Scottish Mortgage Investment Trust – Must Read Before Investing

The Scottish Mortgage Investment Trust is a massive fund with impressive returns, a long history and most importantly a compelling investment philosophy.

Dare I say, its our version of Cathie Wood’s Ark Innovation fund. And dare I say, it could be a more compelling proposition. Let me explain.

These days, you often hear about survivorship bias with investment funds. This is where people only focus their attention on the winning funds, whilst at the same time ignoring the losers.

Loads of funds fail, and get resigned to the pages of history. Only the fittest survive or as Burton G. Malkiel says in his investment classic A Random Walk Down Wall Street:

You can be sure that the surviving funds are the ones with the best record.

Burton G. Malkiel

Now, if that is the case Scottish Mortgage must have been doing something right. That’s because the fund was started way back in the throws of the credit crisis. Not the 2007 to 2009 one I might add, rather the 1907 to 1909 one!

You read that right! Their Investment Trust has been going for over a century and is still going strong today. It is even part of the FTSE100 index.

What’s the motorcar got to do with the price of fish!

The fund was started in 1909 to lend to rubber plantations in the Far East. You see back then, way before the likes of Amazon or Tesla, putting your money into a big disrupter was investing in a new fangled technology called the motorcar.

Scottish Mortgage Investment Trust (SMIT) was betting on a future world where transport would be dominated by four wheeled transport. Of course it was a bet that paid off.

So when you scan your eyes across a list of the companies they invest in today. Names like Amazon, Alibaba and Tesla it’s pretty evident that they’ve kept the original philosophy pretty much in tact.

Scottish Mortgage take a long term high conviction futuristic approach to investing. The trust chooses companies that have the potential to shape the world in which we live for a long time to come.

Certainly sounds convincing, but before you rush off and stick all your savings in this trust there are few things worth thinking about.

First and foremost is the fact that this is an investment trust.

Investment Trusts

Investment trusts are companies that trade on the stock market. If you want to invest in an investment trust you need to buy shares in the company.

They have a number of advantages and disadvantages when compared to other types of funds such as Exchange Traded Funds (ETFs) or Mutual Funds (often called Open Ended Investment Companies [OEICs] or Unit Trusts in the UK) .

The first advantage is the very fact that they are a company. This means they have a board whose job it is to ensure the fund is being run for the benefit of the shareholders. These shareholders are simply investors who buy shares in the investment trust.

The Long and Short of it

In the case of Scottish Mortgage the board is a highly distinguished. Most noticeably the five members include a certain John Kay. As well as being a word famous economist, he is also an author. His The Long and Short of it is a fantastic investment guide.

Companies and investment trusts are also obliged to provide detailed reports that have been independently audited.

This provides investors with access to all kinds of information that wouldn’t be available with other types of fund. Not to mention the fact that as an investor you even have shareholder rights, meaning you can actually vote to help influence decisions.

It’s interesting that investment trusts tend to be much less well known than other types of funds, namely OEICs and Unit Trusts. The reason is they don’t pay commissions, which in turn means less people write about them or advertise them. People don’t like doing things for free!

Why this becomes important for investors is because it means investment trust’s ongoing charges aren’t typically as high as Mutual Funds, OEICs or Unit Trusts.

Closed Ended

Another key characteristic of investment trusts is that they are closed-ended rather than open ended like OEICs and Unit Trusts. As a result the number of shares the trust is divided into is limited.

This is important when it comes to investors adding or withdrawing their money. When money flows into other types of funds they automatically generate more shares. And likewise when money flows out shares are deleted.

Investment Trusts don’t do this. Consequently, they don’t have to buy more shares whenever there is an inflow of funds. And likewise they don’t need to sell more shares whenever there is an outflow of funds.

This matters, because as markets go up people tend to get excited and want to invest more, so more money flows into funds. Similarly, when markets are dropping people tend to panic and want to pull their money out which means money flows out of funds.

The crux of all this is that other types of funds don’t have any control over when they buy and sell, whereas investment trusts have total control over their buying and selling decisions.

This enables investment trusts to choose more opportune times to buy and sell shares, which in turn, means all things being equal, that they should be able to achieve better returns than their contemporaries.

Discounts and Premiums

Due to the fact that that the number of shares in an investment trust is fixed, the share price doesn’t necessarily correspond to the underlying assets. Instead, the shares can trade at a discount or premium to the value of the actual shares in companies they have bought.

As an example, let’s assume an investment trust called BEM contains a single share in Apple. That Apple share is worth £1000, so it figures that BEM’s shares should also be worth £1000 and if there were two investors in BEM shares should be worth £500 each.

However, it doesn’t work quite like that. If BEM is popular the shares are likely to cost more than £500, but if it is unpopular the shares are likely to cost less than £500.

Reasons for over and undervalue tend to follow the funds performance, but there are many reasons why a fund could be over or undervalued.

A superstar fund manager leaving the trust could push the price of shares down. Similarly, the shares of the fund this superstar fund manager joins could rise.

Sharp eyed readers may already be seeing the potential for increased returns by purchasing a fund’s shares at a discount and that’s right. It is possible to use this method to increase returns.

In fact, many investors buy shares in investment trusts when they are trading at a discount in the hope that the discount will narrow towards the price of the underlying assets.

That said, the very fact that these shares can trade at a premium or discount means investment trusts are often considered risker than other types of funds.

Incidentally, right now SMIT shares are trading at a slight premium of 3%.

Cash is King!

Another benefit of investment trusts is that they can hold cash on the side. Maybe they can use this cash to take advantage of opportunities that present themselves in the market, or maybe they can continue to pay a dividend whatever the weather.

On top of that, unlike OEICs or Unit Trusts, investment trusts are more like ETFs in that they don’t have initial charges.

That’s not to say they don’t have any charges. Investment trusts are classed as shares and in the UK you need to pay stamp duty when you buy shares.

You have to pay 0.5% stamp duty at purchase and as with all investments there will also be some additional buying and selling costs associated with the broker you use. (You can read more about fees here.)

Usually the most important cost consideration with any type of investment fund is going to be the Ongoing Charges Figure (OCF), and this is where Scottish Mortgage Investment Trust shines, because they’ve deliberately kept the fees low.

Right now the OCF is 0.37%. This active fund is much cheaper than some of its competitors like Lindsell Train Global Equity or Fundsmith Equity.

In other words, you are paying index tracking fees for a highly experienced proven active management team.

Leverage

Another important characteristic of investment trusts is that they can borrow money. Now, whether this is an advantage is debatable.

On paper investment trusts borrow money to magnify their investment returns. Certainly, if used carefully, this leverage (sometimes called gearing) can be a straight forward way to increase the return on an investment.

As an example, if you have £100 invested and it goes up by 10% you’ll have £110. You’ll have made £10. However, if you borrowed £100 from the bank at a 2% interest rate to go with your £100 pounds and your investment goes up 10% you’ll have £220.

Taking away the £100 you borrowed from the bank and the 2% interest of £2 you’ll have made £18. You’ve almost doubled your return by simply borrowing money.

Investment Trusts can do this large scale, but gearing isn’t always considered to be a good thing, though.

Magnifying returns is all very well in the good times, when your profits are increased. However, it might not be so good in the bad times when your losses are magnified to just the same extent.

Right now SMIT gearing is about 9%.

The Good!

A lot of people like to see investment trusts with a management team in place from the beginning. However, seeing as how Scottish Mortgage Investment Trust has been going for over 100 years, perhaps that is a little too much to ask.

Even though, they’ve not been there since the start, the team running the show have been there long enough to put most investors at ease.

The fund is managed by James Anderson and Tom Slater. Anderson has been at the helm for nearly 20 years now and Slater has been deputy manager for nearly a decade. He became joint manager with Anderson in 2015.

Anderson has a degree in history from Oxford and a master of arts in international affairs and Slator has an undergraduate degree in computer science with mathematics from Edinburgh, merging art and science backgrounds.

Both are partners in Baillie Gifford which runs Scottish Mortgage Investment Trust alongside lots of other investment funds.

Anderson also founded a group called the Long Term Global Growth Strategy Team in 2003, which suggests the two managers have a wealth of resources to call up on.

Here’s what the people behind the fund say:

Scottish Mortgage is an actively managed, low cost investment trust, investing in a high conviction, global portfolio of companies with the aim of maximising its total return to its shareholders over the long term. The managers aim to achieve a greater return than the FTSE All-World Index (in sterling terms) over a five year rolling period. The majority of the portfolio will be held in quoted equities and up to a maximum of 25% of the assets may be invested in companies not listed on a public market (measured at the time of purchase).

Scottish Mortgage Investment Trust

The fund has pretty much the same mandate as it did in the beginning. Choosing to invest in rubber to take advantage of the long lasting economic trend being brought about by the ultimate disruptor, the motor car, set the foundations for the kind of investments SMIT makes today in companies like Amazon, Alibaba and of course Tesla.

There’s a lot of talk these days about closet index funds. This is where fund managers charge investor’s high fees for funds that track indices. These investors could skip the fees and invest in index tracker themselves if they really understood the situation.

However, the team at Scottish Mortgage aren’t afraid to deviate substantially away from their benchmark index. In fact, this fund is just about as far removed from a closet index tracker as you could get.

The management believes strongly in technology and the power it can unleash. Moreover, they aren’t afraid to go in heavy and make strong convictions with big bets on companies they believe in. Amazon for example, currently takes up about 10% of the fund.

The top 10 companies in March 2019 are as follows:

• Amazon
• Illumina
• Alibaba
• Tencent
• Tesla
• Kering
• Netflix
• Ferrari
• ASML
• Ant International

Another important thing to consider is that the fund doesn’t shy away from backing pre-IPO companies. Oftentimes, they make investments before the companies start trading on stock exchanges.

More importantly, for investors, this means this trust gets in early. This is when the possibility to make more money still exists. Recent successes include Dropbox and Spotify for example.

Generally, these are smaller companies and smaller companies tend to be more risky than larger ones. For every Dropbox and Spotify there will be hundreds of companies that inevitably fail and lose investors’ money.

The bottom line is these kinds of companies have the potential for much bigger and faster growth. This in turn can lead to bigger investment returns, but they also have the potential to crash and burn. More risk, but more reward!

That said this approach seems to be paying off so far. Here is the performance of the fund since March 2014:

As you can see the fund has easily outperformed the FTSE All-World Index over the recent 5 year period.

The Bad!

So far so good, but as with anything in life, there are drawbacks.

The first is concentration, geographic, company and sector concentrations all have their issues. Half the fund is focused in North America and over 20% in China. In essence, you have 70% of the fund focused in just two countries, and that at the time of writing are in the midst of a trade war!

On top of that, the fact that one of the countries is still developing brings with it different risks.

Many people like the idea of investing in China because they see its rapid GDP growth. However, investing in China brings dangers to do with governance and liquidity. It’s also worth thinking about the fact that GDP growth doesn’t necessarily equate to stock market growth.

In fact famed US Professor Jeremy Siegel, in his book Stocks for the Long Run says the opposite is true:

It will probably surprise readers to learn that there is a negative correlation between economic growth and stock returns, and this finding extends not only to those countries in the developed world but also to those in the developing world.

Jeremy J. Siegel – Stocks for the Long Run

Stocks for the Long Run contains a comparison of developing countries between 1988 and 2012. As you may have guessed, the country with the largest real per capita GDP growth was China.

China grew at 9% per year during the period, but if you’d invested in China’s stocks at the same time, you would have lost over 5% per year.

And if you think that was the exception, contrast it with the situation in Mexico, where GDP growth was just over 1% a year, yet stock market returns were about 17% annually.

As well as geographic concentration the fund is heavily concentrated in just a few companies. At the time of writing there are 82 holdings in total, but the largest 30 account for 78% of total assets. At the same time the top 10 take up over 50%of the total portfolio.

If something were to go wrong in just one of those companies the fund’s returns could be impacted heavily.

SMIT sector exposure is shown below:

• Consumer Cyclical 39.36%
• Technology 25.98%
• Healthcare 13.02%
• Financial Services 2.57%
• Industrials 0.91%

The trust is also focused in the Consumer Cyclical and Technology sectors. If something were to hit either of the two biggest sectors the fund could suffer.

It might also be a concern to some investors that the fund has being doing so well recently. Research has consistently shown that investors tend to flock to funds that have done well in the past.

Unfortunately, there is a wealth of research out there that shows that funds that have done well in the past are less likely to do well in the future.

In fact, the better they’ve done and the longer the period of doing well, the more likely a period of underperformance is just around the corner.

There’s no doubt Scottish Mortgage Investment Trust has been a great fund in the past. The problem is, past performance is not a reliable indicator of the future.

The team may be the ones that defy the research and continue to outperform the market. On the other hand, they may not.

And think about this for a minute. If you go with the market you are guaranteed to get the market’s returns. The market has in the past proven to be very generous indeed.

If you don’t go with the market you have a chance to outperform. However, at the same time you have a chance of underperforming. Why take the risk with your hard earned money?

The Bottom Line

The bottom line is this. There’s no doubt that there are some risks associated with Scottish Mortgage Investment Trust. However, at the same time, there are also a lot of reasons to invest in this unique proposition.

The special nature of the fund makes it extremely attractive. In addition, the ongoing charges mean an investment isn’t prohibitive for those like me who think fees matter!

Investors who like the strategy and are prepared to take on the associated risks, might find dedicating a portion of their portfolio to this fund increases their diversification whilst increasing their performance at the same time.

Of course there are a couple of groups of investors out there that this fund probably wouldn’t be appropriate for. Those sensible types who want to avoid taking any unnecessary risks, and those fans of high dividend paying funds. The current dividend yield is a measly 0.6%.

Having said that you can pretty much guarantee that you’ll receive the dividend because SMIT has one of the best track records in the industry in this regard.

Its only cut its dividend once in a century!