What latest big deals mean for investment trusts

In a couple of months’ time the number of European investment trusts is likely to have shrunk from 10 to eight, with two mergers having been announced in quick succession.

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The first, disclosed last week (19 June), is the proposed combination of Henderson European Trust (LSE:HET) and Fidelity European Trust (LSE:FEV). The enlarged FEV is expected to have net assets of over £2.1 billion, with Sam Morse and Marcel Stötzel continuing to manage the portfolio under the same investment approach.

Shareholders in HET who don’t want to move investment trust can elect to receive cash for their shares, limited to 33.3% of share capital.

The second proposed merger, announced today (23 June), involves European Assets (LSE:EAT) and The European Smaller Companies Trust (LSE:ESCT). As a result, ESCT’s assets are expected to increase to £780 million and it will continue to be managed by Janus Henderson’s Ollie Beckett.

While the investment objective remains the same, a new dividend policy will be put in place that will target an annual distribution equal to at least 5% of its prior year end net asset value (NAV) on a quarterly basis. EAT shareholders can also cash in, limited to 15% of share capital.

Both mergers are subject to shareholder approval, with votes taking place in the coming months. However, boards typically garner support from large shareholders before proposed mergers are announced, and they are typically given the green light.

The two recent announcements have come hot on the heels of the completion of another big merger, with Henderson International Income Trust combining with JPMorgan Global Growth & Income (LSE:JGGI). That followed a record year for investment trust mergers in 2024, with 10 taking place. The most prominent was Alliance Trust and Witan combining to create Alliance Witan (LSE:ALW).

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The uptick in mergers reflects investment trust boards becoming more size-conscious in a bid to try and win over more investors at a time when the sector’s out of favour.

A key driver has been consolidation within the wealth management industry, with such firms being big investors in investments trusts. As a result, fewer wealth management clients now control greater sums of money and, due to this, will invest only in investment trusts of a certain size for liquidity reasons (the ability to buy and sell easily). For small investment trusts, those with assets of below £300 million, it’s more difficult for larger investors to commit a large sum.

That’s not to say that small cannot be beautiful for retail investors on the lookout for opportunities in potentially under-the-radar investment trusts. Indeed, some investment trusts with a low amount of assets have produced strong long-term performance. However, bear in mind that some small investment trusts have higher costs, including potentially higher dealing spreads.

Ultimately, the bigger an investment trust, the greater the chance of higher demand due to the likelihood of it being on the radar of both retail investors and wealth managers. 

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Another reason why investment trust boards have become more size-conscious is due to the sector being out of favour over the past couple of years. The average investment trust discount has been wider than -10% since 2022, while many trusts are on discounts that are much bigger. When discounts stay at a stubbornly wide level for a couple of years, it becomes more difficult to win over new investors as the discount becomes entrenched. This is particularly a problem for smaller-sized trusts that fall under the radar.

There are a number of drivers explaining the drop in investment trust demand over the past few years, but chief among them has been higher interest rates. Rising rates have caused bond yields to rise to attractive levels, leading many investors to dial down on risk.

To boost demand for a trust’s shares and improve liquidity, boards have a few options. They can issue or buy back their own shares in an attempt to reduce the discount. Alternatively, boards can limit discount risk by putting what is known as a “discount control mechanism” in place. Those trusts with a discount control mechanism commit to keeping the discount within a certain range, typically anywhere from zero to -10%.

However, while buying back shares is a sign of confidence from a board that is viewing the discount as being unjust and too cheap, it’s no panacea. Buybacks won’t prevent discounts widening if there’s no demand for the shares. Moreover, if there is a lack of demand, share buybacks will cause the assets of the investment trust to shrink. Therefore, for small trusts, having an ongoing share buyback policy may not be sustainable.

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Much more important over the long term is the performance of the underlying investments held by the investment trust. This has the biggest influence on the overall total shareholder returns.

Put simply, if the trust doesn’t perform well, it’s likely to consistently have a high discount due to a lack of demand for its shares. For investment trusts that aren’t attracting investors but are carrying out share buybacks, this leads to assets shrinking and means less liquidity for the shares in the future.  

Over the past couple of years, investment trust boards have become increasingly proactive in other ways, including replacing an underperforming manager or fund management group, changing the trust’s strategy to broaden its appeal, or winding up the trust altogether.

Boards are a key advantage for investment trusts. The role of a board includes exercising independent oversight, holding managers to account (with the ability to sack them) and looking after the interests of shareholders (such as by driving down costs).