We know that rising interest rates are on the way, but not yet whether they will be successful in taming inflation or avoid pushing the global economy into recession. The outcome of the war is unknown at this stage and it is far from clear to me that all the bad news is priced in. Yet it was ever thus. Diversification will work its magic while we wait for better news to emerge, which in due course it always does.

The quote on the left hand page was the conclusion of my article in this publication a year ago and while I chose my words carefully, fearful as I was of a poor year ahead, my conclusion turned out to be not quite right in one respect. We certainly saw interest rates rising rapidly as the Bank of England and other central banks struggled to control peak double – digit inflation, with painful knock on consequences almost everywhere you looked.

A year on from the Russian invasion, the war in Ukraine also remains deadlocked, and despite heroic Ukranian resistance there is still no obvious end in sight to that unhappy conflict. So, while there has been plenty of bad news for investors to absorb, it was not that great a year for diversification either, at least in the conventional sense, since the biggest asset classes – equities, bonds and real estate – have on average all declined together.

The fourth bear market since 2000

There have however still been safe havens to be found, principally in gold, the dollar, energy and commodities, but also in a handful of equity markets, including the UK. Investors needed therefore to be much bolder and more wide-ranging in their diversification efforts to avoid suffering losses in an exceptionally poor year. The global equity market decline of the last 15 months is the fourth bear market we have experienced since 2000, while losses in the bond market as bond yields have surged higher have been the most dramatic in living memory.

In the investment trust world, the impact of falling prices across many asset classes was compounded by a significant widening of discounts. At the time of writing in March 2023, the average discount on the 180 or so trusts in the FTSE Closed End Investment Trust index has widened out to 16%, compared to just 2% at the start of 2022. Some of the biggest and most popular trusts of recent years, such as Scottish Mortgage and Polar Capital Technology, have been particularly hard hit, dragging down the index average, which is weighted by market capitalisations.

Many of the sub-sectors that did best in 2021, such as technology, China and biotech, have been among the ones that have done worst since. Among alternative assets, discounts on commercial property and private equity trusts have also widened notably. A combination of rising interest rates and deteriorating economic fundamentals is the worst combination for those two asset classes, underlining the need to be selective when choosing names in those sectors.

Patience is required

The double whammy of falling Net Asset Values and widening discounts is an inherent characteristic of the investment trust sector when markets fall, but needs to be seen in the context of longer-term historical experience. Investors in trusts spend more time enjoying the benefits of the double whammy on the upside than they do on the downside and so patience is required to see out the inevitable greater volatility that comes with the territory. The advantages of the investment trust structure come through in superior performance over those longer periods.

Against this turbulent and difficult background, some trusts stood out for their resilience over the past 12 months. Large defensive trusts, all of which aim for steady positive returns in all kinds of market conditions, have mostly held their value pretty well, and some other trusts in the flexible investment sector have managed to make gains by reading the macro environment correctly.

Other strong performers across the universe included several UK equity income trusts, which after a number of years when their style was out of favour, came back into their own, reflecting the resilience of their dividends and the relatively strong performance of the UK’s FTSE 100 index, in which their holdings are concentrated. In the global equity income sector Murray International, managed by Bruce Stout, has also performed strongly.

In a period characterised for most of last year by much higher energy prices, renewable energy trusts also did well in NAV terms until the second half of the year, although their shares have moved to discounts more recently in the face of higher interest rates, windfall profit taxes imposed by the UK and EU governments and evidence that oil and gas prices are weakening once more.

With only a handful of exceptions, small and mid cap equity trusts in contrast suffered the worst of the double whammy, with share prices tumbling as both NAVs and discounts deteriorated. Overall, around 80 out of the more than 400 trusts tracked by my data provider recorded a positive share price return in the 12 months to mid-March 2023. That number increased to 125 on a total return basis, after taking dividends into account. While the majority have been in negative territory, therefore, more than a quarter have still delivered positive total returns.

Inflation months away from more normal levels

The question on everyone’s mind is how long the current difficult market conditions are likely to persist. The pension fund crisis that followed the disastrous Truss government interlude and recent bank failures have highlighted potential frailties in the global financial system, triggered by rising interest rates. Inflation remains months away from returning to more normal levels and central banks continue to face the same dilemma – how to trade off the need to drive down inflation against the risk of doing so inducing a recession – as they did when I was writing a year ago.

My personal view at the end of 2021 favoured moving into defensive and higher-yielding asset classes, given high valuations, the risk of rising inflation and the belated reaction of central banks. Fortunately, that turned out to be the right thing to do. While I am less confident in my opinion than I was a year ago about the outlook, instinct and experience lead me to think that, My personal view at the end of 2021 favoured moving into defensive and higher yielding asset classes, given high valuations, the risk of rising inflation and the belated reaction of central banks. Fortunately, that turned out to be the right thing to do. While I am less confident in my opinion thanI was a year ago about the outlook, instinct and experience lead me to think that, while bond yields may well have peaked for now and bonds should return to being a safer haven, we have probably still not seen the worst of the current equity bear market.

Sitting tight

Investors with a genuinely longterm horizon are never wrong to sit tight through deteriorating markets, confident that over time they will be more than well recompensed. Those with a shorter time horizon or a more activist approach may still however wish to wait a little longer for the market to turn. When that happens – maybe later this year, maybe early next – they will be well placed to enjoy the double whammy of rising NAVs and narrowing discounts working in their favour once more.

UK small cap trusts and a number of alternatives look particularly well placed to enjoy that next phase to the full when it comes, although trusts with high gearing, short track records and weak balance sheets should best be avoided for now. The great advantage of the investment trust sector is the variety of options that it presents and the scope for diversification across styles, regions and asset types it offers. Notwithstanding the unusual circumstances of the last 12 months and the still uncertain times that lie ahead, the medium- term outlook remains positive although trusts with high gearing, short track records and weak balance sheets should best be avoided for now. The great strength of the investment trust sector is the variety of options that it presents and the scope for diversification across styles, regions and asset types it offers. Notwithstanding the unusual circumstances of the last 12 months and the still uncertain times that lie ahead, the medium-term outlook remains positive.

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Important information

Risk factors you should consider prior to investing: 

• The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested. 
• Past performance is not a guide to future results.