3.2.4 Share diversification in practice
Investment trusts and unit trusts were designed to allow small investors the benefits of diversification, when the amounts that they had to invest did not allow them to buy, for example, ten different shares in reasonable quantities.
The earliest British investment trust, the Foreign & Colonial Government Trust (F&C), was founded in 1868 with the declared investment strategy of buying 18 foreign government bonds, from Brazil to Turkey, Egypt to New South Wales, in amounts ranging from 3% to 20% of the value of the overall portfolio. The prospectus read:
The object of this Trust is to give the investor of moderate means the same advantages as the large Capitalists, in diminishing the risk of investing in Foreign and Colonial Government Stocks, by spreading the investment over a number of different Stocks.
It was such a success that it soon had many imitators, primarily investing in fixed-interest securities. Unit trusts, first launched in the UK in the early 1930s, based on a US idea, concentrated on shares rather than bonds, and overtook investment trusts in popularity during the 1960s.
Investment trusts are companies whose shares are traded on the stock market and can be bought and sold by investors. Investment trusts invest in shares whose total market value is called the net asset value of the trust. Interestingly, the market value of an investment trust company’s shares does not have to be the same as the net asset value of the underlying portfolio. The investment trust share price can be at a discount or premium to the net asset value per share.
Consider, for example, an investment trust with a market value of £100 million divided into 10 million shares priced at £10 each. It may, in fact, hold a portfolio worth £120 million, which represents £12 per share. In this case the shares would be trading at a discount of £2 to the net asset value of £12. The size of the discount or premium is what balances demand with supply. Although popular investment trusts may trade at a premium, typically investment trusts trade at a discount. This discount can vary, adding an additional risk to investment. Investment trusts, being companies, can also borrow, which also adds to investment risk.
Unit trusts are structures that hold shares in trust for the beneficiaries, the unit trust holders. Open-ended investment companies (OEICs – pronounced ‘oiks’) are similar but use a corporate rather than trust structure. The value of the underlying investment portfolio of a unit fund is also called the net asset value; but in this case the market price at which the units are bought or sold is the same as the net asset value (with a spread between the bid and the ask price). There is no discount or premium. The balance of supply and demand determines the number of units, so that popular unit trusts grow in size, and unpopular ones shrink. This is why unit trusts are sometimes called ‘open-ended’. In contrast, investment trusts are called ‘closed-end’ because they cannot create additional shares as can unit trusts – unless they make a new share issue in the stock market. Demand for investment trusts is reflected in the premium or discount to net asset value, whereas demand for unit trusts is reflected in the number of units. Unit trust managers have to keep a certain amount of the portfolio in very liquid assets to allow for possible redemptions. Unit trusts do not borrow money.
Life insurance company investment funds are run along the lines of unit trusts and are funds in which investors invest through the wrapper of a life insurance company policy.
Looking at the correlation between returns shows that there are different levels of portfolio diversification. The first is to spread the portfolio across a number of shares, say UK shares listed on the London Stock Exchange, typically spread across a number of different sectors. The next stage is to widen the portfolio to include overseas investments. The idea is that the US stock market is less correlated with the UK stock market than, for example, BP and Vodafone are in the UK. The final stage is to include emerging stock markets, which are even less likely to be highly correlated, for example, the Chinese and Indian stock markets can be argued to have ‘decoupled’ or disconnected from developed economy markets. In building portfolios of shares, fund managers work through these levels of portfolio diversification on behalf of their investors.
As of November 2014, F&C stated that it held shares in more than 500 companies across the globe. It also stated that it invested in another asset class, private equity funds – that is, funds that buy whole companies rather than just shares. International diversification will reduce risk by more than just diversifying across companies in the same country. However, 500-plus companies is a large number when it comes to management costs and monitoring, and it may be that these costs outweigh the diversification benefits of holding such a large number of shares.