19 Apr 2009 | History

Investment Trusts - Storms of the Past  

Investment trusts have been relatively resilient during previous financial crises.  Claire Swan explains why.

“Put not your trust in riches but put your riches in Trust”, said John Guild, the first chairman of the Alliance Trust. In the current financial climate, Guild’s words still ring true. The historic experiences of British trusts are both encouraging and pertinent.

The First Trusts

When the first British investment trust – the Foreign and Colonial Government Trust – was established in 1868, the proposal was to give the investor of moderate means the same advantage as the large capitalist in diminishing the risk of investing in foreign and colonial government stocks, by spreading the investment over a number of different stocks.

Robert Fleming created the first Scottish-registered trust, called the Scottish American Investment Trust, in Dundee in 1873. The company was described as the first Association in Scotland for investments in American railroad bonds, carefully selected and widely distributed, and where investments would not exceed one-tenth of the capital in any one security. Guild, who was also one of the four Scottish American trustees, apparently reported that ‘while in this country you could not lend money on first-class railway debentures at over four or 4.5 per cent, in America you could get seven per cent with the best security of this description.’

Investing in this diversified manner ensured that no stock dominated the portfolio. For instance, a shareholder in the Scottish American Investment Trust with a single £100 certificate had an interest in around 30 different securities, with less than £3 per £100 certificate on average in any one investment.

Only five years later, Scotland faced the first major banking crisis of the period. On 1 October 1878, the respectable City of Glasgow Bank closed its doors after heavy investment in the US railroad industry had aided its failure. The bank fell foul to the consequences of lack of diversification and amassed debts of over £5m. Several of the bank’s directors who had been making fraudulent transactions were later imprisoned.

In 1890, Barings also faced collapse after a series of defaulting loans to Latin America, such as those to Argentina’s President Julio Roca. Roca’s intention was to create the ‘Paris of South America’ by implementing expansive and expensive transport and public infrastructure works. Barings Bank funded most of this to the tune of around £38m. The Bank of England had to rescue it with an £18m bailout, living up to Walter Bagehot’s view of it as the ‘lender of the last resort’.

Prudent Management

Research suggests that in 1890, there were nine investment trusts registered and operating in Scotland with average annual returns calculated as being between four and five per cent. The Scottish American Investment Company is estimated to have yielded between 5.5 and 7.5 per cent annually, even during years of crisis up to 1929. In fact, the Scottish trusts’ overall performance seems to have been better than many parts of the economy, including other Scottish companies investing in American land and cattle ventures. The trusts are said to have even maintained their dividends throughout the First World War.

Another facet of their prudent management was their reserve funds. Rather than distributing all their profits, the remaining net income, after the fixed and prudent ordinary dividends were paid, was placed into a reserve fund to be kept for a rainy day. So even when profits were low, trusts were still able to pay a dividend.

In addition, any capital profits, which were tax exempt, were placed into a capital reserve from which dividends could not be paid, so protecting and enhancing the shareholders assets.

The Dow Jones Industrial Average suffered great losses following the infamous 1929 stock market crash and by mid-1932 it had lost almost 89 per cent of its value. However, the Scottish trusts’ revenue reserves left them in a strong position to continue to pay dividends.

Some American trusts fared less well, such as Goldman Sachs Trading Corporation, financier of a number of American investment trusts, whose share price fell from $104 before the crash to just under $2 by 1932. Research suggests that by this time, the number of trusts in Scotland had increased four-fold since 1890, yet yields remained stable.

More recently, the trusts’ closed-end mechanism has helped them through particularly tough times, as in 1987 when global equity markets panicked after a long run up, and the Dow Jones fell on one day by 22 per cent. By contrast, an open-ended fund, such as a unit trust or an OEIC, has to contract or expand as the investor sells or buys units in that fund. At times of panic, such as in 1987, many people decided to sell at once, forcing OEIC managers to reduce their funds’ holdings and putting further pressure on the market value for remaining investors. An investment trust, however, has a fixed share capital where the sold shares are transferred to another holder in the market; the investments of the trust itself do not have to be traded, and can await a later upturn in fortunes.

Long-term initiatives and strong safety mechanisms have worked well for many traditional Scottish trusts during previous financial storms. If history is anything to go by, the wise old words from over a century ago may still be true today.

Claire Swan works for Baillie Gifford as an investment operations graduate. Claire is writing her PhD on the origins and development of the Scottish investment trust industry to 1914 and has recently been awarded a Carnegie Scholarship. This article refers to research conducted as part of her PhD studies.

The views that are expressed in this article should not be taken as fact and no reliance should be placed upon these when making investment decisions. They should not be considered as advice or a recommendation to buy, sell or hold a particular investment.

This article contains information and opinion on investments that does not constitute independent investment research and is, therefore, not subject to the protections afforded to independent research.

Investment markets, including currency exchange rates, can go down as well as up and market conditions can change rapidly.