It has been a volatile couple of years in the stock market – and it may stay that way for a while. I have been thinking about how well my portfolio is positioned for any future market volatility.
One of the questions on my mind is whether owning shares in some investment trusts could boost my returns in turbulent times. I think the answer depends partly on my investment approach and objectives. Here, I’ll explain why.
Diversification
One of the benefits of an investment trust is that it offers me diversification. A trust will often invest in dozens of companies. Sometimes it may even own shares in hundreds of different businesses. Buying shares in such an investment trust can offer me a level of diversification I would struggle to achieve as a private investor.
But is that good or bad when markets are choppy? The general principle is that diversification helps to reduce risk, by limiting the impact of any one investment performing poorly. That would be true for an investment trust.
But if the market overall goes down and a trust owns hundreds of different companies, it may well lose value broadly in line with the market. Actively picking companies that do well even in a tough market may help a trust’s performance . But I think it is optimistic to expect that investment trusts with very broad holdings will not suffer at least to some extent when the market tumbles.
Smoother income potential
If income was my main focus as an investor, one benefit I could receive by owning shares in investment trusts is the potential for dividend payments less immediately affected by business performance.
That is because the rules of such trusts basically allow them to hold money in reserve to make dividend payments in years when their own dividend income falls. That helps explain long periods of stable or growing dividends from investment trusts like Scottish Mortgage and City of London.
But I see that as a relatively short-lived benefit. Reserves can only last so long. Ultimately, over the long term, these investment vehicles cannot consistently pay out more than they earn themselves. Still, I do see some appeal in the idea of a trust being able to sustain its dividend for a couple of years while it rides out a stock market storm.
Actively-managed investment trusts
One of the things many investment trusts offer is active management of their portfolio. Typically as a shareholder, I would pay an annual management fee. That would help fund professional managers tasked with finding shares to buy for the trust.
The right manager could help a trust do well even in choppy markets. But the difficulty is finding one or more with such management. Past performance is not a guide to what will happen in future. Indeed, periods of market volatility can be exactly what cause a previously successful investment strategy to come unstuck.
So although owning shares in actively-managed investment trusts could help me to ride out bumpy times in the market in theory, there is no guarantee that it would in practice. That would depend on which specific trusts I decided to buy.
