2012 forward review - Opportunities & Risks

Paul Locke Investment Trusts
44.20.7050.6709
plocke@canaccordgenuity.com
2012 – opportunities and risks
This is our fourth consecutive annual trust review and it comes after one of the most
tumultuous years for the global economy and the pricing of risk assets in a generation.
It would be a delight for us to argue the case for a strong rebound in both global growth
Inside levels and equity pricing in 2012, but the reality is that, for the west at least,
Global snapshot .................................2 structurally, little has changed thus far.
Key themes.........................................3
Investment trusts ...............................9 In last year’s review we highlighted three key questions for investors:
Overview .......................................... 11 • Can the Euro survive its design flaws?
Portfolio strategy ............................. 20
Other stock picks for 2012............. 24 • What will the level of US commitment be to fiscal orthodoxy (and when)?
Summary.......................................... 28 • What are the prospects for a soft landing in China?
Key data trends for 2011 ............... 29
These questions remain unanswered, which suggests to us continued strong volatility,
uncertainty and risk in the coming year.

Political incompetence and vacillation has left the global economy floundering, with the
risk of renewed recession (or worse) and we think this could continue in 2012 as the US
heads further into its election cycle. We have moved from a financial to a sovereign debt
crisis and almost back again with a series of band-aid (monetary) policies failing to
provide a proper resolution to the key problem of excessive debt and the need for
governments and individuals to deleverage.

Companies have impressed in taking up the slack against a poor economic backdrop
and, in many cases, remain lean and profitable. But, questions remain over forward
earnings as Europe in particular heads back into recession.

Despite politicians’ inability to grasp the economic nettle, we see grounds for optimism,
though this remains on a highly selective asset class and manager-specific basis. We
hope to point out some of these potential “winners” and areas to avoid in 2012 and
beyond in the following pages.

We believe the year ahead offers a number of changes and challenges, not all of which
will be negative. It will be a demanding time for trusts, their managers and boards as
market uncertainties continue but also as we move towards the introduction of the
Retail Distribution Review (RDR) at the year-end. Investors will need to be nimble and
selective to profit from the current market environment, but we are of the view that the
broader closed-end fund sector remains the best place to generate excess returns.

This research note is produced by Canaccord Genuity Limited which is authorized and regulated by the Financial Services Authority (FSA).
This is non-independent research and a marketing communication under the FSA Conduct of Business rules. Please see the important disclosures section in
the appendix of this note which are an integral part of it or visit http://www.canaccordgenuity.com/EN/about/Pages/UKDisclosures.aspx for more
information.

11 January 2012 2012-004

2

GLOBAL SNAPSHOT Yield dynamics – 10Y yield and % point change

Strategy drivers for 2012
• Macro concerns continue to dominate – another difficult
year.
• Possible collapse or (at minimum) transformation of the
Euro – more European QE likely.
• Equities – a mixed picture:
- Emerging markets start to outperform developed
markets from H2.
- Low interest rates will continue to reward income –
but not all yields are alike.
- Markets are not normalised – key thematic drivers
and herd mentality will drive profits.
• Commodities – risks and opportunities abound, but
Key market trends - 2011
drivers will be stock and sector specific:
- Risks of a Chinese hard-landing imply continued,
sentiment-driven volatility.
- Significant opportunities in constrained supply
assets (gold, shale gas).
- Oil market volatility to intensify – supply not
constrained, but political risks are rising (particularly
over Iran).
• Property – prime assets to continue to drive NAV growth.
• Defensive assets will maintain their advantage.
• Growing risk of global socio and geo-political unrest –
disenfranchised populations carry risk and where next
after the Arab spring? Inflation (Current annual rate - %)
• Extended recession in the West and risks of rising global
protectionism.
• Emerging market – monetary easing provides some (but
not sufficient) support to global markets.
• 2012 pricing suggests an even stronger reliance on QE
and corporate earnings to underpin equity growth.

Notable elections in 2012
January Egypt & Taiwan
February Greece & Yemen
March Egypt & Russia (both presidential). Iran
April Korea, France (presidential 1st round)
May Palestine, France (presidential 2nd round) Budget deficits (% of GDP)
June Bahamas, Serbia, France
July Mexico, Mali
August
September Hong Kong
Venezuela & Slovenia (both presidential). Ukraine,
October
Georgia and Lithuania
November US & Romania
December Korea (presidential)

Source for all charts: Canaccord Genuity Limited, Datastream

2012 – opportunities and risks 11 January 2012

3

KEY THEMES
MACRO
All aboard If investors thought 2011 was a rollercoaster ride, 2012 risks shaping up to be even more
unpredictable. For four years, we have argued that the crisis of the west has been
structural in nature rather than cyclical and, therefore, something that can be resolved by
a resumption of growth. Many, if not most, structural issues (excess debt and the need for
individuals and governments to deleverage) remain fundamentally unresolved, while new
distortions in lending, debt and broader financial markets have been created (notably
state ownership of its own asset base in the West through newly printed money).

Dealing with change A key concept for investors to accept is that the world has changed and continues to
change. The crisis of 2008 accelerated this process and we believe the eventual winners
could be many of the larger emerging states such as Brazil, India and China. However,
this is not guaranteed and these states, along with Russia, the fourth member of the
BRIC quartet, have their own problems to overcome in 2012. Therefore, we do not
expect a repeat of post-Lehman’s 2008 when China expanded its own balance sheet to
support the global economy this time around (or at least not to the same extent).

As we have argued previously, however, there is always room for pricing growth in a
variety of asset classes. Part of this could be general, supported by still more monetary
expansion as the US, Europe and the UK deploy yet more quantitative easing (despite the
largely still unproven case for its use thus far). But more likely, in our view, is that
investors will have to delve deeper to unearth the pricing gems in 2012, amid a backdrop
of sluggish economic growth, heightened fears for corporate earnings and, ultimately,
the still strong risk of sovereign and bank sector default.

KEY EVENT RISK
Below we explore some areas that we see as the key geopolitical and economic risks
moving into 2012 and, more crucially, how some anticipated events could be used
through exposure to specific funds.

Instability in the Middle East Key event risks in 2012 could centre on a number of different but inter-linked points in
the Middle East. Public aspirations from the Arab spring of 2011 remain, as yet, almost
entirely unsatisfied and further violence should be expected. Where political pluralism of
some kind has taken hold, the clear winners have been Islamic-focussed organisations,
which is likely to raise concerns in the west, so long the supporter of a number of the
region’s autocratic regimes.

But the Arab spring has now spread to one of the region’s lynchpin states in Syria and
the collapse of the Assad regime carries risks far beyond Syria’s borders, with a likely
impact on Iran, Lebanon, Turkey and Israel. Elsewhere, an increasingly fractured Iraq is
more and more coming under Iran’s influence (a final humiliation in wake of the Iraq
war), while prospects for a strategic military strike against Iran also remain.

This may or may not be linked to that country’s nuclear ambitions, or to a growing
power struggle from within the Middle East itself. Syria’s collapse could ultimately
provide for growing internal divisions within Iran (a second Green revolution, perhaps)
while pressures for an oil embargo to be imposed on Iran could spark a more aggressive

11 January 2012 2012 – opportunities and risks

4

response. Similarly, despite spending billions of dollars on welfare projects in an attempt
to placate its own population, discontent within the Shia minority in Saudi Arabia
remains and may surface further in 2012.

This all has implications for the oil sector. While OPEC has the capacity to raise output
(and could have done so already as the most vivid sign of its support for the global
economy), an event-driven spike in oil prices, with all its implications for economic well
being, cannot be dismissed in 2012.

Hard landing in China However, this appears unlikely to us, particularly with the transition in power of much of
the political establishment that is due to take place in early 2013. But investors should be
prepared for such an eventuality, which could spark (at least in the short term) a
potential collapse in commodity pricing, with implications for a vast number of states
including the producer states in Latin America as well as Australia and Canada. Once
more, we highlight that while attention in recent years has been focussed on Chinese
demand as the key underpin for commodities pricing, this ignores fundamental supply
factors and any notable correction in pricing should be viewed opportunistically. Chinese
authorities have room to ease monetary policy further, though not to the same extent as
in 2008. However, we expect the government will, above all else, be keen to oversee a
smooth transition to the new political leadership that takes control in 2013, which
suggests it will do everything possible to avert any economic hard landing.

China – a changing of the guard One of the key changes for 2012 will be the run up to an effective changing of the old
guard in China – this after a decade in power. Amid a backdrop of growing structural
weakness and imbalance in the Chinese economy, the country is due to replace much of
its political leadership in late-2012, for just the fifth time since the revolution and with its
new leaders set to rule for the next decade. The Communist Party has already indicated a
dramatic shift away from what some say is a failing system of firstly export-led growth
and subsequently investment-led expansion.

As well as Vice-President Xi Jinping and Vice-Premier Li Keqiang being likely to succeed
the current incumbents, President Hu Jintao and PM Wen Jibao effective from the
Congress of late-2012 (officially from March 2013), there are due to be significant changes
to the higher ranks of the People’s Liberation Army (PLA) as a number of its leading
figures reach mandatory retirement. Orderly transition will be the priority, which will
include doing everything to ensure continuity in economic well-being for the populace.

However, this political accession will also be accompanied by strong economic transition
from 2013 onwards and particularly in 2013-15 (external situation allowing) as attempts
are made to refocus towards a more consumption-based growth strategy. This will not
be easy and perhaps key here will be how the new government reacts to any signs of
civil unrest.

Sovereign default Arguably, the key western developed states have escaped lightly thus far. With global
interest rates low and the emphasis firmly on creative book keeping, debt burdens have
been manageable. However, 2013-15 offers one of the largest roll-over periods in history
for a number of western economies. With this backdrop, one has to ask whether these
highly developed but indebted states could cope with another banking or liquidity crisis.
The answer has to be no, but even in the absence of such a crisis, sovereigns face a wall
of repayment, excessive debts and a likely increase in financing costs as interest rates
eventually rise (or new debt terms are secured). The European authorities have already
pushed forward vast sums in the form of a new borrowing facility in a bid to ensure


5

monetary stability and minimise risks of a banking crisis. This may actually prove more
beneficial, given its specific targeting, than the broad-brush QE approach adopted
elsewhere. However, we cannot dismiss the risk of sovereign default and a renewed
banking crisis in 2012.
Prospects for the other BRICs (and Time has already been called by some on the BRIC phenomenon. However, while we
emerging markets) agree that the BRICs face significant problems in H1/12, they again have room to ease
monetary policy as the global economy slows. Indian inflation appears increasingly
structurally ingrained, which raises concerns, while Russian autocracy looks likely to
come under ever greater scrutiny. However, broader trends such as young populations
(ex-China where demographic problems will grow), ever expanding credit, mortgage and
consumer markets and the sheer dynamics of many emerging market companies appear
likely to continue to underpin the BRIC and broader emerging market phenomenon for
some time.

US elections The US elections will perhaps be the defining event of 2012, as well as just how well the
US and global economies cope. Key will be the ability of political figures to rise above the
mud-slinging and enact necessary fiscal reforms (or even extend or manage existing
legislation). Signs are not positive that this can be achieved, though we see no reasons to
be excessively pessimistic at this stage. Much will depend ultimately on the choice of
Republican candidate to face President Obama which, as yet, is undecided. Any
polarisation of politics does not bode particularly well for strong and decisive legislative
action with prospects for either damaging tax cuts on one hand or a failure to rein in
spending excess on the other.


6

Figure 1: Scenario analysis
Scenario Key fund exposure Focus/dynamic
Capital protection Personal Assets Trust; Premia Personal Assets may not suit all investors with concerns over two
Plus key portfolio dynamics – US Treasuries and Gold (some 50% of
NAV). Premia Plus will succeed IVPH.L from end-February 2011
and offers a proven methodology through a futures-based
allocation model and will provide an original concept for
investors in 2012.
Chinese hard landing All commodity funds will be hard hit, but indirect exposure will go
significantly further. Chinese centred funds and those exposed to
producer nations in, for example, Brazil, Australia and Canada
could be expected to suffer disproportionately
Commodities City Natural Resources High Yield Potential for a shock and continued escalated volatility on
Chinese hard landing prospects. Yet key themes such as shale
gas/oil and margin growth at gold miners continue to underpin
this fund relative to its peers, while M&A activity is also expected
to be supportive
Cyclical recovery – emerging markets Templeton Emerging Markets. We still advise caution on many emerging market equities in Q1-
Q2, but monetary policies are now being eased and the long-
term case for the asset class and particular high profile states
remains fundamentally intact. Key emerging markets will be the
long-term winners of the West’s current crisis.
Discount to cash Federated Enhanced Treasury See page 27
Income Fund (FTT.N)
Discounted yield Guggenheim Enhanced Equity A covered call fund, GGE strongly outperformed the S&P500 in
Strategy (GGE.N) 2011 and more than doubled its yield (to an indicated 7.7%, with
3% from income). Yet this elevated distribution policy has yet to
be fully reflected in its discounted rating (-14.5%).
Europe Jupiter European Opportunities Positive stock and country allocation with strong management.
Inflation protection Western Asset/Claymore Inflation- While UK-listed funds offering “inflation protection” attract
linked Opps (WIW.N); Western significant premiums (such as those in the PFI arena), WIW and
Asset/Claymore Inflation-linked WIA both attract double-digit discounts, offer yields of circa 4%
Secs (WIA.N) and are at least 80% invested in inflation-linked securities and
has strongly outperformed the S&P500 in the last 5 years.
Innovation & development Biotech Growth Trust A vibrant performer in its own right, BIOG also benefits from
accelerated bid activity in the sector, including that for key
holding Pharmasset. With cash-rich pharma stocks seeking to
buy rather than develop new product lines, we see the potential
for further growth in the BIOG NAV.
Japan Baillie Gifford Japan Stronger GDP growth prospects as the post-earthquake recovery
continues, combined with exceptional stock selection from
manager Sarah Whitley.
Oil price spike Artemis Alpha; Petroleum & Over one-third of the ATS portfolio is exposed to oil and gas
Resources Corp (PEO.N) producers with, markets allowing, still strong upside value to be
gained from the present carrying value. PEO’s NAV effectively
tracks the DJ Oil & Gas Index and offers a portfolio dominated by
names such as Exxon Mobile and Chevron.
Property F&C Commercial Property Trust; Continued exposure to prime assets is recommended, at least in
ISIS Property Trust H1/12. Strong and proven managers at F&C REIT, with IPT also
commanding a significantly higher yield than the sector average.
Yield differentiation New City High Yield; Middlefield Proven manager with an exceptional track record in active
Canadian Income portfolio management, NCYF offers both a more durable and
differentiated source of yield (for MCT see page 24).

Source: Canaccord Genuity Limited

The death of North Korean leader Kim Jong-il in December 2011 threw another potential
Korean peninsular – death of a ‘hand grenade’ into the global mix. Jong-il’s death and his succession by his third son,
dictator
Kim Jong-un, raises the prospect of heightened political uncertainty, both internally and
regionally.

Succession planning in North Korea has been underway since Kim Jong-il suffered a
stroke in late-2008. However, the late nature of Jong-un’s move to become the preferred


7

successor over his two older brothers, together with the young General’s (as he has been
termed) lack of experience, suggests his powerbase is likely to be immature and
underdeveloped. This latest succession, therefore, suggests an expanded role for the
military, at least in the short term.

External powers are also likely to seek to raise their influence in coming months,
particularly China. However, prospects for a Korean version of the Arab spring seem
small in such an isolated state and, more likely, is a scenario of rising regional tensions
in the broader Korean peninsular.

A shift towards protectionism Perhaps one of the greatest triumphs of 2011 was the lack of protectionism or new trade
barriers that are often erected opportunistically during a period of global economic crisis
by politicians threatened by their own inadequacies to cope with that crisis. This does
not mean they will not come, however, and an extended period of stagnation or renewed
recession in the west would dramatically increase the likelihood of an escalation in trade
tensions and the imposition of punitive sanctions by certain states.

ON A BRIGHTER NOTE …
The most favourable scenarios for 2012 generally point to a further year of muddling
through for the global economy with the possibility (though not probability) of a surprise
on the upside for global growth given that sentiment is so weak. Investors may also
benefit from a herd mentality in following the continued risk-on, risk-off movements and
close correlations of major asset classes in Q1 in particular. But, we recommend being
quick to take profits on both sectors and outperforming stocks.

In terms of governmental support, key will be to watch for further supportive action from
the world’s monetary authorities, which equity markets have generally lapped up during
the last two years. However, the risk here is that the drug of monetary stimulus will
begin to wear off and the resultant equity highs will be less frequent and less euphoric.

Corporate earnings We think this may be the biggest determinant of equity movements in 2012 – just how
well earnings growth performs both in absolute terms and relative to expectations. Apart
from governments’ continued support of risk assets through monetary expansion, it has
been the broad health of company balance sheets that has maintained equity expansion
in recent years. While we expect this to continue in a number of areas (defensives, gold
producers, emerging market consumption plays, innovative technologies), strong focus
should be paid to first quarter earnings in particular and to the durability of income
streams in order to determine just how well companies are performing, this as Europe
and, possibly thereafter, the US head back into flat growth or outright recession.

H2 revival in emerging markets Many emerging markets are now at the top of their previous tightening cycle and some,
including China and Brazil, have already been cutting interest rates as their economies
slow. Inflation remains relatively entrenched in states such as India and Turkey (the
latter offering the risk of another hard landing) and we advise caution. However,
expectations are that a renewed loosening of policy during 2012 will provide support to
equities. The underperformance of emerging market equities in 2011 was perhaps not
surprising given their strong recovery since the post-Lehman’s era. However, we regard
the asset class strongly from both a top-down and bottom-up perspective, with an
emphasis firmly on managers with a bias towards stock selection rather than index
replication.


8

Event specific Events such as the Queen’s Diamond Jubilee (June) and the London Olympics (July-
August) should not be entirely dismissed and they offer potential upside to UK-focussed
equities and other asset classes in 2012. Specific analysis of the benefits of major events
on stock markets is relatively limited and, of course, gains have already been derived by
London and the broader UK during the construction and build-out process. However, we
think additional tourism and consumption are likely to benefit key stocks in 2012.

… AND MICRO
We see two defining risks in the year ahead – the risk that corporate fundamentals,
having been so strong in recent years, could disappoint as economies weaken once more
and, secondly, the imposition of ever more restrictive regulation.

Of course, the idea of tighter regulation in, for example, the banking sector, is to create a
Excessive regulation carries risks more efficient and secure system. However, risks remain that inadequate steps will
merely delay not prevent a renewed banking crisis, while excessively restrictive and
hurried laws could prompt both a further decline in lending and, as we have already
seen, threats by major institutions to relocate.

But not all legislation is negative. After all, 31 December 2012 will see the
But RDR provides the Trust world implementation of the FSA’s Retail Distribution Review (RDR), initially launched in 2006
with opportunities as a means of improving training of financial advisers and raising the transparency and
fairness in the fee charging system. 2012 could, therefore, be a pivotal year for the entire
investment trust sector. Will trusts themselves be sufficiently well prepared to access the
distribution platforms? Which funds or groups will benefit most? And, will independent
advisors be sufficiently well versed in the often esoteric workings of the trust sector?


9

INVESTMENT TRUSTS
TRENDS IN PRICING …
At the end of 2011, the average, cap-weighted discount for the trust sector had barely
changed over that for the corresponding period of 2010, reaching 10.9% against 10.5%
for end-2010. However, this masked significant changes in the ratings applied to both
specific sub-sectors and, of course, individual funds.
Yield continues to dominate The search for yield remained a dominant feature with income funds often rewarded
pricing with elevated ratings. Risk perception also prompted a notable de-rating of certain asset
classes, including property and private equity. This slippage in discounts was often
accompanied by little regard for some strong individual performances and increasingly
active attempts by at least some of these funds to buttress shareholder value. Such
diverse trends in pricing were exacerbated by the August 2011 sell-off in equities. Many
sectors experienced widening discounts in this period, with the exception of areas such
as UK Income Growth sheltered by a stronger retail shareholder base and the allure
offered by a headline yield.

Figure 2: Sector discount/12-month NAV performance trends (end-2011)

35.0

0.0
25.0

-10.0
15.0

5.0
-20.0

-5.0
-30.0

-15.0

-40.0
-25.0

Discount (LHS) 12 mth NAV perf (RHS)
-50.0 -35.0
Technology/Media
Sector Specialist: Property


Private Equity - Fund of Funds

Asia Pacific ex Japan - Income

Global - Growth & Income

UK - Income Growth

Global/Overseas Growth

UK - Growth

UK - Mid Cap
UK - High Income

Biotechnology/Pharmaceuticals

Emerging Markets - India

Asia Pacific - inc Japan

Private Equity - Direct
Global - Fund of Funds

Japan - Smaller Company
Emerging Markets - China

UK - Small Cap
Asia Pacific ex Japan - Smaller

Asia Pacific ex Japan - General
Sector Specialist:

US - General

Sector Specialist: Commodities

Japan - General

Europe - General

Europe - Smaller Companies

US - Smaller Companies

Weighted Average
Emerging Markets - Global

Sector Specialist:
Environmental

(Direct - Europe)
& Natural Resources
(Direct - UK)
Sector Specialist:

(Equity)
Companies

Source: Canaccord Genuity Limited, Datastream. Note: past performance does not predict future results

… AND PERFORMANCE
Some performance goes Canaccord’s NAV performance analysis of major funds in 2011 throws up a number of
unrewarded interesting trends. First is the sharp outperformance of private equity as an asset class,
with private equity trusts comprising nine of the top ten performing trusts during the
year.


10

Cynics may argue that this is merely a continued base effect from the post-Lehman’s low
or that valuations and pricing, in line with global equity markets, are at risk of coming
off once more, making 2011’s performance illusory and temporary. Canaccord would
strongly disagree. The sector has moved on. Specific funds such as Princess, Dunedin
Enterprise and, more recently, SVG Capital, have announced shareholder-friendly
actions including the return of capital to investors.

Others such as F&C Private Equity (FPEO) have continued to pursue a relatively
uninterrupted programme of enhanced value realisations despite a still weak economic
and market backdrop. While risks do remain, particularly regarding the valuations of
specific portfolios, it is our view that those with conservative pricing models such as
FPEO actually offer shareholders a relatively high level of downside protection,
particularly at current levels of discount.

Figure 3: Key investment trusts
Top 10 performers by NAV (TR) Bottom 10 performers by NAV (TR)

Source: Datastream, Canaccord Genuity Limited.
Note: this excludes a number of smaller UK-listed vehicles. Past performance does not predict future results

A temporary slip in performance? Sectors that dominated the underperformers in 2011 were the emerging market and
commodity funds. Once more, this phase of underperformance should be put in context
of the previous sharp rise in values in the preceding 2-3 years. Indeed, the weighted
average NAV decline of 17.1% for the emerging market trusts in 2011 means the three-
year growth rate was reduced to a still robust 83.8%. Similarly, taken over the last
decade and even allowing for the slump in 2008, the MSCI Emerging Market Index still
rose by 265% in the decade to end-2011, an almost eight-fold increase on that for the
S&P500. Other key underperformers in 2001 included SR Europe and Aurora, though
these reflected a far higher degree of fund-specific and stock selection weakness rather
than soft markets alone.

Biotech stars in NAV terms By sector, the leading performer in NAV terms in 2011 was the small Biotech/Pharma
sector, with the private equity fund of funds and property sectors not far behind. At the
other end of the scale, the largest losses occurred in the Indian and Chinese fund sectors,
with drops of over 30% in NAV over the year.


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OVERVIEW
• Yield – not all income is equal

• Board-led activity – not a great start

• Alliance Trust – a year of change

• RDR – hard work ahead to maximise benefits

Highlights of the year ahead In this year’s review, we highlight a number of themes that we regard as appropriate,
both historically and looking forward into 2012. The world can look forward to a number
of key events in 2012 including the 18 National Congress of the Communist Party of
th

China, and the subsequent transition of power within the ruling elite for the first time in
a decade. We also have the US Presidential and legislative elections, the London
Olympics, the Queen’s Diamond Jubilee and, in the trust world, the final push to financial
equilibrium as RDR comes into effect from the start of 2013.

In last year’s review, we highlighted the persistence in underperformance across
elements of the trust sector, arguing in favour of greater elasticity in the movement of
funds between management groups for perpetually underperforming managers and that
Lacking imagination? the “solution to such persistence in underperformance must lie with boards, managers
and, of course, shareholders”. We also argued that Discount Control Mechanisms
(DCMs), while useful as part of a wider armoury will not resolve issues such as relentless
weakness in relative NAV performance and that boards must become more imaginative
in the way they approach change in order to protect and enhance value for the
shareholders they represent.

This year, we continue this theme in part with one of the Global Growth sector’s weakest
performers of the last five years, Alliance Trust (ATST.L), which in 2011 initiated its first,
democratically accessible DCM. We ask whether this actively applied DCM has added
value for shareholders and whether we can expect more of the same in 2012.
Yield dynamics – how well do We also look into the effects of dividends on a fund’s profile. Yield has come to dominate
trusts stack up? discount pricing in an era of exceptionally low interest rates. But this raises as many
questions as it answers. For example, while many trusts amplify the impact of a
consistently rising nominal dividend, often over many decades, just how many funds are
fully maintaining the value of these dividends against a backdrop of often significant
inflationary pressures?


12

YIELD - ALL INCOME IS NOT NECESSARILY EQUAL
If there has been one dominant, even overriding, theme in the trust world in recent years,
Interest rates to stay low for some it has been that of income. This is not surprising in an environment of both heightened
time yet uncertainty and historically low interest rates, with both the US Federal Reserve and the
Bank of England having already signalled their intent to keep rates low for the next two
years. Almost all fund launches and secondary market issues in 2011 had a strong
income theme, while ratings of higher-yielding trusts also remained relatively high and
seemingly protected.

However, a high headline yield does not necessarily translate into a good deal for
investors. Indeed, shareholders will have to be increasingly savvy in the year ahead to
ensure their dividend flow is not disrupted (at the stock or sector-specific level) or that the
benefits of this yield are not offset by a variety of other factors.

Three- year figures look good … In this report we seek to analyse some of the attributes offered by higher yielding funds in
recent years to determine if elevated pricing has, in effect, been worthwhile. As shown in
the graphic below, on a three-year basis many high-yielding funds have delivered
exceptional NAV returns, far beyond those offered by government debt. And many of
these funds have been rewarded for these profiles, with elevated, often premium, ratings.

Figure 4: Selected funds - yield relative to NAV total return (three years)

Source: Funddata, Canaccord Genuity Limited

However, over 12 months the picture looks different, with many funds that often retained
… but shorter-term dynamics raise elevated ratings delivering a poor showing in terms of overall NAV returns. Yet this
questions disparity in return profile was not always reflected in weaker pricing levels, with the
glamour of a high headline yield often underpinning prices despite evident weakness and,
in some cases, often strong losses on the capital side. This has begun to change, however,
with heightened market volatility in the final quarter of 2011 prompting de-ratings on
high-yielding funds such as TR Property Trust (TRY.L). We also saw other, even
premium-rated yield plays such as Henderson Far East Income (HFEL) and Blackrock
Commodities Income (BRCI.L) move back into discount territory (albeit at marginal


13

levels). In these cases, market pricing finally began differentiating between not just a high
headline yield, but the broader dynamics of an often poor total return profile offered by at
least some of these funds.

Figure 5: Selected funds - yield relative to NAV total return (12 months)

Source: Funddata, Canaccord Genuity Limited

One further dynamic that we believe investors should increasingly take on board is the
And what about inflation? current and future rate of inflation, as rising prices necessarily eat into or erode the value
of a fund’s dividend income, particularly if growth in this income is not fully maintained.

This is particularly pertinent going forward as central banks seem keen to foster even
higher price pressures in order to monetise debt. Indeed, the priority is on loose and even
highly expansionary monetary policy to support growth (almost at any cost) with pricing
pressures that do exist (now and in future) of secondary concern to many governments.

So where do the yields of many of our income-based funds feature relative to current
levels of inflation? As can be seen in the chart below, many UK-listed funds fare poorly.
Indeed, not only have many incurred capital losses over the last year, they also feature a
headline yield that is below the current rate of UK inflation, offering, therefore, far more
than investors would be able to generate from keeping their money in the bank, but a
real terms contraction nonetheless.

If UK inflation were to persist at these levels, therefore, it is not just the headline yield
that is important, but the real terms adjusted level of payment and, of course, the rate of
forward growth likely to be achieved in a given fund’s future dividend stream.


14

Figure 6: Selected income-focused trusts – yield relative to UK inflation

Source: Canaccord Genuity Limited, Datastream

Yield growth – the real dynamic?
Dividend growth disappoints Much is often made in the trust sector of funds having delivered dividend growth for
extended periods, often stretching into many decades. Significantly less emphasis is
placed on the actual rate of dividend growth that has been delivered during these years.
However, surely a real test of
Distribution of yield growth by fund (5 year, % of total)
the vibrancy of a manager’s
performance is the
willingness to share those
benefits with the fund’s
shareholders, through both
Alpha delivery and dividend
growth.

But dividend expansion
within the trust sector over
the last five years has been Source: Funddata, Canaccord Genuity Limited
disappointing to say the
least. There are, of course, exceptions, with funds such as City Natural Resources High
Yield (CYN.L,) having delivered a doubling of its dividend in the last five years, only to see
its headline yield diluted by the even more dynamic rise in the share price and NAV.
Inflation-adjusted dividend growth But we find the overall picture disappointing in terms of the ability of many funds to
is even weaker expand their payout ratios at a decent rate over time. Now, of course, many of these
funds do not even claim to have a progressive dividend policy: they are growth-orientated


15

and this should be taken on board. However, Canaccord analysis using an annualised
rate of dividend growth for the last five years for 435 London-listed trusts reveals that a
staggered 71.7% had either failed to implement any annualised increase over this five-
year period or had actually experienced a contraction in their dividend payments
(perhaps temporary, but a cut nonetheless). Only 28.3%, or less than one-third of trusts,
experienced an annualised growth rate in their dividend over this extended five-year
period under review.

Yet while this may be
Inflation adjusted yield growth (5 year, % of funds) disappointing in its own
right, a pure expansion or
contraction in dividend
growth rates does not tell
the entire story. Over this
five-year period, inflation
in the UK averaged an
annualised 3.23% or a
cumulative 17.2%. Now
this, to the shareholder at
Source: Funddata, Canaccord Genuity Limited. least, should represent a
natural level of dividend
growth required for the level of their income to stand still. However, when adjusted on
this basis, the percentage of funds that have delivered sub-inflation growth in their five-
year annualised dividend rate rose to 78.6%, with only 21.4% of LSE listed trusts
managing to grow their dividend at a level in excess of the cumulative rate of UK inflation
in this period.
Closer scrutiny of yield dynamics is In summary, we suggest that rather than looking at the headline yield, investors need to
needed delve far deeper, looking at the level and consistency of capital growth achieved by a
particular manager (as this is highly complementary to any dividend payment) and the
rate of growth in dividend that has and is expected to be obtained from a particular fund.

BOARD-LED ACTIVITY - NOT A GREAT START
How active were boards in 2011? In our 2011 forward review, we argued that persistence in NAV underperformance had
become endemic in some areas of the trust sector and that Discount Control Mechanisms
(DCMs) had, in some respects, simply perpetuated such underperformance. We also
stated that we believed the sector lacked the “elasticity in movement” and that the
answer “cannot be with yet more buybacks or tenders and removing capital from the
Trust market. The answer has to be with board and investors becoming more proactive
in moving assets elsewhere”.

Not very is the answer! Did this prove to be the case in 2011? The short answer has to be no. We did not see any
dramatic upsurge in boards seeking to move assets from perpetual underperformers to
higher Alpha managers or from overpopulated sectors to areas that are vastly under-
represented (such as mainstream US equities).


16

Funds came and went in 2011.
Notable casualties included Anglo & Selected trust sectors by capitalisation
Overseas plc and Electric & General (£m)
Investment Trust, though assets
were not retained within the trust
sector by initiating something new
or innovative – a move to an asset
class or manager that investors
wanted and would perhaps
appreciate more (and price
accordingly).

Separately, 2011 saw one trust
move away entirely from its
previously tight DCM. Gartmore
European (now Henderson
Source: AIC
European Focus Trust) having seen
its capitalisation slip from over £400 million to under £90 million, changed tack on its
DCM, investment remit and approach – this to effectively prevent a further death of a
thousand cuts. While the board of Gartmore European decided to abandon a rigid system
to prevent the fund moving to an illiquid rump, contrast this with Alliance Trust – which
moved from perennially denying the use of buybacks to become one of its greatest
advocates, at least during 2011.

STS board deserves all the praise We would argue that the most rewarding, board-led move in the trust sector in 2011 was
that of Securities Trust of
Discount trends, STS versus 12-month average Scotland (STS.L). The fund
6 had long struggled in the UK
4 Income Growth sector with a
2
comparatively low level of
0
reserves and a surplus of
-2
peers, with the board
-4

-6
therefore making the decision
-8 to move the fund to the Global
-10 Growth & Income sector. A
09/02/2011

09/04/2011

09/05/2011

09/06/2011

09/08/2011

09/09/2011

09/11/2011

09/12/2011
09/12/2010

09/01/2011

09/03/2011

09/07/2011

09/10/2011

simultaneous change in fund
manager (while staying at
STS Ave Martin Currie) provided a
Source: Canaccord Genuity Limited, Datastream further fillip, with the move
welcomed by the market with
a shift to a premium rating. STS has since this period sustained a good initial
performance in its new home, outperforming many of its counterparts, albeit over a very
short time.
A new style of product from Other changes were also apparent. Invista Foundation Property Trust has moved to the
Invesco stewardship of Schroders, while perhaps more exciting is the change in Invesco Perpetual
Select’s Hedge Fund class to that of a conceptually new (for the trust sector), long-only
model operated by the group’s Premia Plus team in Atlanta. Canaccord met with this
team in late-2011 and we believe it offers a differentiated model from the Fund of Hedge
Funds grouping, with a strong record in terms of minimising drawdowns (thereby
enhancing overall returns) and this against a backdrop of full asset liquidity and no costly


17

lock-ins. The transfer of this asset class does not officially take place until February 2012,
although we are optimistic it will offer shareholders something different and strong,
particularly amid the wild market swings we have seen in 2011 and expect to see once
more in 2012.

But, unfortunately, that was about it. 2011 was not a year in which boards sought to
rejuvenate or rapidly improve the foundations of many poorly performing funds, with the
perpetuation of underperformance for another year at least. Boards may look to the
volatility of markets in 2011 as good reason to sit tight, but ultimately the sector needs to
reward strong-performing managers (which it does to a reasonable degree) and penalise
those that consistently fail to deliver (which it often fails to do).

Perhaps 2012 will see a more proactive response from boards. However, at present, truly
imaginative board initiatives remain in relatively short supply with the use of share
buybacks, the occasional tender or open-ending remaining the preferred options to take.

ALLIANCE TRUST - A YEAR OF CHANGE …
… but did shareholders truly benefit?
A new kid on the buyback block Perhaps one of the most dramatic events of 2011 was the shift in corporate governance
by the previously reticent Alliance Trust in finally enacting a fully democratic share
buyback policy. This contrasted with the fund’s previously somewhat shallow (just two
repurchases) and highly selective (favouring specific shareholders) repurchase system.

The move was dramatic. Some 10.25% of the fund’s share capital has disappeared since
February, with a massive 67.76 million shares repurchased and cancelled. This enhanced
the NAV for those that remain by an estimated 6.48p per share (or just over 7p when
calculated on a cum-income basis), with the fund’s discount moving from 16.2% at the
start of the year to 14.9% at its close.

Unleashing the big bazooka So superficially, at least, the repurchase programme has not materially enhanced the
NAV or provided significant levels of discount compression. ATST certainly used its “big
bazooka” in 2011 and it could be argued that with holders of 10.2% of shares seeking an
exit in the first year of the programme (this, remember, at still strong levels of discount),
such a buyback system was needed. After all, without the company buying in its own
shares so extensively and if the secondary market alone had been used to satisfy those
shareholders seeking an exit, the fund’s discount would have been substantially wider.

Yet even with this sizeable chunk of the fund’s shares repurchased and cancelled,
questions remain over the validity of the programme notably for the following reasons:

• Those shareholders seeking change have not exited the fund.

• Enhancement to the NAV has, arguably, been marginal.

• No sign as yet of closure in demand by those shareholders seeking an exit.

• NAV performance, the real dynamic behind ATST’s wide discount, shows few
material signs of improvement.

Share buybacks have become the norm and often the first port of call rather than a “tool
in the investment trust box” in recent years. This, we believe (and as we highlighted in
last year’s forward review), could prove detrimental to long-term shareholders in the
sector as liquidity shrinks still further.


18

Figure 7: Alliance Trust – monthly share buyback analysis

Source: Funddata, Bloomberg, Canaccord Genuity Limited

ATST has been late to the party in terms of introducing a widely accessible buyback
programme, but the inherent problems the fund faced prior to its adoption remain
intractably in place – performance. There are simply too many far better performing
vehicles out there for investors to choose from.

Are share buybacks enough? Despite the fund’s shrinkage in 2011, it remains at a sustained 5.5% discount to its peers
in the Global Growth sector (against 6.9% at the end of 2010). One could argue that this
discount would have been significantly higher in the absence of the new DCM, yet the
reality remains that ATST’s problems of persistent underperformance, and discounted
pricing (to its peers), will not go away if another 70 million shares (or more) were to be
cancelled in 2012 as well.
RDR could disproportionately One glimmer of light for ATST is perhaps the commencement of the Retail Distribution
benefit ATST Review (RDR) from the start of 2013. Given the fund’s size, marketing capacity and
existing positioning within the retail market, as well as the presence of its own RDR-
ready platform, it should be among the main beneficiaries of the expected increase in
retail demand for trusts as discrimination in the broader funds market is removed. What
percentage of the still potentially sizeable slack in institutional demand seeking an exit
from ATST can be offset by higher, RDR-based retail purchases? Only time will tell.

RDR - MAXIMISING THE BENEFITS
2012 should prove a pivotal year for funds as we move towards the introduction of RDR
from 31 December. Will RDR provide a huge surge in new client demand? Probably not,
but it should be welcomed nonetheless, with far too much emphasis placed on share
repurchases in recent years rather than attracting new clients into the sector.

Brokers have gorged themselves on share buybacks in recent years, but the question
remains as to whether this has really delivered a more vibrant and accurately priced
investment trust sector, Again, the answer is probably no, but what we have now is the
opportunity for the sector to offer itself to retail clients and their advisors on a level
playing field and for this new source of client demand to be brought into what remains a


19

fundamentally attractive means of accessing global risk assets and high quality managers
(this on a long-term basis without liquidity call interruptions).
Branded names the main RDR by its nature is likely to favour those bigger franchises within the investment trust
beneficiaries at the outset sector – well known and branded management houses and the larger capitalised,
relatively mainstream funds. With interest rates remaining low and gains from RDR
obviously biased towards the retail client, initial attention is also expected to be focussed
on higher-yielding, mainstream funds rather than those at the more esoteric end of the
trust spectrum. Funds such as Alliance Trust should also benefit from the outset with its
own RDR-compliant platform, while pressure will intensify for other funds to maximise
their presence within the existing platform system.

This market is dominated by highly interactive and all-encompassing platforms operated
by CoFunds (multiple owners), FundsNetwork (managed by Fidelity) and Skandia Group’s
platform. These platforms offer advisors a one-stop shop for all their pricing, trading and
settlement needs as well as the usual variety of product packaging or wrapping options
under which such investments are ultimately held (SIPPs, ISAs etc). According to the AIC,
these three platforms currently account for 70% of the £164 billion platform market, with
CoFunds alone claiming a 26% market share.

A cursory glance at the websites of these groups reveals little information on the trust
sector or individual trusts at this stage, which is not surprising as they do not presently
offer investment companies. However, to get off the ground running, it will be crucial for
trusts, their boards and their brokers to access these existing distribution networks in
order to maximise potential interest in the shortest possible time.

Overall, RDR should be welcomed We believe RDR should be welcomed, with the long-term bias by financial advisors to
higher fee-paying unit trusts set to be consigned to history. This does, however, create its
own problems that will have to be overcome. The uplift in potential demand created by
RDR will not necessarily be smooth or equally spread. Individual trusts will have to fight
hard to establish themselves both with the platform providers and the broader advisor
community.

Similarly, explanation of the benefits (and risks) of investing in investment trusts will be
required. Joe Public may not take kindly to being told that while their investment had
outperformed the market, they had actually lost money due to a notable widening of the
fund’s discount. Other key features that will assist trusts in terms of maximising upside
gains from RDR will probably include a low TER and plain structure.

This is perhaps understandable but a shame nonetheless. Indeed, rather than the main
beneficiaries of RDR in the trust world being those funds, as is presently anticipated, from
the big houses and with a greater index bias and often little managerial added-value, the
real gems to be found in the trust sector are those that provide something different from
the norm and where the manager is allowed to add true value.


20

PORTFOLIO STRATEGY
Introduction
Cautious in H1/12 We retain a cautious outlook on global equities, particularly in the first half of 2012.
Macroeconomic uncertainties persist and concerns remain over the durability of
momentum in corporate earnings. Underlying companies have proved resilient post-
2008, yet earnings downgrades appear to be accelerating as economic activity dampens
still further. And if this materialises, markets do not necessarily look that cheap.

However, our expectations are for an accelerated growth profile for certain asset classes,
perhaps from end-Q1 but most likely from mid-2012, as emerging markets undertake an
accelerated monetary easing and China, in particular, deploys strategies that are more
accommodating in terms of forward asset growth.

Indeed, it could be argued that while severe macro imbalances remain to be addressed,
these could be superseded by strong socio or geo-political risks during 2012. While
sovereign risks have certainly not gone away, tensions, particularly in the Middle East
and South East Asia, could come to the fore in 2012 – a case of the global economy
muddling through and being overtaken in importance by events elsewhere.

Global equities The concept of wealth protection should therefore be a priority for investors, particularly
in the first quarter of 2012. This suggests investors may be wise to take a short-term
allocation to funds such as Personal Assets (PNL.L). However, with almost 50% of assets,
allocated to global bonds and gold this, of course, carries its own risk dynamic. This
could take the form of a sharper upturn in global growth than expected (unlikely) or a
more pronounced decline in sentiment towards the increasingly distorted US Treasury
market (expected to materialise at some point).

For those that believe US Treasuries will retain their shine and defensive attributes, we
would allocate capital to Federated Enhanced Treasury Income Fund (FTT.N). At end-
November 2011, this US-listed vehicle had 90% of its assets invested in US Treasuries or
cash, with just less than 10% in government agency MBS’s, yet attracted a 13% discount.

Elsewhere, we continue to favour strong, stock-picking managers rather than quasi
trackers, with thematic or stock-specific earnings momentum (or protection) ultimately
set to be rewarded. In this respect, we continue to favour allocations to the distinctive
management skills offered by, for example, Bruce Stout at the currently more defensive
Murray International (MYI.L) and, for longer-term investors, Michael MacPhee and
Gerald Smith at Mid Wynd (MWY.L) and Monks (MNKS.L) respectively.

Commodities Concerns over a hard landing in China and the growing correlation of many asset classes
(including Gold with equities) led to a sharp fall in equity pricing in this sector from April
2011 onwards, with the average, market cap weighted drop in NAV among the
commodity trusts reaching 23.1% for the year as a whole. This is disappointing but,
perhaps, not surprising given the run up in pricing seen since late-2008 with, for
example, the NAV of City Natural Resource High Yield (CYN.L) rising a staggering 270%
from October 2008 to end-2011 or almost 4.5 times the level of return achieved on the
FTSE100 over the same period.

A combination of resource scarcity (in certain areas), high margins and new thematic
drivers (shale gas in Europe, for example), continue to underpin our optimism for (highly


21

selective) areas of the sector. However, we advise caution in Q1/12, with little
discrimination between various sub-asset classes and concerns over the health of the
Chinese economy merely set to produce intense levels of volatility. However, we do not
share concerns that China is moving towards a hard landing, while cash-rich corporates
eager to access new supply chains are likely to underpin further growth in the M&A
market. Again, underlying market dynamics favour a more selective rather than broad-
brush approach and, as a result, we continue to favour City Natural Resource High Yield
as the best means of accessing the commodities space.

Smaller companies Last year, we asked whether the time had come again for smaller companies. Growing
risk aversion over 2011 suggested this was not the case, with the FTSE Small Cap Index
falling almost 15% over the year, against a drop of just 5.5% for the FTSE100.
Simultaneously, discount pricing on smaller company trusts widened from an average of
14% to 18%.

Part of the reasoning behind our prognosis last year was that the long-awaited and
required consolidation of the smaller company space had finally taken place, leaving
investors with a leaner, fitter, but still diverse, selection of funds. While further
consolidation appears likely, we take comfort from the performance of Strategic Equity
Capital (SEC.L) and Montanaro UK Smaller Companies Trust (MTU.L), which finished in
first and second place respectively in terms of NAV performance in 2011. Both also
comfortably beat the FTSE Small Cap ex-ICs Index for the year as well as the FTSE100.

We remain positive on both of these funds in 2012, each for their own, slightly different,
reasons. SEC’s development of its portfolio continues apace and this is now a nicely
maturing basket of individual stocks, often now paying dividends and achieving growth
and therefore finally being credited with the pricing we believe it deserves. We cannot
say the same for SEC – a fund not only offering one of the tightest DCMs in the broader
trust sector, but also a NAV performance rating within its peer group of first and third
respectively over both one and three years (this with a three-year NAV return of over
140%). Therefore, we hope and anticipate that SEC’s managers will be more
appropriately rewarded by the market in 2012.

MTU also continues to perform well, benefitting greatly from the manager’s consistent
approach and the stock selection skills of the broader team. By using a highly targeted
and internally-driven method of stock selection and investing only in profitable
companies, MTU offers shareholders strong assurances in a period of intense volatility.
Yet once again, MTU stands at a discount to the small-cap sector despite having
generated a similar NAV return to that of the often premium-rated Standard Life UK
Smaller Companies Trust (SLS.L) over both one and three years.

Emerging markets In July 2010, we argued specifically in relation to Asian equities, that “irrational
enthusiasm” and growing global cross winds suggested that the “market may be
reaching a short-term top or a stage at which such exuberance may be quickly followed
by disappointment”. The region, as measured by the MSCI Asia ex-Japan index, has
dramatically underperformed the S&P500 and FTSE100 since this period providing, of
course, natural disappointment for investors.

Concerns remain that certain weaknesses within Asia (such as high inflation in India) are
becoming more structural than cyclical in nature. However, in broad terms, we continue
to favour both Asia and the broader emerging market sphere and underperformance,


22

particularly since August 2011 needs to be set against the dramatic rise in equity pricing
that once again followed the post-Lehman’s lows.

We expect further weakness in the early stages of 2012 but see the next six months as a
period of accumulation on the dips and any widening in accompanying trust discounts.
Caution is advised on key states – potential overheating in Turkey, risks of a hard
landing in China – but the asset class contains some of the world’s most vibrant and
(now) increasingly attractively priced companies. Similarly, demographic changes and
shifts in middle class consumption patterns and product demand offer strong
opportunities to longer-term investors. As such, while we view 2012 as likely to continue
to provide some volatility in the asset class (particularly in H1), we are of the view that
prospects for the next decade remain excellent.

We believe short-term risks suggest a need for wider pricing on our previously favoured
Aberdeen Asian Smaller Cos (AAS.L) and that discounts on the emerging generalist trusts
are also uncomfortably tight given anticipated risks in H1/12. However, the Asian
generalist trusts are looking increasingly attractive and we favour allocations to strong,
stock-picking funds such as Aberdeen New Dawn (ABD.L) and Edinburgh Dragon
(EFM.L) in the year ahead. Fidelity Asian Values’ (FAS.L) currently higher exposure to
the Korean market should be noted by investors as a potential key point of both upside
and downside risk.

For those seeking broader global exposure to emerging markets and stock-specific rather
than index-based Alpha, we would recommend exposure to funds such as Scottish
Mortgage (SMT.L), Monks (MNKS.L) and Mid Wynd (MWY.L). Each of these funds has
30%+ allocated to the asset class, on a highly selective, stock-specific basis rather than
through simple index exposure. For those looking for an uptick in emerging market
pricing after the weakness of 2011, but within the confines of a broader allocation and
often at more attractive pricing levels, these funds appear to tick a number of boxes.

Private equity In a period of intense volatility and uncertainty, many private equity funds generated
positive and signifcant returns in
Discount trends – Private equity funds (2011)
2011 and should be
congratulated for doing so. The 50.0

sector also witnssed notable 30.0

improvments with the adoption 10.0
of shareholder-friendly policies
-10.0
such as accelerated returns of
capital (from realisations), -30.0

tenders and buybacks, with -50.0

funds such as Dunedin -70.0
Enterprise (DNE.L), Princess
1 5 /1 2 /2 0 0 6
1 5 /0 3 /2 0 0 7
1 5 /0 6 /2 0 0 7
1 5 /0 9 /2 0 0 7
1 5 /1 2 /2 0 0 7
1 5 /0 3 /2 0 0 8
1 5 /0 6 /2 0 0 8
1 5 /0 9 /2 0 0 8
1 5 /1 2 /2 0 0 8
1 5 /0 3 /2 0 0 9
1 5 /0 6 /2 0 0 9
1 5 /0 9 /2 0 0 9
1 5 /1 2 /2 0 0 9
1 5 /0 3 /2 0 1 0
1 5 /0 6 /2 0 1 0
1 5 /0 9 /2 0 1 0
1 5 /1 2 /2 0 1 0
1 5 /0 3 /2 0 1 1
1 5 /0 6 /2 0 1 1
1 5 /0 9 /2 0 1 1
1 5 /1 2 /2 0 1 1

(PEY.L) and SVG Capital (SVI.L)
to the fore; we do, however,
Direct FofFs
consider SVI’s recently
Source: Canaccord Genuity Limited, Datastream
announced distribtion policy to
be punitive given the amount of cash already on the balance sheet.

3i and Candover aside, returns in the sector were positive and a further refocussing of
balance sheets also continued. Yet such improvements and strong levels of realisation on
funds such as F&C Private Equity went largerly unrewarded.


23

Of our four favoured funds in our forward note for 2011, three generated double-digit
returns for investors: LMS Capital (+23.6%), F&C Private Equity (+13.2%) and GPE
(+14.4%) with only one - Electra (-15.5%) - falling short of expectations. Though the
macro environment remains onerous, we continue to favour the sector moving forward
and allocations should be made primarily on the basis of portfolio valuation and
realisation potential. Therefore, we continue to recommend buying F&C Private Equity.

Further consideration should be paid by investors to this sector. We would also consider
HgCapital (HGT.L) in 2012. Though not cheap compared to its peers, we regard it as a
proven source of Alpha with a team offering a strong track record. We were previously
less optimistic on this vehicle, believing that the then premium ratings applied missed
the point of a high cash weighting and forward risks of both de-rating and, in particular,
that this money would take time to put to work (i.e. an extended J-curve). Well the fund
still has a strong cash bias, but the current estimated double-digit discount is certainly a
more attractive point to access this actively-managed fund.

As can be seen from the graph on the previous page, private equity as an asset class was
signfiicantly de-rated by the market in 2011 despite often strong gains in terms of NAV
delivery, balance sheet improvments, enhanced value realisations and, in some cases at
least, a still strong level of portfolio activity. Not all funds delivered, but many did and
some went further in dramatatically enhancing their relations with their shareholders
through plans to return capital.

It is arguable, however, that during 2011, little or no differentiation in pricing occurred
between the good, the bad and the downright ugly during this renewed de-rating phase.
For example, Dunedin Enterprise has delivered NAV growth of over 30% in the last three
years and introduced a new distribution policy in 2011. Other funds such as Candover
and 3i lost over 30% of shareholder NAV in the same timeframe. Liquidity may be one
thing, but long-term and proven management performance is also worth paying up for.

However, we do expect material differentiation to occur on a fund-specific basis in 2012
across the broader private equity sector and for the discounts of the strongest funds to
rebound positively.


24

OTHER STOCK PICKS FOR 2012
Biotech Growth Trust (BIOG.L) This trust does not always offer investors a smooth ride and we expect no difference
moving forward. However, we believe the long-term fundamentals remain strong and the
outlook for the sector robust, with cash-rich companies bidding for new product lines.
Management has a proven track record and our prime concern here remains not the
asset class, but a fairly concentrated shareholder register and an often shallow level of
daily liquidity.
Middlefield Canadian Income With a yield of 4.8% (payable quarterly), we are of the view that MCT offers distinct
(MCT.L) advantages over some of its other income counterparts. These include a strong exposure
to the vibrant Canadian economy with MCT particularly well exposed to favoured sectors
such as the high yielding end of the energy and real estate markets. The fund also
provides far greater levels of geographic, stock and yield-specific diversification than
many FTSE100-based UK income trusts, though MCT would be heavily exposed to a
sharp drop in commodities pricing and a broader global economic slump. The fund
offers a covered dividend and a great track record of Alpha delivery and could be used as
a bolt-on strategy to a broader pool of income vehicles.

India Fund Inc (IFN.N). Aberdeen Asset Management assumed control of this fund in late-2011 and we expect
that this will now be managed in a similar vein to the strong-performing New India Fund
(NII.L). NII has added material value for investors in the last three years, versus both the
Sensex and its peers, yet with a capitalisation of £115 million and an often poor trading
profile, slips below the radar of at least some investors. IFN, in contrast, is capitalised
almost five times larger than NII and offers a trading profile (in volume terms) over five
times greater, so we believe this vehicle should appeal under its new stewardship to a
broader range of clients. India itself offers further potential weakness in the short term
and rising expectations for a pronounced cut in interest rates may yet be dashed amid
still strong inflationary pressures. However, the supply of strong, relatively cash-rich
companies is exemplary and, for longer-term investors, we believe further market
weakness will provide grounds for long-term and opportunistic accumulation.

Premia Plus When this share class is introduced from the end of February 2012 (in place of the
existing Invesco Perpetual Select Hedge fund class), it will target a continuously balanced
exposure to commodities, stocks and bonds, with ample diversification and a proven
record. Canaccord met with lead managers Mark Ahnrud and Christian Ulrich in late-
2011. They presently manage US$3.2 billion under this strategy and results have been
exceptional, not just in terms of the level of returns (with strong capital protection), but
also the stability of those returns over various market phases. In the three years to end-
November 2011, the approach generated a return of 17.4% against 11.0% for the 60/40
World Balanced Index (a combination of the MSCI World Equity Index and Barclays
Aggregate Bond Index).

The existing Fund of Hedge Funds sector contains many inadequacies, including (but not
limited to) a lack of transparency, poor (relative) performance in both rising and falling
markets, high fees, exposure to often lower-tier managers and costly lock-ups. But such
characteristics cannot be labelled at Premia Plus. The fund will offer a balanced exposure
to a variety of sub-classes within each of the commodity, equity and bond spaces, with
the aim of minimising excessive drawdowns, with this blended approach also ensuring
continued outperformance of at least some elements of the portfolio whatever the market


25

backdrop. The use of futures to operate this strategy also allows for immediate and
comparatively costless liquidation (if required) of the portfolio and we look forward to
providing investors with greater detail on the strategy and people concerned in the next
two months.

Murray International (MYI.L) Canaccord last met with manager Bruce Stout in October 2011 and his stated aim then
for 2011 as a whole was to preserve capital and raise the fund’s dividend, both of which
he achieved. Offering an already fairly defensive bias, Stout was at the time raising the
fund’s level of security still further, with purchases of further stock in Mexican beer-
producer FEMSA, which performed very well (in pricing and revenue growth terms) in
2011 and the always cash-generative Johnson & Johnson.

In broader terms, as readers will have seen from this report, we commend such a
defensive but still stock-creative approach to global markets and portfolio construction.
After all, in times of turbulence, it is good to hold stocks that are less sensitive to
economic shocks. Some may argue that it is an easy call to recommend the already
premium-rated MYI. Yet it is Stout’s strong simultaneous exposure to both cash-
generative but still dynamic themes such as rising emerging market consumption that we
salute and we expect the fund to protect on the downside in 2012 with the potential to
also benefit on the upside as the cyclical recovery in emerging markets takes hold.


26

US CEFS - WHERE THE ACTION IS?
An underutilised source of Alpha There is little doubt that the US closed end fund sector remains an attractive but under-
utilised source of global exposure for many UK-based investors. Indeed, it is arguable
that US CEFs should be viewed as highly complementary to the UK trust sector and, as
such, we have included a number of these funds in this review. US listed vehicles operate
in a different, arguably more retail-based, environment, which often provides disparities
in trading patterns compared to their UK-listed counterparts. However, once these
differences are understood they should not be viewed by investors as being problematic.

At the time of writing this report, the US CEF sector comprised 635 funds, with net
assets of US$210.9 billion. Of these funds, just over 9% were capitalised at below US$50
million. The US CEF sector offers a market capitalisation-weighted discount of just 3.1%.
However, this hides a huge spread of ratings, from discounts of over 30% (for example,
on the small Foxby Corp, which has 17% of its assets invested in Apple Inc) to premiums
in excess of 70% for Pimco’s Global StockPLUS & Income Fund (PGP.N).

Greater and targeted choice We believe the US CEF
market provides investors Assets and no of funds by listing
with a broader choice of
funds as well as
differentiated types of
asset, many of which are
simply not available in the
UK trust market. These
include funds that invest in
government debt, covered-
call funds, emerging
market debt vehicles as
well as those investing in
limited duration securities,
a broader span of high Source: Canaccord Genuity, AIC, Morningstar
yield instruments and
single country equity funds. The latter include funds exposed to, for example, Germany,
Ireland, Australia, Chile, Mexico (2 funds), Korea (3 funds), Singapore, China (4 funds), of
which one is an A-Share fund, Indonesia and Turkey. The sector also includes two
regional Latin American equity funds, offering an alternative option for holders of, for
example, Blackrock Latin American Investment Trust (BRLA.L) which has often attracted
an elevated rating given its relatively unique position in the UK market.

Similarly, though vastly under-represented in the UK trust sector, the US CEF market
offers investors a number of discounted funds exposed to the US equity market – one of
the world’s strongest equity markets in 2011 but one where UK investors have the choice
of just one actively-managed trust in the form of JPMorgan American (JAM.L).
S&P500 – under-represented in One has to ask if JAM is so highly rated because of the manager and the benefits
the UK Trust market provided by the fund, or simply because of the absence of any real competition in the UK
trust sector. So, for UK investors, some of these US listed funds such as Adams Express
(ADX.N, -16.5% at year end) or the (recently) stronger-performing Tri-Continental Corp
(-15.1%) may offer a more attractive alternative.


27

Delights and dangers
The US CEF market may be new to many of our readers, but that it provides
opportunities that are not often available within the UK market is beyond doubt. It also,
as highlighted above, provides strong complementary advantages to clients, being able to
switch between similar vehicles with similar remits, but where advantages of greater
liquidity, choice and managerial Alpha can, perhaps, be found in the US funds market.

But there are downside risks. Corporate governance levels in the US market remain
Corporate governance is often
poor … fundamentally weak, though we are optimistic that key shareholders are now robustly
taking up the challenge of improving shareholder welfare. Similarly, the bias towards
high income funds within the US CEF market should always be treated with some
caution. While reporting levels (and standards) have generally improved, many such
… but key clients are driving funds are still simply returning capital to shareholders rather than accrued income and
improvements being disproportionately rewarded for doing so. For example, the high-yielding
Cornerstone Total Return (CRF.N) has attracted premiums in excess of 80% during the
last five years – a period in which the capital value of the fund’s NAV has dropped by
almost 70% and the total return on the NAV has been a relatively shallow 17%. So an
80% premium for an annualised NAV total return of 3.2% (and -14.8% on the price)
seems excessive to us to say the least.

Discount to “cash” anyone?
Irrationally priced Federated Enhanced Treasury Income Fund (FTT.N) – US Treasuries were all the rage in
2011 as everyone headed for the “security” provided by this asset class. This has come
despite the minimal and often negative real terms yields on offer and risks to the
downside stemming from the increasingly unbalanced state (re massive state ownership)
of the Treasury market itself. But amid this rush into Treasuries, FTT was left behind,
moving from a 6.4% discount at the start of the year to -12.7% at its close.

At end-November 2011, the fund had 89% of its assets in US Treasuries, 9.9% in US
government MBS and 1.1% cash. The average weighted coupon was a small 3.05% with
the yield on the fund itself standing at 6.3%. Either way, for a “risk-free” asset that in
2010 attracted a premium, we believe this fund offers some true value. And if US
Treasuries are effectively “cash” given the nature and liquidity of the market, we ask why
FTT trades at a near 13% discount?


28

SUMMARY
OUR VIEW OF THE YEAR AHEAD
2012, or at least the first few months, are expected to be characterised by a need to
implement fairly extensive capital protection, minimising downside risk exposure and
avoiding further, government-induced, pitfalls. 2011 provided opportunities for a
decisive change in government policy in the west and these opportunities were sadly not
taken up (despite numerous, “last chance” summits). The end of 2011 also heightened
volatility and closer correlation among asset classes.

Don’t hide behind the curtains! This does not mean a lack of opportunities and that clients should overweight cash and
hide behind the curtains! We expect opportunistic and theme-specific events will come to
the fore throughout the year and, increasingly (though not at the start of the year), we
expect key emerging and other asset classes to return to profitability. Cyclical recovery in
emerging markets will happen, though not on the scale seen in the post-Lehman’s era.

We see little point betting against the herd in times of macroeconomic and market
instability, though we advise investors to be nimble and to be prepared to take profits on
a shorter duration than during normalised markets. The most optimistic scenario at this
stage is that corporate profits continue to please on the upside (hence our bias towards
stock-picking managers) and that the global economy muddles through. However, socio
and geo-political risks such as the US election cycle and tensions in the Middle East could
come to the fore, actually superseding concerns at the economic level.

AND TRUSTS
In terms of trusts, we advise continued allocation to higher Alpha and consistent
managers – those with a natural bias towards stock selection rather than indexation and
managers that have seen this cycle before and acted accordingly. Yield will continue to
dominate with interest rates low, but some disappointment may be felt both with the
quality and durability of this yield. We also advocate strong diversification in terms of the
source (sector and fund) of this yield.
Specific managers provide Given the economic and market backdrop, discounts have, in many cases, remained
opportunities relatively (if not overly) tight. However, numerous opportunities continue to exist within
the Trust sector and the final weeks of 2011 finally started to throw up some more
exciting (and reflective) risk pricing (though some funds and sectors continue to offer
little on value-adjusted risk/reward basis). The US fund market, in contrast, was
arguably more fully reflective of risk pricing in 2011 and we would strongly urge
investors to make greater use of this space moving forward.

And we now move forward onto a new stage for the trust sector with the implementation
of the long-awaited RDR from the end of the year. This could present significant
opportunities for the sector as a whole and specific funds, but the benefits cannot be
guaranteed and managers, boards and brokers will need to work hard to make the case
for investing in investment trusts.

Wishing you all a very profitable 2012.


29

INVESTMENT TRUST SECTOR – KEY DATA TRENDS 2011

Selected sector discount spreads (end-2011) Selected sector NAV performance spreads (2011)

Volume trends (% of funds - 2011 versus 5Y average) UK Inc Growth – Spread by capitalisation (£m)

2011 – Overall trust sector
• Cap weighted 1Y trading volume as a % of 5Y average – 88%

UK Small Cap Trusts –dispersion of % NAV returns (2011) Private equity discount trends (5 years)
50.0

30.0

10.0

-10.0

-30.0

-50.0

-70.0
15/12/2006

15/03/2007

15/06/2007

15/09/2007

15/12/2007

15/03/2008

15/06/2008

15/09/2008

15/12/2008

15/03/2009

15/06/2009

15/09/2009

15/12/2009

15/03/2010

15/06/2010

15/09/2010

15/12/2010

15/03/2011

15/06/2011

15/09/2011

15/12/2011

Direct FofFs

Source: Funddata, Datastream, Canaccord Genuity Limited. Note: past performance does not predict future results.


30

APPENDIX: IMPORTANT DISCLOSURES
Analyst Certification:-
Each authoring analyst of Canaccord Genuity Limited whose name appears on the front page of this research hereby certifies that (i) the
recommendations and opinions expressed in this research accurately reflect the authoring analyst’s personal, independent and objective views
about any and all of the designated investments or relevant issuers discussed herein that are within such authoring analyst’s coverage universe
and (ii) no part of the authoring analyst’s compensation was, is, or will be, directly or indirectly, related to the specific recommendations or
views expressed by the authoring analyst in the research.
Ratings/Coverage:-
None of the stocks covered in this research are under formal and regular coverage by the analyst nor are they formally rated in accordance
with the Canaccord Genuity Ratings System.
Disclosure and Disclaimer:-
For the purpose of UK regulation Canaccord Genuity Limited produces non-independent research which is a marketing communication under
the FSA Conduct of Business Rules and has not been prepared in accordance with the FSA requirements to promote independence of research
nor is it subject to the prohibition on dealing ahead of the dissemination of investment research. However, Canaccord Genuity Limited does
have procedures in place to manage conflicts which may arise in the production of research, which includes preventing dealing head and
Chinese Wall procedures.
The authoring analysts who are responsible for the preparation of this research are employed by Canaccord Genuity Limited, which is
authorised and regulated by the Financial Services Authority (FSA).
To access the specific company disclosures of relationships and other material interests please refer to
http://www.canaccordgenuity.com/EN/about/Pages/UKDisclosures.aspx
The authoring analysts who are responsible for the preparation of this research have received (or will receive) compensation based upon
(among other factors) the Corporate Finance/Investment Banking revenues and general profits of Canaccord Genuity. However, such authoring
analysts have not received, and will not receive, compensation that is directly based upon or linked to one or more specific Corporate
Finance/Investment Banking activities, or to recommendations contained in the research.
The information contained in this research has been compiled by Canaccord Genuity Limited from sources believed to be reliable, but (with the
exception of the information about Canaccord Genuity) no representation or warranty, express or implied, is made by Canaccord Genuity
Limited, its affiliated companies or any other person as to its fairness, accuracy, completeness or correctness. Canaccord Genuity has not
independently verified the facts, assumptions, and estimates contained herein. All estimates, opinions and other information contained in this
research constitute Canaccord Genuity Limited’s judgement as of the date of this research, are subject to change without notice and are
provided in good faith but without legal responsibility or liability.
Canaccord Genuity salespeople, traders, and other professionals may provide oral or written market commentary or trading strategies to our
clients and our proprietary trading desk that reflect opinions that are contrary to the opinions expressed in this research. Canaccord Genuity’s
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views expressed in this research.
This research is provided for information purposes only and does not constitute an offer or solicitation to buy or sell any designated
investments discussed herein in any jurisdiction where such offer or solicitation would be prohibited. As a result, the designated investments
discussed in this research may not be eligible for sale in some jurisdictions. This research is not, and under no circumstances should be
construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to
carry on the business of a securities broker or dealer in that jurisdiction. This material is prepared for general circulation to clients and does
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Genuity Limited, its affiliated companies or any other person accepts any liability whatsoever for any direct or consequential loss arising from
or relating to any use of the information contained in this research.
For United Kingdom and European Residents
This research is for persons who are Eligible Counterparties or Professional Clients only and is exempt from the general restrictions in section
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Services Authority.
For United States Residents
This research is distributed in the United States by the entity that published the research as disclosed on the front page of this report to “major
U.S. institutional investors”, as defined under Rule 15a-6 promulgated under the US Securities Exchange Act of 1934, as amended, and as
interpreted by the staff of the US Securities and Exchange Commission (SEC). Analyst(s) preparing this report are resident outside the United
States and are not associated persons or employees of any US regulated broker-dealer. Therefore the analyst(s) may not be subject to Rule 2711
restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.
Additional information is available on request.
Copyright © Canaccord Genuity Limited 2012. – Member LSE, authorized and regulated by the Financial Services Authority.
All rights reserved. All material presented in this document, unless specifically indicated otherwise, is under copyright to Canaccord Genuity
Limited. None of the material, nor its content, nor any copy of it, may be altered in any way, or transmitted to or distributed to any other party,
without the prior express written permission of the entities listed above.


31


32

Research Specialist Sales Market Making Corporate Finance
Paul Locke Nicholas Corke Angelo Sofocleous Gordon Neilly
+44 20 7050 6709 +44 20 7050 6546 +44 20 7050 6547 +44 20 7050 6778
plocke@canaccordgenuity.com ncorke@canaccordgenuity.com asofocleous@canaccordgenuity.com +44 131 222 9409
gneilly@canaccordgenuity.com
Analytical support Andrew Davey Andrew Lewis
+44 20 7050 6542 +44 20 7050 6544 Sue Inglis
Freddie Solway
adavey@canaccordgenuity.com alewis@canaccordgenuity.com +44 20 7050 6779
+44 20 7050 6707
+44 131 222 9414
fsolway@canaccordgenuity.com
singlis@canaccordgenuity.com
Chris Whittingslow Cheyne Bunnett
+44 20 7050 6528 +44 20 7050 6545
cwhittingslow@canaccordgenuity.com cbunnett@canaccordgenuity.com Rishi Zaveri
+44 20 7050 6780
rzaveri@canaccordgenuity.com

Specialist Sales – US
Stephen Davis
+1 617 788 1678
sdavis@canaccordgenuity.com
Marc Loughlin
+1 617 788 1676
mloughlin@canaccordgenuity.com

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2012 forward review - Opportunities &amp; Risks

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