Small is becoming less beautiful in the investment trust world. Problems of wider discounts, poor liquidity and even – in some cases – weaker performance, have started to worry investors.
Another headwind is that wealth managers often won’t touch investment trusts with less than £250 million of assets. They usually need to buy in bulk for a range of wealthy clients, and consider it too risky to hold, say, 10% or 20% of a trust. There can be problems buying enough stock, and problems exiting if they are too dominant a part of the shareholder register. Smaller trusts create complexities. For the trusts themselves, it can deprive them of a natural buyer.
Chris Clothier, co-manager of Capital Gearing (LSE:CGT) Trust, says: “In general, trusts below about £250 million in size are not a viable proposition, particularly because of the mergers that are taking place in the wealth management sector – such as Investec merging with Rathbones. Private client wealth managers are a major investor in the sector and their increasing size demands ever larger and more liquid trusts to invest in.”
However, James Carthew, head of investment company research at QuotedData, suggests that while the sector can’t always bow down to the needs of wealth managers, the lack of demand can hit smaller trusts.
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He says: “The clamour for investment company mergers is mainly coming from the big wealth managers and the brokers that they trade with. Consolidation among the wealth managers is putting all but the very largest - multi-billion pound - trusts out of reach for them and, frankly, I’m not sure it is worth scrambling to meet their ever-greater demands for size.
“Most conventional investment companies’ registers are dominated by individuals, however, and they are becoming increasingly important to alternative funds, too. Individual investors don’t have the same liquidity concerns, but they are worried about being scalped by wide bid-offer spreads, which do tend to be wider for smaller trusts.”
He adds that when investment companies are too small, ongoing charges ratios tend to be too high. Some have got round this by subsidising a fund’s expenses or using unconventional charging structures - as Ashoka WhiteOak Emerging Markets (LSE:AWEM) does, for example. Carthew adds that sub-£50 million funds “may need to think about their future”.
Equally, the demands of wealth managers may not be the only problem. Some trusts are small because the manager has underperformed or the asset class is out of favour. They haven’t been able to raise capital and aren’t growing through investment performance.
Nearly one in three trusts are below £200 million
Investors are left with an inefficient and unpopular trust. These trusts may also be vulnerable to a wind-up or merger. While this may improve performance in the longer term, it can be disruptive. As a result, unless there are clear reasons why a trust is small, it can be a red flag for investors.
As it stands, data from Morningstar shows that there are 99 investment trusts with below £200 million in assets out of a universe of 324 (excluding VCTs) – equivalent to 30.5% of the market.
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Performance data (to the end of August 2023) suggests that smaller trusts have tended to perform worse in certain sectors. For example, in the UK Equity Income sector, only one small trust – Chelverton UK Dividend Trust (LSE:SDV) – has outperformed the sector average, while seven have underperformed. Over three years, two smaller trusts have outperformed. The sector contains 20 trusts.
In the UK All Companies sector, it is a similar picture. All three smaller trusts are below the 10-year sector average, although this evens out over three years. In the Global, North American and Global Emerging markets sectors, the sample size is smaller, but smaller trusts seem to keep pace with larger trusts. For example, in the global sector, the Lindsell Train (LSE:LTI) investment trust has notably outpaced the sector average, while Keystone Positive Change (LSE:KPC) is some way behind.
The UK Smaller Companies sector is also more evenly split. Over 10 years, five out of the 12 smaller trusts in the sector have outpaced the sector average – and some of those – Strategic Equity Capital (LSE:SEC), Rights & Issues (LSE:RIII), Invesco Perpetual UK Smaller Companies (LSE:IPU) – by a considerable margin. Over three years, nine smaller trusts out of 17 have delivered higher returns than the sector average. This suggests that a smaller size is far less of a hindrance for smaller company funds and may even be an advantage.
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Clothier agrees that there are areas where small can be beautiful, “such as niche strategies that can’t deploy large amounts of money or managers with a very strong following”. Some investment approaches are better suited to smaller funds, micro-cap funds, for example.
Nick Wood, head of fund research at Quilter Cheviot, says size isn’t everything. He explains: “It isn’t always the case that smaller trusts necessarily offer less value to shareholders than larger trusts, but it can often be the case. Looking at examples of where small is beautiful, the River and Mercantile UK Micro Cap (LSE:RMMC) trust has repeatedly handed back capital once it has moved above £100 million, seeing this as a maximum for its strategy.
“On the other hand, for trusts invested in larger and more liquid assets, capacity can be many times that. With more assets comes the ability to lower costs, and be more flexible around share buybacks, for example. On the latter point, smaller trusts can sometimes find buybacks problematic when they move to a discount, as ever decreasing size simply reduces the ability of larger market participants to invest.”
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Annabel Brodie-Smith, director of communications at the Association of Investment Companies (AIC), says: “It depends upon the mandate and shareholder base. A smaller size is particularly suitable for specialist areas like micro-caps, where there are capacity constraints. Bigger is not always better, especially where there might be a smaller investment universe and the aim is to achieve the best possible performance.”
Consolidation has been picking up
Where funds are small and struggling to get the attention of investors, in many cases there will be little choice but consolidation or wind-up. Clothier says: “With most trusts standing at discounts, growth isn’t a viable option. The simplest solution is for trusts to liquidate while offering a rollover option, where investors have large capital gains, into either another trust or an open-ended fund pursuing a similar strategy.”
Boards have understandably been reluctant to do this. After all, it may put them out of a job. Nevertheless, there are signs that they are increasingly taking action. Brodie-Smith says: “We have seen a wave of consolidation within the investment company sector in recent years with boards acting proactively to deliver shareholder value, and this year the pace has stepped up.
“High-profile deals like the merger of Perpetual Income & Growth with Murray Income, and Scottish Investment Trust merging with JPMorgan Global Growth & Income have captured attention. Mergers aim to create larger and more liquid companies and reduce costs. Since 2021, 10 investment company mergers have completed, and another five deals have been proposed this year.”
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Abrdn, for example, plans to merge its Smaller Companies Income trust with Shires Income Ord (LSE:SHRS) and has also launched a review into its abrdn Diversified Income & Growth (LSE:ADIG) fund to address its persistent discount.
Wood believes these trust mergers are to be commended if they result in a better outcome for both parties. He adds: “Most likely cost efficiency and an improved performance outcome are high on the board’s list of reasons to do so. However, it isn’t always the silver bullet, not least because the expense of carrying out the merger can in some cases be too high for it to be practical. Boards may also wish to consider whether wind-downs would be a suitable option.”
There are reasons that smaller trusts can work, and in areas such as smaller companies, small may even be an advantage. They can give managers flexibility to invest in niche asset classes and opportunities. However, investors should be cautious in areas where trusts are small for no discernible reason other than that they have failed to attract the interest of investors. Size can matter in delivering value to investors.
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