saw a change in market leadership, with value stocks outperforming, following several years where growth stocks led the market. The manager believes this trend will continue at least until the end of 2017 and, although he prefers overseas to UK equities, he has been adding to value-tilted UK equity funds such as Temple Bar Investment Trust in FMPI and Fidelity Special Values in FMPG. He does not have a strong view about the near-term direction of stock markets, noting that events in 2016 such as Brexit and Donald Trump’s success in the US presidential election would have been expected to drive equity markets lower, when the opposite has in fact been true so far. Hewitt suggests that when politics affects markets, it is important to focus on the individual good managers. Over the long term, the manager is comfortable owning trusts with a structural growth bias, such as Finsbury Growth & Income Trust.

Considering the outlook for 2017, the manager suggests that for most equity markets, fundamentals are better than had been anticipated, with investors having greater confidence for an earnings recovery in most regions. Inflation is set to move higher in the UK and US and more interest rate rises are expected in the US over the year. The outlook for the UK stock market is uncertain, given the Brexit overhang, and there is potential for further weakness in sterling.

For FMPI, the manager looks for diversity of income. He believes that in 2017, dividends from UK companies should be strong, as sterling weakness has boosted the value of their overseas earnings. However, he feels this may not be the case in subsequent years, and therefore does not want too much exposure to the big dividend-paying companies such as BP and Shell.

There are some areas for potential investment that have secular growth characteristics, such as biotech and technology. Trusts exposed to these areas are ones that the manager likes to buy and hold for the long term. Even if they see short-term declines in periods of stock market weakness, the profit is often multiple times the original purchase price. As examples, in FMPG, the manager has made significant gains from long-standing holdings Allianz Technology Trust and Polar Capital Technology Trust.

FMPT manager Peter Hewitt has an absolute-return mentality, aiming to preserve capital in difficult markets while growing it in rising markets. If he is cautious on equity markets, he can increase his cash weighting or invest more in non-equity assets, such as lower beta investments in FMPG or infrastructure assets in FMPI, while he is able to employ gearing when he is bullish on the outlook for investment companies. The manager is unconstrained by the benchmark.

For FMPI, there has been a significant broadening of investment opportunities due to the increased number of income-focused trusts in areas such as Asia Pacific, emerging markets and natural resources, and in the FMPG portfolio, there is the potential to invest in new and existing sectors with strong growth characteristics such as technology, biotechnology, flagship funds run by specialist investment boutiques, emerging markets and private equity. Both FMPI and FMPG have a bias to global and overseas exposures. The unique feature of FMPT, whereby income generated at FMPG is transferred to FMPI, means Hewitt does not have to invest higher up the yield spectrum in search of income, and can invest in vehicles with slightly below-average yields due to the income boost from FMPG.

The manager holds some absolute return-focused, multi-asset trusts in FMPG, such as Personal Assets Trust, RIT Capital Partners and Ruffer Investment Company. He notes that growth funds such as Scottish Mortgage Investment Trust will likely underperform in weak equity markets, so when markets de-rate, it is important to have some stabilising investments. Holding these investments in the FMPG portfolio has not impinged too much on relative performance in rising stock markets, while affording a level of protection in falling markets; these trusts are not held in FMPI, as it holds other defensive investments, such as infrastructure.

The manager supplements external research on closed-end funds with his own proprietary research; a key element of which is a rigorous programme of manager meetings. Meeting with management of potential and existing holdings is an important factor in the investment process, both to identify managers who are able to consistently outperform their benchmarks (and FMPT’s benchmark, the FTSE All-Share index), but also to understand the investment processes and styles of the individual managers. While a consideration is made regarding the discount of potential investments, this is not the dominant factor for stock selection, although the manager would prefer to invest at a discount than a premium. When researching a potential investment, the manager considers a series of factors, including the investment company’s objective and benchmark, its dividend policy, whether there is a discount control mechanism, the level of gearing, the use of derivatives and the composition of the board. He is not averse to investing in companies that charge a performance fee if the fee is capped and sensibly structured. The manager has regular input from F&C’s multi-manager team to help form his macro views, although FMPI and FMPG are principally constructed on a bottom-up basis.

As shown in Exhibits 1 and 2, at end-February 2017, FMPI’s top 10 holdings accounted for 32.6% of the portfolio; broadly similar to 32.4% at end-February 2016. For FMPG, over the same period the top 10 exposure was also similar at 29.3% versus 30.3%.

Exhibit 4 shows that both FMPI and FMPG have broad geographic exposure with more than 50% invested in the UK and North America, albeit in different proportions. In terms of changes over the last 12 months, both portfolios have decreased exposure to cash and the UK, with the largest increases in exposure to North America and the Far East & Pacific.

Since the Brexit referendum, there has been a higher level of activity than normal, so in FY17, portfolio turnover in both FMPI and FMPG will be higher than a typical level of c 20% (excluding activity from share issuance).

New positions in FMPI include newly listed BB Healthcare Trust, Renewables Infrastructure Group and niche property specialist, Civitas Social Housing. Hewitt intends to use gearing (at a c 2% cost) to invest in certain infrastructure-related trusts, typically yielding in excess of 5%; this is of benefit to the revenue account. Illustrating the reduced UK exposure over the last 12 months, complete disposals include Merchants Trust,1 Standard Life Equity Income Trust1 and Standard Life UK Smaller Companies1 convertible stock. Along with BB Healthcare Trust, FMPI also owns Swiss-domiciled BB Biotech1, which is able to pay dividends out of capital.

FMPI’s largest position is Murray International Trust (3.9% dividend yield), which is a large global fund managed by Aberdeen Asset Management; it primarily invests in equities, but also holds a selection of fixed income securities. Murray International has a broad geographic exposure with c 40% exposure to Asia Pacific ex-Japan and Latin America/emerging markets. Another top 10 holding is Henderson International Income Trust1(3.1% dividend yield), which aims to provide a high and rising level of income as well as capital growth. The trust is unusual in that it invests solely outside of the UK; around a third is invested in the US.

For FMPG, there are new positions in Templeton Emerging Markets Investment Trust1 and Fidelity Asian Values and disposal of two trusts exposed to the UK: BlackRock Throgmorton Trust and Schroder UK Mid Cap Fund. Although some Asian and emerging market equities have been weak in the near term, as a result of US President Trump’s talk of protectionism, the manager is positive on the asset classes for the long term and considers that they are attractively priced.

FMPG’s largest position is Polar Capital Technology Trust, which invests in a diversified portfolio of global technology stocks across the capitalisation spectrum, although around two-thirds is invested in companies with a market cap above $10bn. Polar Capital Technology’s largest position by quite some margin is Alphabet, which is the parent of Google. Another top 10 holding for FMPG is classified in the AIC’s Flexible Investment sector: RIT Capital Partners, which aims to generate long-term capital return while preserving capital via investment in a variety of asset classes, although more than 50% of the portfolio is in listed equities. The trust has no formal benchmark, and since inception in 1988 has generated NAV total returns of 12.7% pa.

During H117 (ending 30 November 2016), FMPI’s NAV total return of 10.0% was ahead of the 9.6% benchmark total return. The unexpected Brexit vote led to significant weakness in sterling, which boosted the returns from overseas equities to sterling-based investors. The best performers were BlackRock Commodities Income Investment Trust (+34%), which benefited from improving commodity prices, and BlackRock North American Income (+26%), which benefited from a strong US equity market. Exposure to emerging markets also added to relative performance. Most of the detractors to FMPI’s performance in H117 were UK equity funds, such as Aberforth Geared Income Trust (-8%) and Standard Life Equity Income Trust1 (-7%), which has since been sold.

Looking at relative returns in Exhibit 6, FMPI’s NAV total return has outperformed the FTSE All-Share benchmark over one, three and five years and since inception.

During H117, FMPG’s NAV total return of 10.0% was ahead of the 9.6% benchmark total return. The best performers were the Polar Capital Technology Trust (+39%) and the Allianz Technology Trust (+34%); both have good long-term performance track records and have allowed the manager to gain exposure to secular growth in the technology sector. Other strong performance contributors in H117 were US equity trust Gabelli Value Plus Trust (+38%) and Monks Investment Trust (+30%), which is a global trust with c 50% of its assets in the US. The detractors to H117 performance tended to be UK and European trusts with a small-cap bias. These included UK smaller company specialist Strategic Equity Capital (-14%) and European Assets Trust1 (-6%), which invests in mid- and small-cap European equities.

Looking at relative returns in Exhibit 9, FMPG’s NAV total return has outperformed the benchmark over one, three and five years, but has lagged modestly since inception.

The manager notes that he was particularly pleased that both FMPI and FMPG outperformed the benchmark in H117; following the Brexit vote there was a period of meaningful underperformance versus the benchmark (Exhibits 7 and 10), given the portfolios were positioned for a remain vote, meaning they had overweight exposure to UK small- and mid-cap companies.

In normal market conditions, FMPT’s board aims to maintain FMPI’s and FMPG’s share price discounts to NAV below 5%. FMPT has the authority to buy back up to 14.99% of shares of each portfolio in issue annually and allot up to 10% of shares to manage a discount or premium. So far in FY17, share buybacks have been modest – for FMPI, 0.5m shares have been repurchased at a cost of £0.6m and for FMPG, 0.3m shares have been repurchased at a cost of £0.4m. In practice, both FMPI and FMPG have historically traded close to NAV.

FMPI’s current 2.4% share price premium to cum-income NAV compares to an average 0.7% discount over the last 12 months (range of a 2.8% premium to a 2.9% discount). The premium is modestly higher than the average of the last three years. Over the last five years the share price has averaged the level of the NAV.

FMPG’s current 1.1% share price discount to cum-income NAV compares to an average 0.5% discount over the last 12 months (range of a 4.0% premium to a 3.2% discount). The discount is wider than the average 0.5% premium of the last three and the 0.5% discount of the last five years.

FMPT comprises two portfolios – FMPI currently has 41.6m ordinary shares in issue, with a further 0.9m shares held in treasury, and FMPG has 33.7m ordinary shares with a further 0.6m in treasury.

During FY16, FMPT was selected as the rollover option for the winding up of the Cayenne Trust, which led to a c £12.9m inflow, (increasing the size of the trust by c 20%) with c £7.0m into FMPI and c £5.9m into FMPG; shares were issued at a c 0.85% premium to NAV. This follows a c 20% increase in the size of FMPT in FY15 as a result of shareholders electing to stay invested in an F&C product when British Assets Trust moved to an external manager.

On 10 February 2017, FMPT announced it had entered into a £5m five-year loan facility with Royal Bank of Scotland at a fixed interest rate of 2.03%. This replaced a £5m unsecured revolving credit facility; the new facility was fully drawn down by FMPI. FMPT also entered into a £2m two-year unsecured revolving credit facility with Royal Bank of Scotland. Gearing of up to 20% NAV is permitted at both FMPI and FMPG.

F&C is paid an annual management fee of 0.650% pa of total assets in each portfolio, payable quarterly in arrears. The fee is reduced to 0.325% pa on any investments that are managed by F&C. For FMPI, the management fee is split 60:40 between capital and revenue; for FMPG, the split is 80:20 respectively. A 10% performance fee is payable on the excess total return of FMPI and FMPG versus the benchmark total return. It is capped at 0.35% of the total assets of the relevant portfolio, is charged 100% to capital and is only payable if the NAV has increased over the financial year or, in the case of FMPG, its NAV is higher than that at the date of the trust’s inception and higher than the start of the financial year (the watermark NAV). If the watermark NAV has not been achieved by the end of the fourth financial year following the award of a performance fee, the performance fee will be forfeited. Any underperformance of either FMPI or FMPG versus the benchmark must be made up in any subsequent financial year before any performance fee is payable, thus creating a high watermark for the relative performance versus the benchmark.

In FY16, FMPI’s ongoing charge was 1.09%, which was a 7bp reduction versus the prior year; FMPG’s ongoing charge was also 1.09%, which was a 6bp reduction year-on-year. The reduced ongoing charge was helped by the rollover of Cayenne Trust, which enlarged FMPT by c 20%. It should be noted that the current ongoing charges are significantly lower than five years ago; in FY12 FMPI’s ongoing charge was 1.44% and FMPG’s was 1.59%.

Shareholders have the right to convert their income shares into growth shares and vice versa annually in October. This is subject to certain minimum and maximum thresholds; to date the minimum limit has not been achieved and so there have been no conversions.

All income accrues to FMPI; any net income generated from FMPG is transferred to FMPI in exchange for an equal amount of capital. The transfer has no tax implications for shareholders, as both trusts are held in the same capital structure. This strategy boosts the income prospects of FMPI and the capital growth potential of FMPG. The natural yields of the underlying portfolios are c 4% for FMPI and c 1-2% for FMPG.

FMPI’s dividends are paid quarterly in October, January, April and July. In FY16, the annual dividend of 5.20p was 4% higher than FY15 and was 1.08x times covered by revenue (1.17x covered in FY15). Annual dividends have risen for five consecutive years. At the end of FY16, the revenue reserve was c 43% of the annual dividend cost, which provides a buffer in the event of lower revenue generation. So far in FY17, three dividends have been declared – 1.25p per share in each quarter, which is a 4.2% increase versus the prior year; the fourth interim dividend will be declared based on the actual income for FY17. FMPI’s current dividend yield is 3.9%, which is higher than the yield on the FTSE All-Share index (3.5%).

FMPI and FMPG are members of the AIC Global Equity Income and Global sectors respectively. However, these sectors contain a range of funds with differing mandates and geographic exposures. For example, FMPI has higher UK exposure and lower North American exposure than the Global Equity Income peers. The manager suggests that he would find it challenging to have significantly less UK exposure, as there are not enough high-quality income-focused trusts with no UK exposure in which to invest. He also stresses that for both FMPI and FMPG, although they invest globally, the aim is to generate higher total returns than the FTSE All-Share index.

In Exhibit 13, we highlight a selection of investment trusts that invest in collective vehicles. Although they adopt different strategies, we believe that a comparison has some relevance. FMPI lags the peer group average over one, three and five years, while FMPG is ahead of the peer group over five years and behind over one and three years. FMPI is one of only two peers trading at a premium and FMPG has the narrowest discount in the group; their ongoing charges are broadly average. FMPI has higher gearing than average and has the highest dividend yield in the peer group and as discussed in the body of the report, any net income generated by FMPG is transferred to FMPI in exchange for capital; therefore it does not have a dividend yield.

There are four directors on the board of FMPT; all are non-executive, independent of the manager and were appointed on 22 February 2008. Chairman Richard Martin is an adviser to several family groups and is a director of Aurora Investment Trust. The senior independent director is David Harris; he is CEO of specialist investment and marketing group InvaTrust Consultancy and is a non-executive director on other boards including Small Companies Dividend Trust and Manchester and London Investment Trust. The other two board members are Colin McGill, who is a qualified lawyer and accountant, and Alistair Stewart, who is also a qualified accountant.