Diversification’s downside: resilience has a price

Benjamin Roth’s The Great Depression: a diary isn’t the cheeriest of reads. Roth was a lawyer, practising in the 1930s in Youngstown, Ohio – an industrial town that was home to several steel companies.
 
Booming during the 1920s, it had been badly hit by the Great Depression that began with the financial crash of 1929. Roth’s diary, published in 2009 at the instigation of his son and grandson, meticulously recorded the period from June 1931 to December 1941.

Very much an amateur economist, Roth recorded many of the predictions that were variously made during those years – and fascinatingly, subsequently went back to them as the years passed, to record how they worked out. Reading it over the weekend, I spotted one such update dating from 1962, two decades after the diary closed.

Long-term returns

Coincidentally, I’d picked up Roth’s diary to re-read just after finishing John Newlands’ excellent short history of the Dunedin Income Growth Trust (LSE: DIG), covering the years from its launch in 1873 up to 2018.
 
Newlands, for readers who don’t recognise the name, is something of a historian of the investment trust industry, and the author of the classic text on the subject.
 
Dunedin, he relates, was founded by Robert Fleming – yes, that Robert Fleming, of lauded investment banking firm Robert Fleming & Co – very early on in his stockbroking and banking career. Inspired by the launch of the Foreign & Colonial Investment Trust (one of the world’s very first investment trusts) in 1868, he decided to emulate it, but invest in shares rather than government bonds.
 
And both Roth’s diary and Newlands’ history of Dunedin, I realised, made exactly the same point: the future is unknowable, and predictions about it are often wrong.
 
The best defence against that uncertain future: invest conservatively, invest with an eye for bankable income, and – above all – diversify.

Diversified holdings

Granted, Fleming and his various successors over the years might not recognise some of Dunedin’s largest holdings today: AstraZeneca, GlaxoSmithKline, Diageo, BHP Group, Rio Tinto, Weir Group, National Grid and so on.
 
But they would surely understand the selection principles at work, and which are at work in the many other income-seeking investment trusts that have followed in Dunedin’s wake, sometimes decades later.
 
Murray Investment Trust (founded in 1923), City of London Investment Trust (1891), The Merchants Trust (1889), Lowland Investment Company (1963) – all hold diversified portfolios of large, high-quality, higher-yielding FTSE 100 companies.
 
It’s a policy that has served them well, as you can see. Because if you’re still successfully serving investors’ needs after 100–150 years, you must be doing something right.

Income at a price

And it’s fair to say that here at The Motley Fool we’re fans of investment trusts. I hold a few myself.
 
But equally, we’re aware of their limitations.

For one, they come at a price: although generally cheaper than open-ended investment funds, their managers levy an annual charge on investors, generally in the range of half a percent to one percent of the trust’s value.
 
That may not sound much. But if a trust is yielding – say – 5% after charges, such a fee means that investors’ income would have been 10–20% higher, if they had held the trust’s underlying investments directly, rather than through the trust.

Diluted returns

Yet investment trusts have another, more fundamental, weakness. Because diversification has a downside: risks are spread, but so are returns.
 
The popular City of London Investment Trust, for instance, has 86 holdings. As of its latest quarterly update, only one of these holdings – British American Tobacco – made up more than 4% of the portfolio. Most of the trust’s top ten holdings are of the order of 2.5–3.0%.
 
Put another way, a trust that is so diversified is never going to shoot the lights out from a capital gains point of view. It’s simply too diverse. Income will be resilient and reliable, to be sure. But growth is going to fairly closely track the Footsie as a whole, albeit the higher-yielding part of the Footsie.

And put another way still, once you’ve factored in the typical trust’s charges, it may be better to simply buy a cheap index tracker, where charges are on the order of one-tenth of the typical trust.

Focus finds favour

As ever, legendary investor Warren Buffett sums it up best.
 
“Keep all your eggs in one basket, but watch that basket closely,” he wrote.
 
It certainly hasn’t harmed Buffett’s returns.