The big trends shaking up investment trusts

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This week, Kyle is joined by ii’s Dave Baxter to discuss key developments and trends impacting investment trusts. The duo run through why US activist investor Saba Capital is targeting the sector and which trusts it has in its sights. Kyle and Dave also explain the rise in trust mergers (including why a recent high-profile merger was abandoned), and why they are fans of the move by some trusts to offer performance-linked ‘escape routes’.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to the latest episode of On the Money, a weekly look at how to make the most out of your savings and investments.

In this episode, we’re going to be focusing on some key developments that have been impacting investment trusts. Joining me to discuss this topic is Dave Baxter, senior fund content specialist at interactive investor. Dave, thank you for joining me.

Dave Baxter, senior fund content specialist at interactive investor: Pleasure.

Kyle Caldwell: So, Dave, to start off, I just want to get across that we are both big fans of investment trusts.

For those who are maybe less aware, investment trusts are like a fund, they invest in a selection of different types of investments. However, there are some differences between an investment trust and a fund.

One of the big differences is that an investment trust is a company that’s listed on the UK stock exchange, and there’s two parts to an investment trust. So, there’s the share price, which fluctuates in terms of supply and demand, and there’s also what’s known as the net asset value or the NAV. This reflects the value of the underlying investments that are held within the investment trust.

You quite often see investment trusts trading on a discount, which means that the share price is trading below the value of the underlying investments.

In some cases, an investment trust discount gives investors an opportunity to potentially pick up a bargain. However, and as we’re going to talk about, Dave, that’s not always the case.

Another difference between an investment trust and a fund is that investment trusts have independent board members, and it’s their duty to act in the interest of shareholders. They even have the power to change the fund manager or fund manager group running the investment trust.

Now, a problem that investment trust boards have been seeking to try and solve is the fact that trust discounts have been trading on wide levels for around three, four years. The typical investment trust has been trading on a discount of around 15%.

Dave, to start off with, there’s not just one single answer to this, but what, for you, are the main reasons why investment trusts have been trading on these stubbornly wide discounts for a couple of years now?

Dave Baxter: Yes. So, it’s interesting. Trusts do, structurally, tend to be on discounts anyway, but as you mentioned, they’ve widened out since around 2022, maybe late 2021. There’s a few culprits that stand out to me.

One is interest rate rises. That sent a bit of a shock through markets anyway, and in particular maybe some popular trusts and some more growth-focused trusts. So, that was the thing.

And while we’ve seen discounts come in a little bit this year, they still haven’t completely recovered.

Some other things to mention. One big structural issue is wealth managers. They are kind of professional buyers of funds. They have been consolidating over the years, so gobbling each other up, and wealth managers are getting bigger and bigger and bigger.

This means that in order to hold a trust, they now need the trust to be bigger, so that it’s liquid enough for them to trade in and out. So, that is limiting the number of buyers for given trusts, which is probably also holding those discounts out.

A couple of other things are worth mentioning. One, it’s a bit of a vague idea, but you might just have a spiral of sentiment. People keep talking about the fact that these discounts are persistent, and therefore, people are seeing the investment trust sector as being in crisis and not really wanting to touch it.

Finally, this is maybe a bit of a consequence of the rate rises that we mentioned, but investors might still be a bit uncertain or unconvinced about the valuations on certain assets, so things like private equity and infrastructure. They might feel like they don’t know what the true worth of it is in an era of higher rates where those assets are, in theory, less valuable.

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Kyle Caldwell: Going back to your points on consolidation within the wealth management industry, what this means is that if an investment trust has assets of less than £300 million, they are not really going be on the radar of a wealth manager. They are not going to be able to have enough liquidity for the wealth manager to buy that type of investment trust.

I’m going to come on to this in a moment. We have seen an uptick in investment trust mergers over the past two years in particular. One reason is because investment trust boards know that there’s increased importance in terms of having scale.

For a retail investor, that doesn’t mean you can’t look for investment trusts that are below £300 million. Indeed, in some cases, some of them might be a potential hidden gem.

However, the main thing to consider for retail investors with an investment trust that’s got a small amount of assets, is the bid/offer spread. Because there are instances where the bid/offer spread is pretty wide due to the fact that its got a smaller amount of assets.

In terms of investment trust discounts, I think sometimes it’s not completely understood in terms of how to compare an investment trust discount.

Ultimately, with investment trust discounts, they don’t converge to net asset value. They tend to converge to their mean discount over time. I think that’s a better sort of proxy to look for rather than think, ‘OK, an investment trust’s trading on a discount of 15%. So, what this means is that, over time, that discount may go to NAV, net asset value.’

If it’s trading on a discount of 15% and it’s been on a discount of 15% for the past five years, then arguably, it’s potentially not going to be a bargain.

Dave Baxter: Yeah. I think it’s also worth mentioning that people maybe sometimes get a bit too worried about discounts. It’s not necessarily the end of the world.

It does open you up to the risk of corporate action of different kinds, but there are many cases, and this used to be the case with private equity trusts, where for years and years and years, they languished on these huge discounts. But if you look at the underlying share price returns, then you’ve done extremely well.

Kyle Caldwell: In terms of other reasons why investment trusts are on wide levels, as you mentioned, Dave, interest rate rises have been one of the big causes of it.

So, we saw interest rates in the UK rise from rock-bottom levels to peak at 5.25%. Obviously, we’ve now been seeing interest rates come down, and the expectation heading into 2026 is that we may see another interest rate cut in the not-too-distant future.

However, interest rate rises have increased the level of income that an investor can receive from lower-risk assets such as bonds and cash. And due to that, investors are less incentivised to take greater levels of risk when you can get a yield of, say, 4%, 4.5% on a very low-risk asset like cash or a money market fund.

Dave Baxter: Yeah. As we’ve discussed, money market funds are stubbornly popular, and maybe we will see that shake out as rates come down. But, you look at this year, you’ve had a context where equity markets are racing ahead. So, how much is it going to take to draw people back into those risk assets?

Kyle Caldwell: I mentioned earlier that there’s been an uptick in investment trust mergers over the past two years. Just to quote some statistics on it, 2024 was a record year for investment trust mergers - 10 took place. Probably the most prominent was the merger of Alliance Trust and Witan to create Alliance Witan Ord (LSE:ALW).

This year, we’ve seen some other mergers take place. So, Henderson European Trust merged into Fidelity European Trust Ord (LSE:FEV), and another tie-up saw European Assets merge with the The European Smaller Companies Trust PLC (LSE:ESCT).

However, a recently proposed merger, which in fact is now being abandoned, was the proposed combination of HICL Infrastructure PLC Ord (LSE:HICL) and the Renewables Infrastructure Grp (LSE:TRIG).

Dave, you’ve been covering the developments of this proposed merger, which have proven controversial. Could you talk us through it?

Dave Baxter: So, anyone who loves a bit of drama will have enjoyed this. It’s been quite a tumultuous couple of weeks. So, a couple of weeks ago from when we’re recording this, they came out with the idea of this mega-merger, the Renewables Infrastructure Group and HICL.

Both infrastructure trusts would create a vehicle with great scale, and they said it had a good sounding from some of their bigger shareholders. However, it quickly hit the buffers.

You saw HICL shares tanked a bit. TRIG shares, conversely, rose. But a lot of people took issue with the nature of the merger because what you’ll be doing is combining so-called core infrastructures, what HICL holds, things like hospitals, roads, that kind of stuff, with renewable energy infrastructure, which is subject to so many more moving parts and has had a lot of challenges in the last couple of years. So, opposition mounted.

About a week ago, we saw a group of shareholders who had something like a combined 13% of HICL saying that they opposed this. It’s been HICL shareholders in particular being against it. And now, on the morning of the day we’re recording this podcast, we saw it get abandoned.

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Kyle Caldwell: Yeah. As you mentioned, Dave, they invest in the same sector, but it’s a very broad sector, and the assets they both hold are not like for like. So, going back to Alliance Witan, that was a much cleaner merger. They both had a multi-manager structure. They are both dividend heroes. I can see why that got the go-ahead, why that got the green light.

Whereas with this one, the main opposition to it was the fact that they are investing in different types of infrastructure assets. If you’re a shareholder in HICL, then you’re buying it because you want exposure to that part of the infrastructure sector rather than owning renewable infrastructure, which is a completely different asset mix in terms of type of investment.

You wrote a story, Dave, in which there were a number of investors who clubbed together in opposition over this proposed merger. Could you talk us through that?

Dave Baxter: Yeah. So, again, this really built up the drama. You had CG Asset Management, which runs the portfolio on the Capital Gearing Ord (LSE:CGT), a wealth preservation trust, initially coming out really hard against this deal.

They described it as appalling, and they had some of issues we’ve highlighted. You’re mixing different sectors. They felt like, basically, it would be fine if you already held both HICL and TRIG. But if you’re a HICL shareholder, you were kind of getting a raw deal because, I suppose, in recent years, renewables have just had so many more issues. HICL invests in so-called core infrastructure, which is quite slow and steady in some ways, whereas renewables have had a lot of problems.

So, yeah, they basically came out against that for those reasons.

To mention some other criticisms, issue has been taken with the fact that InfraRed, the investment manager of both trusts, is, I suppose, potentially benefiting from this, and the deal would have allowed TRIG to avoid a continuation vote due next year.

The thing that’s really irked quite a lot of shareholders is the fact that the four boards are keeping their jobs. So, you would have basically ended up with an 11-strong board, which is enormous. Our columnist, Ian Cowie, was looking at some of the numbers and what cost it would have been.

So, all those things mounted up to basically lead to many people opposing this.

Kyle Caldwell: While there’s been an uptick in mergers, which as mentioned, is because there’s now an increased focus among investment trust boards on scale and trying to rein in a discount, or at least control a discount [so] that it doesn’t spiral to a really high level.

The big story in the investment trust world over the past 12 to 18 months or so has been US activist investor Saba Capital. Around this time last year, the investment trust industry was rocked by Saba Capital sort of coming on to the scene and launching a campaign to try and oust the boards of seven investment trusts.

Those seven investment trusts were Edinburgh Worldwide Ord (LSE:EWI), Keystone Positive Change, Baillie Gifford US Growth Ord (LSE:USA), The European Smaller Companies Trust PLC (LSE:ESCT), Henderson Opportunities, CQS Natural Resources G&I Ord (LSE:CYN), and Herald Ord (LSE:HRI).

Saba requisitioned general meetings for all those seven investment trusts and asked shareholders to vote on whether the boards should be ousted.

Now, while Saba was unsuccessful in its campaign, shareholders did vote against the proposals, and the board members retained their places at all seven of those investment trusts. It did lead to a fair bit of change. Some of those investment trusts no longer exist, and others have introduced certain policies to try and appease shareholders, trying to make their investment proposition potentially more attractive.

Dave Baxter: Yeah. So much has happened that it’s almost quite difficult to keep up with. But to summarise some of it, Keystone Positive Change and Henderson Opportunities ended up basically disappearing. So, they both did a kind of wind up where you had the option to roll over into an equivalent open-ended fund. That allowed Saba to get out closer to NAV and shareholders to do so as well.

Some of the trusts ended up, I suppose, having a harmonious conclusion to the Saba fight. So, the CQS trust and European Smaller Companies ended up getting Saba off of the shareholder register by holding a tender offer. But then, interestingly, you have a few names, Herald, Baillie Gifford US Growth, and Edinburgh Worldwide who are still stuck with Saba. Saba is still something like a 30% shareholder there. So, they are kind of in limbo for the time being.

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Kyle Caldwell: Let’s come on to Edinburgh Worldwide. As you recently reported, Dave, Saba has now come back again and requisitioned another meeting with Edinburgh Worldwide. And, again, it’s calling for the whole board to be removed.

Now, last time around, the ultimate aim of Saba was that it would run some sort of investment trust or exchange-traded fund (ETF) that would invest in investment trust discount opportunities. However, so far, it’s simply asking for the board to be removed.

It hasn’t stated publicly what its intentions are after that. If it is successful and new board members are introduced, it’s not then said what would happen next, whether the investment strategy would change, whether it would try to be its fund manager.

Dave, could you run through the reasons why Saba has returned?

Dave Baxter: Yeah. So, they issued an open letter to the board. They have bemoaned, basically, sort of inactivity on the part of the board since they survived the attack earlier this year. They’ve argued that performance hasn’t been good, and there are different sides to that argument. They’ve also complained that the board has carried out an inadequate level of share buybacks.

I suppose in my mind, the issue is more, as I mentioned, that Saba has a really big position there, and what they would want is to get out. So, they would require the board to do something like a big tender offer like the CQS Trust or European Smaller Companies did, so that they can get out at a profit.

Kyle Caldwell: Yeah, and they want to get out at a lower level of discount. Or, ideally, they want to get out close, or at net asset value, at the value of the underlying portfolio rather than the share price trading below it.

In terms of other investment trusts in Saba’s sights, you’ve got a list from Winterflood, which highlights the investment trusts in which Saba is a big shareholder, typically at least 10% or more in terms of its position.

Are there any trends within the types of investment trust that Saba is targeting? Is it simply a case that they are looking at out-of-favour investment trusts that haven’t been performing well over the past three, five years? And in some cases, that’s down to the investment style or the area of the market that the investment trust is focusing on.

Dave Baxter: So, I think they are looking at out-of-favour trusts, and they are looking where discounts are pretty wide so that, in theory, if they can do a tender offer or that kind of thing, they can make a decent profit versus their original investments.

There’s a couple of interesting trends here. So, there’s still kind of a Saba backlog. We’ve talked about the original targets, but there’s also lots of different trusts that it’s held for quite a while. So, you have various UK small and mid-cap names, like, for example, Schroder UK Mid Cap Ord (LSE:SCP), BlackRock Throgmorton Trust Ord (LSE:THRG), where it has big stakes.

It also has a really big stake in Crystal Amber Ord (LSE:CRS), so that’s quite a niche UK small companies fund. It’s already been in wind up for quite a long time. Although recently, it now has one remaining position. It thinks it can hold on and get a, I suppose, more profitable exit from that position further down the line. So, the trust has basically chosen a new investment manager and wants it to oversee that. So, that’s maybe the first wave of positions that Saba has.

What’s really interested me in recent months is, I interviewed Saba in an old job. It must have been January this year. At the time, they were saying they didn’t really want to hold things outside the equity space because they wanted to be able to accurately value the positions, and they didn’t know how to value unlisted assets. But what we’ve seen in recent months is they’ve begun to take up so-called alternative asset class trusts.

So, battery storage funds. A week or so ago, they disclosed a position in Pantheon International Ord (LSE:PIN) with the private equity name, things like Molten Ventures Ord (LSE:GROW). That’s kind of fascinating because they are potentially chasing bigger discounts, but they might struggle to use some of the techniques they’ve previously used to get out quickly because the portfolios are not very liquid, and you can’t suddenly liquidate a load of private equity assets in order to do a tender offer, that kind of thing.

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Kyle Caldwell: For me, as a retail investor, if I owned any of those investment trusts that Saba have big stakes in, and they are applying pressure on the board to rein in a discount, if that discount narrows, then that gives the retail investor a better opportunity to get out at a better price, if indeed they wish to do so.

I’ve mentioned that a lot of these investment trust that its targeting have been out of form. In a lot of cases, it's been the investment style or the area of the market it invests in - it’s faced a lot of headwinds, and that hasn’t helped performance. But if you are unhappy with performance, then a narrowing discount gives you the opportunity to get out at a better price.

Now, we’ve seen Saba have success in certain areas. Early this year, Middlefield Canadian Enhanced Income ETF (LSE:MCTC) turned from an investment trust into an ETF. And we’ve seen in recent weeks, Smithson Investment Trust Ord (LSE:SSON) propose to turn from an investment trust into an open-ended fund. Saba holds around 17% in Smithson, and they’ve clearly used their influence. They don’t want Smithson to be trading on a wide discount. They want that discount eliminated, and that has led to Smithson’s proposal to turn into an open-ended fund.

Dave Baxter: Yeah, it’s interesting. I think it’s interesting to explore whether we would see more of that. I did have a quick look at some of those trusts listed by Saba, and it’s hard to tell on the face of it whether that could apply there.

But I did create a handy checklist of features which might make it easier to convert into an ETF, into an open-ended fund, that kind of thing. So, it might simply be if you’re not using or reliant on the features of an investment trust. For example, you don’t need to use gearing. You don’t have the massive position sizes that are not always permitted in an open-ended structure. And, importantly, you hold stuff that is pretty liquid, and you don’t need the closed-ended structure in order to do that.

So, it’ll be interesting to keep an eye there and just see whether Saba does end up pushing for more of that kind of action.

Kyle Caldwell: Yeah. I think the areas of the investment trust industry in which Saba’s not really looked at the moment - well, I’m assuming it has looked, but it hasn’t ventured into - are those investment trusts that have a really long track record of growing their dividends year in, year out.

They are using the structural advantage that investment trusts have of being able to retain 15% of income generated each year in a dividend reserve. What that means is that when an investment trust has a lean period, when there’s fewer dividends coming in, the investment trust can dip into those reserves to keep income payments flowing or maintain the level of income.

For a lot of investors in those types of investment trusts, they are buying it primarily because, all things being equal, the income generated each year should be maintained or should go up, especially if it has got a lot in dividend reserves.

Those types of investment trusts, I could never really envisage seeing them turn into an ETF or an open-ended format because they are using the structural advantages that investment trusts have in terms of being able to put away a certain amount of income each year to then pay at a later date.

Dave Baxter: Yeah, and I suppose we’re seeing that driving popularity for those names. Earlier, we were discussing names like City of London Ord (LSE:CTY) that tend to trade on small premiums. So, they are clearly in lots of demand and also, therefore, not really a bargain that Saba can pick up, at least at the minute.

Kyle Caldwell: To end, I wanted to touch on share buybacks. This is one of the tools that an investment trust board has to try and rein in, or keep a discount broadly at a similar level over time.

However, as you know, Dave, these share buybacks are certainly no panacea. Ultimately, if an investment trust isn’t performing well, if it’s not doing something sufficiently different from the wider market, then what share buybacks do is they’ll shrink the size of the investment trust rather than stimulate demand. I think performance is key.

Going forward, we’ve had 10, 15 years of global stock markets performing really well. We don’t know how they are going to fare in the future over the next 10, 15 years. But I think due to how well global stock markets have performed, a lot of investors are now taking the view that if you just own the market, you’ve done pretty well. They think, ‘Why would I try and go down the active management route in order to beat it?’

Because as we know, with an active fund, there is the opportunity for outperformance, but there’s also the risk of underperformance, and in some cases, quite vast underperformance versus an index.

Dave Baxter: Yeah, I agree. It comes down to performance. It also comes down to doing something distinctive. The problem, I suppose, with the idea of being distinctive is, as you’ve said, equity markets have just done incredibly well in recent years.

So, doing anything different to the index has been, if not extremely painful, it’s been very easy to underperform. But perhaps we’ll see things turn around and then see things change.

Kyle Caldwell: One final trend to note is that we have seen a bit of a rise over the past couple of years in what is known as performance-linked tender offers. Essentially, if you remove the jargon, what some investment trusts have said is that if they don’t beat a comparable index over a certain time frame, such as five years, then they’ll offer shareholders an escape route.

There’ll be a certain percentage of shares that can be what’s known as tended, and you can get out of that investment trust at close to net asset value.

Dave Baxter: Yeah. I think it’s a good mechanism and one of the many things trusts can use to perhaps ease people’s concerns about underperformance. Although the question is, if you have a performance-linked tender offer on a three-year basis, is someone going to stick with the trust that long if it’s not delivering the goods?

Kyle Caldwell: Just to put some figures on this, since the start of 2024, 12 of the 22 investment trusts that have a performance-related tender offer have since put one in place, so just over half have introduced a performance-linked tender offer.

Among the fund managers that have introduced such an arrangement are Baillie Gifford, JPMorgan, BlackRock, and Aberdeen for some of their investment trusts. These policies provide a clearer exit opportunity for investors, but, as mentioned, I think if I was in one of those investment trusts that had this sort of policy, I’m going to be happy either way.

I’m going to be happy if performance has improved and it’s beaten a comparable index. I’d also be potentially happy to get out at a better price if I couldn’t envisage performance improving over time.

Dave, thank you very much for coming on the podcast today.

Dave Baxter: Thank you.

Kyle Caldwell: And thank you for listening to this episode of On the Money. If you enjoyed it, please let us know what you think. You can comment on your preferred podcast app. And if you’d like to leave a review or a rating, that would be much appreciated. In the meantime, you can find more information and practical pointers on the interactive investor website, which is ii.co.uk.

We’ll be back next Thursday. Hopefully, see you then.