A total return of 2400% since first investing in a trust might seem like the best of results, but James Johnsen explains, dealing with such success can be a two-edged sword…
As ‘big tech’ hits some regulatory and tax headwinds (a Biden presidency and US anti-trust legislation, adverse tax regulation in Europe, political clampdowns in China), many are asking whether funds like Scottish Mortgage (“SMT”) have seen their best growth days and have only downside risks to contemplate.
We first started adding SMT to Church House (private client?) portfolios in the aftermath of the dotcom crash in the early noughties. SMT was then a circa £1.5bn fund, regularly trading at around 20% discount to net assets. This provided what, only in retrospect, can be seen as a unique entry point.
Side-stepping the crowded debates over valuations in the tech space, ‘new normals’ or the rotation from ‘growth’ into ‘value’; our main preoccupation relates to where a massive outperformer like Scottish Mortgage has significantly skewed preferred asset allocations, or where CGT issues have clouded essential risk management disciplines. A recent case study illustrates the issue.
A real life SMT holder
Our client, Mr. F, had built up significant capital over his working life developing and eventually selling an engineering company. To this was added the proceeds from one or two property deals. Having taken significant risks with his ‘working’ capital during his years in employment, Mr. F’s main priority was capital preservation. However, having significant wealth (including property assets) he felt comfortable exposing one of his main portfolios (which included a ‘joint’ £1m ISA pot) to a long-term, moderate risk mandate. He therefore chose to be invested at Risk Level 5 on the Church House scale of 1 – 10, (with 1 traditionally consisting of a portfolio of gilts and 10 being highly speculative. Most Church House clients are invested at Risk Scales 2 - 8).
In 2003, along with all other clients on this scale, 3% of the then total 18% overseas equity allocation was switched to SMT. This fund had originally attracted our CIO’s attention because it was run by a manager, James Anderson, with a broader world view, a differentiated approach and a healthy disdain for benchmarks – all attributes that reflected our own approach and which we knew would resonate with our clients.
SMT’s growth record has been nothing short of stellar since, producing a total return of 2400% since 2003. But, as the graph below shows, not always in a straight line. As ever, the key has been to stick with the fund and its strategy; the manager has never wavered from it so nor should long-term investors.
There have been some notable opportunities where the fund has traded at a premium to net assets and in these instances a bit of judicious ‘top-slicing’ of profits has been undertaken, although this has often been constrained by CGT allowances. We have also added the fund continuously in newer portfolios over the years, especially when the discount opened up.
In the case of Mr. F, despite the occasional profit taking to re-balance weightings, such was the growth of the fund that his 3% allocation had by 2020 grown to nearly 20% of his total portfolio. This was clearly too weighty a risk for a moderate, balanced portfolio. When Tesla accounted for 14% of the fund in the summer of last year, it became time to take radical action and so a planned programme of disposal of over half the holding was made, with the resultant CGT being provisioned for within the portfolio. The tax hit is substantial (£200k+), but as the client ruefully agreed, it is only a reflection of the extraordinary success he has enjoyed (and if the Chancellor is tempted to raise CGT rates, then the bitter-sweet tax aftermath will suddenly taste less bitter).
Where next then?
Of course, this left the problem of how to reinvest the net proceeds. Clearly, most of these have been allocated to other asset classes to re-establish the correct weightings for the risk scale. But within this section of the global equity bucket, we have favoured Monks Investment Trust over the past couple of years, as a lower risk alternative to Scottish Mortgage. Monks is a low-charging investment trust also run by Baillie Gifford and shares several stocks with its stable mate, but does not have the latter’s high allocation to unquoted stocks and is not quite so concentrated in tech.
This better reflects the risk parameters (including liquidity requirements) of many of our client risk profiles. However, Monks has also enjoyed consistently excellent performance and now regularly trades at a premium making it harder to buy too. But there are still days when even funds like Scottish Mortgage can be bought if one monitors the discount/premium situation closely (see lower graph) so there are always ways to gain exposure if you are patient and firmly fixed on a long-term holding strategy. As I write, SMT fund trades on a small discount to NAV (-1.8%).
As ever, the key in running such portfolios, is not so much in worrying about funds like SMT but more in carefully building in the optimal blend of asset classes less correlated to equities, notably in fixed interest, absolute return and infrastructure. If these are managed correctly, then they should buttress the portfolio in times of market stress and additionally provide a stable income return on top of the capital growth generated by the equity allocations.
In summary, long-term holders of Scottish Mortgage should not worry so much about the debate surrounding valuation of ‘big tech’ or the demise of ‘growth’ as to the more fundamental question of whether their holding truly reflects their risk profile in the long term. As we often try to explain to new clients, successful investment management is mostly about effective risk management, or protecting the downside in rough weather so that your portfolio is in good enough shape to participate in the upside when the winds blow in your favour.
The contents of this article are for information purposes only and do not constitute advice or a personal recommendation. Investors are advised to seek professional advice before entering into any investment decisions. Please also note the value of investments and the income you get from them may fall as well as rise and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future. performance.