Don’t underestimate the importance of diversification

3 mins. to read
Don’t underestimate the importance of diversification

We all know how important it is to have a diversified portfolio, but even if you invest in relatively uncorrelated funds it does not mean that they are without risk. In the last few weeks there has been a series of completely unconnected events that have had a negative impact on a number of income generating investment trusts that will have affected investors’ portfolios.

At the end of July the government announced that it would ban new-build houses being sold as leasehold and that ground rents on flats could be cut to zero. This followed widespread anger over the exploitative contracts that were being offered by some of the large housebuilders.

The news came as a blow to Ground Rents Income (LON:GRIO), a London-listed investment trust that aims to pay a rising income from a portfolio of ground rents, with the shares down around 10% since the announcement. It is difficult to predict the full extent of the impact on the fund, although the management has estimated that the negative sentiment could reduce the NAV by about 4.5%.

During the recent Labour Party conference, the Shadow Chancellor John McDonnell made the surprising announcement that if elected they would ‘bring existing PFI [Private Finance Initiative] contracts back in-house’. The briefing note said that they would ‘review, in conjunction with local authorities, NHS Trusts and other public bodies, all PFI contracts’ and ‘consult on appropriate methods’ for returning the ownership and responsibilities of SPVs [special purpose vehicles] to the public sector, with shares-for-bonds nationalisation the preferred approach.

PFI is a way of creating public–private partnerships by funding public infrastructure projects with private capital. It is a controversial area because of the high costs, with many of these contracts paying a high inflation-linked income. Some of them are owned by investment trusts operating in the infrastructure sector such as HICL Infrastructure (LON:HICL), International Public Partnership (LON:INPP) and the John Laing Infrastructure Fund (LON:JLIF).

The shares in these funds have fallen 3% or 4% since the news, but the broker Canaccord Genuity is “unconvinced by the practicalities of nationalising PFI contracts given the complexities involved and the significant compensation that would be required to terminate these contracts.”

It is a controversial area because of the high costs, with many of these contracts paying a high inflation-linked income.

Another market moving event was the devastating series of hurricanes that has hit the US and the Caribbean. This has had a severe impact on shares in the CATCo Reinsurance Opportunities fund (LON:CAT), which are down almost 20% in the last few weeks.

CATCo invests in a portfolio of catastrophe bonds, which are securities issued by an insurance or reinsurance company that transfer a specified set of risks to the investors. A typical example would be a loss arising from a well-defined natural disaster. If the loss then occurs, investors would not get all of their money back.

The fund holds a diversified portfolio of these securities to limit the risk from any single event, but the series of storms in the last few weeks has been unusually destructive and costly to repair, hence the severe write-down in the value of the shares.

All of the investment trusts mentioned above have a relatively low correlation with the more mainstream areas of the markets and they all pay a decent level of income, but they are clearly not without risk. When investing in these sorts of alternative asset classes it is essential that you understand and are comfortable with the risks that you are taking with each holding and that you are sufficiently well-diversified to limit the impact on your overall portfolio.

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