Manchester & London: Too cautious or complex to keep up with Scottish Mortgage?

As with other technology-focused trusts, it’s been an up-and-down year so far for Manchester & London (MNL), with inflation jitters threatening to undercut high valuations while China’s crackdown on the sector has grown bolder and further reaching.

That follows a 2020 when the £244m investment trust did not flourish to quite the same degree as rivals, despite a portfolio centred around US big tech. That said, the fact a 16% portfolio return for the year looks pedestrian is as a reminder of just how explosively the ‘FAANG’ stocks rallied after the coronavirus crash 16 months ago.

Against that backdrop, Investec analyst Alan Brierley wrote a damning ‘sell’ note this March, taking the trust to task for ‘awful’ disclosure and questioning whether investors can be sure what they’re buying.  

The closed-end fund, led by Mark Sheppard at M&L Capital Management, performed strongly after rotating out of UK companies in 2015 to go all in on global growth and tech that for a while led us to dub it a ‘mini’-Scottish Mortgage (SMT) when in 2018 it won a Citywire performance award for its three-year returns. However, as Brierley pointed out, performance had worsened since 2018, with the trust lagging SMT and other tech-focused trusts, as well as core holdings like Amazon and Microsoft, in the internet surge that followed the initial pandemic panic.

Speaking to Citywire, Sheppard said 2020 could be seen as a ‘disappointing’ year, relatively speaking, with returns held back after he and co-manager Richard Morgan positioned the portfolio more cautiously in the ‘eye of the storm’ in the second quarter. 

‘If you’re going to level a criticism at us, we weren’t brave enough,’ said Sheppard.

Although hindsight has proved him wrong, Sheppard argues such caution was justified and that the trust has performed in line with the FAANGs since then. 

However, the trust can puzzle observers. During the China tech stock sell-off of recent days, MNL shares have not fallen much, despite a 30% net exposure to Chinese companies, such as Tencent and Alibaba.

Tech sector travails

The concerns around performance have coalesced to drive a derating. MNL shares have slid to trade nearly 13% below net asset value (NAV) , more than double the 5.3% average discount of the past year.

‘There has obviously been this cyclical rotation and move towards cyclicals and obviously we’re not the theme du jour at the moment,’ said Sheppard.

‘There’s no reason to suspect that it’s not temporary because it seems to have affected sector-wide rather than [being] intrinsic to ourselves,’ he added.

The manager, who owns more than half of the trust’s shares through a company he controls, and has also bought back shares regularly this year, pointed out larger rivals had similarly derated. It is worth noting that while MNL resides in the Association of Investment Companies’ Global sector, the portfolio consists almost entirely of tech companies, sector funds and exchange-traded funds (ETFs).

The £1.3bn Allianz Technology Trust (ATT) has slipped to a 7% discount, having typically traded less than 2% below NAV. Herald (HRI) has tended to trade at a wider than 10% discount, but nonetheless the £1.5bn trust is 13.4% adrift of NAV today. Polar Capital Technology (PCT) – which MNL owns a stake in for the more mid-cap US tech exposure it offers – is on a 7.7% discount versus a 6% average over 12 months.

Sheppard also emphasised that contrary to the perception in some quarters, he was positive rather than negative on other tech trusts, feeling they and his fund all offer something distinct. MNL still owns PCT, and he backed ATT and Scottish Mortgage (SMT) for a decade at Midas Investment Management’s wealth management business, which he founded before selling it to Tilney in 2017.

Chief among Brierley’s contentions was a seeming disconnect between MNL’s strongly-performing core of holdings and lagging returns last year, leading the analyst to question the clarity around the portfolio.

The managers’ selling of ‘covered’ call options on stocks they own – giving other investors the right to buy the stocks if they fall –  produces income to generate the trust’s comparatively high 2.3% yield, given the dearth of dividend-payers in the portfolio. But these also effectively act as short positions and cap upside if shares rise quickly, as in the second quarter of 2020, driving last year’s underperformance.

Sheppard defended the disclosure made on factsheets. In particular, he said representing positions with the net ‘delta-adjusted exposure of options’ was the industry norm, used by other fund managers including Fidelity, Goldman Sachs and, indeed, Polar Capital. Given the downside or upside from an option fluctuates relative to the price of the underlying stock, this indicates what the equivalent exposure would be from, say, just buying Amazon shares, as opposed to owning the shares as well as selling an option.

MNL has made some changes to its factsheets to provide more clarity, including adding a visual chart to show its overall market exposure. There is also a link to its website with more information.  

Why we’re learning to code

In terms of the outlook for the portfolio, the managers feel the rise of cloud computing has been the major driver of the sector. That may continue for the next three to five years, but they expect artificial intelligence to become the next key theme.

To understand how that could develop, both Sheppard and Morgan have been learning how to code, arguing this is an important part of their ‘edge’.

Both have been undertaking Computer Science degrees at The Open University. Sheppard said he was nearing the end of his third year, with Morgan not far behind, and he has now been accepted to do a Masters in AI at Bath.    

So far, they expect AI’s development to favour the same set of tech winners. The portfolio’s top five of Amazon, Microsoft, Alphabet, Alibaba and Tencent combined accounted for a net 57% of exposure at the end of June. Sheppard said most of the top scientists in AI work in the research departments of these companies and emphasised the importance of scale in pushing the area forward.

‘If you rank them on academic distinction and amount spent, you’re going to come to that list,’ he said.

The two new buys last month were the iShares Expanded Tech-Software Sector and Global X Cloud Computing ETFs. At 1.9% and 1.4% positions respectively, Sheppard said both were ‘pragmatic momentum’ plays.

Over the five years to 27 July, MNL shareholders have enjoyed a 145% total return, underpinned by a 127% underlying investment return. Both figures beat the 86% of the MSCI AC World index, but trail the more volatile but similarly positioned Scottish Mortgage, which has generated 347% for shareholders and a 358% return on net assets.

Complicated picture

Having seen Manchester & London’s live position sizes as part of the interview, I can confirm that there is nothing ‘hidden’ in the portfolio which mysteriously detracted from returns last year. The handful of positions outside the top 20 and not listed on the factsheet are small options positions relative to the size of the fund.

However, while the options strategy clearly helps generate income for a growth-driven portfolio, the lagging returns in last year’s explosive second quarter for tech seem to indicate that this is not a one-way street. (The fund ended March 2020, as the rally was taking off, with 88% exposure to the market.)

It is undeniable the mathematics of options trading is baffling – as is evident from even the thinnest discussion of ‘delta-adjusted exposure’ – and from my understanding, it seems possible that underlying exposure can shift quickly in volatile conditions. All that makes it difficult to represent stock exposures with one number.

While many other trusts such as Fidelity China Special Situations (FCSS) or Gervais Williams’ funds (with spectacular results last year) use some derivatives, it also does clearly complicate the offering for investors.

MNL’s website and linked articles attempt to explain why the managers think the options strategy represents an attractive mix of risk and reward, as well as explaining the hedging strategy and why the fund is benchmarked against a UK index. It broadly makes sense, but personally I’d prefer a simpler approach that offers a long-term, positive approach to tech companies without the derivatives wizardry. A bit like Scottish Mortgage in fact.

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