Investment trusts: a sector under siege

Peter Walls cannot remember a time “when passions were running this high” in the world of investment trusts. 

“A sector that has been around for more than 150 years and has served generations of investors well appears to be under siege,” says the manager of the Unicorn Mastertrust Fund, which invests primarily in a range of listed investment companies.

As inflation continues to erode the value of people’s savings, many investors are looking to investment trusts to provide a measure of protection from economic problems. Investment trusts can offer a flow of income via dividends, or focus on growth companies that fuel investment returns if managers succeed in picking winners.

However, trusts have also suffered from high inflation, as investors have taken advantage of raised interest rates and poured money into government bonds. This means discounts to net asset value — a measure of investment trusts’ health — have widened dramatically. That has put their boards under pressure. 

Some market analysts believe this represents a chance to buy at the nadir of market sentiment and watch returns accumulate as the market recovers over the long term. Others worry that extreme discounts suggest deeper problems at some trusts: for these, a recovery may never materialise. As Britain’s retail investors cast the net wide for reliable growth and income, should investment trusts form part of the answer? FT Money examines the outlook for the sector. 

From heroes to zeroes

It wasn’t like this just a few years ago. Nick Wood, head of investment fund research at Quilter Cheviot, harks back to the “good days” of 2020. “The investment trust base was on an absolute tear . . . infrastructure and renewables were on huge premiums and investment trusts were great for income investors.”

But that was before inflation took off and the Bank of England introduced a succession of interest rate rises. Since investors can now get a 5 per cent “risk free” return on their cash in the bank, many feel no urgency to take on equity risk.

So the investment trust universe has seen a significant sell-off over the past 18 months, with the average discount — the gap between trusts’ share prices and the net value of their assets — widening from around 2.2 per cent at the start of 2022 to 16.9 per cent by the end of October 2023, according to the Association of Investment Companies (AIC), the trust lobby group. This is the widest discount for a month-end since the last day of December 2008, when the world was in the depths of the global financial crisis and the average investment trust discount was 17.7 per cent.

The AIC cites a number of problems — including high inflation, interest rates and unhelpful regulation. But Thomas McMahon, investment trust research manager at research firm Kepler Trust Intelligence, thinks most of the historic discount opportunity can be put down to interest rates.

A trust with a headline yield income of 5 per cent that can be bought on a discount gives the investor an income of more than 5 per cent. “Discounts have widened to give 7 per cent income — which alongside the capital growth potential gets people interested. People are concerned about this recession and the economy but eventually they’ll realise cash loses to inflation,” says McMahon.

When discounts are wide, one school of investing thought holds that this is an attractive time to invest. When the appetite for more risky asset classes recovers, investors could enjoy enhanced returns from a double bonus of positive movements in the net asset value of the trust and reduced discounts.

With virtually all investment trust sectors at historically wide discounts, Peter Hewitt, manager of the CT Global Managed Portfolio Trust, an investment trust that invests in a range of investment companies, calls it “a once in a generation opportunity”.

The last time discounts were this wide — at the end of 2008 — the average investment company returned 39 per cent over the next year and 119 per cent over the next five years, according to AIC data.

Mick Gilligan, head of managed portfolio services at wealth manager Killik & Co, says that of the 147 larger (£250mn market cap) investment trusts that he monitors, 70 per cent trade on discounts of 10 per cent or more. “This is a very large number of attractively valued trusts that investors can choose from. Lots of equity markets — UK, Asia, emerging — look cheap. The long-term returns from investment in these areas look bright.”

The discount flipside

But a big discount can just as easily be read as a warning to investors, not an opportunity. Investors must tread carefully when a trust is on an “extreme discount” of around 50 per cent, says Wood of Quilter. “It’s telling you the market doesn’t believe the valuation or the market is concerned about the ability of the trust to continue,” he says.

Some sectors look riskier than others. Wood says the digital infrastructure sector includes some trusts on extreme discounts. Hewitt is avoiding commercial property trusts given the impact of hybrid working, and debt and credit trusts — “you don’t know where problems will pop up”. And Gilligan warns: “The portfolios of some of the global trusts look very richly valued,” pointing to examples such as STS Global Growth & Income and Lindsell Train.

To avoid pitfalls, investors can consider trusts which have sold some of their assets at a premium, or are actively buying back stock. Such actions suggest the existing portfolio, which is available to buy on a discount, is more attractive than any alternative investments that the managers might select.

Another thing to watch out for is the level of debt or gearing in an investment trust. The ability to borrow to buy shares or other assets sets trusts apart from other funds. But investors need to be aware of how much the managers have been paying for that borrowing as interest rates have risen. Some trusts locked in long-term low-cost borrowing deals before interest rates rose, so are in a good place. But Pittard says: “If significantly geared, and the market perceives the amount or cost is too high, the investment company typically trades at a discount to its peers.”

There are other trends contributing to the picture of a “sector under siege”. One is the scarcity of investment trust launches, with just two new issues this year after a complete drought in 2022. Amid share price declines, some launches have struggled to meet a minimum size. Christian Pittard, head of closed end funds at Abrdn, says: “I believe the new issue market will recover, but it requires innovative strategies that investors cannot easily access in other wrappers like exchange traded funds and open-ended funds.”

Trusts in flux

A bigger trend is increasing consolidation in the sector. Plans announced this year include the merger of Abrdn New Dawn with Asia Dragon; Henderson Diversified Income with Henderson High Income Trust; and a double merger of Nippon Active Value with Abrdn Japan and Atlantis Japan Growth. The AIC says investors want bigger, more liquid — but cost-effective — companies. Wood says: “For some of the smaller trusts, being acquired and improving management is good for shareholders.”

The AIC points out the increasing presence of activist investors on investment company share registers, which it says shows that “some, at least, recognise the value in the sector”. Walls points to Saba Capital, which has built stakes in several companies as a predator to watch.

For investors without new funds to invest in, one option can be the “sister” investment trusts to some open-ended funds — conventional unit trusts or mutual funds — that follow the same investment goals and are managed by the same fund manager. 

Wood says: “If you own an open-ended fund, it’s a good time to be switching to the equivalent investment trust.” He gives the example of the Fidelity European Fund and Fidelity European Trust. Both have the same managers and the investment trust is trading on an 8 per cent discount. Alternatively, for investors holding funds without a “sister” trust, one option might be to consider an investment trust with a different manager but similar remit.

For an investor, it will always be impossible to call the bottom on prices. But those with available cash can lower their risk by spreading money between a few discounted trusts. McMahon says: “If you could force yourself to invest in five to 10 diversified investment trusts and forget your password for five years, it’s likely you would do well. Looking back, it will have been a good time to have bought in.”