Investment trust investors are suffering this year, with the sector dropping around 2% so far in 2023, including dividends.
A key reason for the average trust being in the red is the widening of discounts, which in the spring reached their widest levels since the financial crisis of 2008. Since then, they have not yet begun to narrow, according to data from industry trade body the Association of Investment Companies (AIC).
The typical global trust is now on an 12% discount, while UK All Companies trusts are on 12.5% discount on average and UK Smaller Companies are on a 13% discount, according to data from Morningstar.
Overall, investment trusts on average are on a 14% discount, excluding Venture Capital Trusts, according to the AIC.
Investment trusts are listed on the stock exchange, so the value of the shares can diverge from the underlying value of the assets that a trust owns. In times of market stress and poor sentiment, discounts tend to widen, while they narrow when investors are feeling optimistic. Trusts can also use gearing, or borrowing, to amplify returns as well as losses, which can affect investor sentiment as well.
Widening of discounts goes beyond market sentiment
But the reasons for the unusually wide discounts at the moment go beyond market sentiment. Given that global shares have risen about 10% this year, in sterling terms, there is much less “fear” in markets than during the global financial crisis, so you might have expected discounts to narrow this year and boost returns for shareholders after a genuinely tough 2022 for stock and bond markets.
There are two reasons that discounts are stubbornly wide: the impact of interest rates on trusts investing in “alternative” assets, and news rules around cost disclosure that are making some investment trusts less attractive to investors.
Alternative investment trusts that pay an income have grown in importance over the past decade, as investors have looked for income and returns away from mainstream-listed stocks and bonds due to falling yields.
Alternative sectors popular with income seekers on wide discounts include: Renewable Energy Infrastructure and Infrastructure (on 16% discounts on average); UK Commercial Property (25% average discount for the sector); and Debt – Direct Lending (24.5% discount on average).
The share prices of such trusts have fallen dramatically as investors have moved money into bonds, where yields are between 4.5% and 5% on gilts and around 6.5% on investment grade corporate bonds. These trusts also use debt to finance acquisitions, and so rising interest rates makes that debt more expensive.
Higher interest rates also affect the valuations of infrastructure assets, resulting in a greater “discount rate”, which is what the future cash flows of an asset are measured against. This leads to a lower valuation placed on an investment.
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Emma Bird, head of investment trust research at broker Winterflood Securities, says: “Government bonds now offer a meaningful yield for the first time in many years, which has led to significant equity outflows in order to support growing fixed-income asset allocations.
“Furthermore, asset classes such as infrastructure and property have been hit particularly hard, as investors anticipated a fall in net asset values due to the impact of rising discount rates and an increased cost of debt, while share prices also fell as the yield pick-up versus UK gilts narrowed, making the trusts look relatively less attractive.”
Private Equity is another sector that has seen discounts widen significantly, with long-term winner HgCapital Trust on a 17% discount, Pantheon International on a 38% discount and HarbourVest Global Private Equity on a 42% discount.
Investors are selling private equity trusts as they are sceptical about the net asset values of unlisted assets, which have been much more resilient than similar public market valuations.
Bird adds: “We suspect that a large part of the sell-off can be attributed to negative investor sentiment as a result of macroeconomic uncertainty amid an inflationary and rising interest rate environment.”
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James Carthew, head of research at investment trust analyst QuotedData, says that higher interest rates are diverting money away from alternative investment trusts, but because yields have now risen due to falling prices, the outflows should be slowing.
However, he says that another reason is that ongoing charges disclosures are penalising the use of investment companies.
Cost disclosure rules
This headwind refers to changes to the rules around how investment companies report fees, which is having knock-on effects for wealth managers which own investment trusts in client portfolios and have to update their overall fund fees.
The Financial Conduct Authority (FCA) asked the Investment Association (the open-ended funds industry trade body) to provide new guidance on how costs should be reported.
Now, when an open-ended fund holds shares in a trust, it must add on the trust management fees to its total running cost figure.
While this may seem like a sensible move, critics say that it is not fair. Baroness Bowles of Berkhamsted, a House of Lords peer, says that the rules ignore the nature of investment trusts.
“An investment trust is essentially like any other publicly traded company from an investment perspective. If a fund invests in the ordinary shares of a listed commercial company, the internal costs of that commercial company do not have to be shown in aggregated charges.
“For both listed commercial companies and listed investment trust companies, everyday running costs are disclosed in accounts, reflected in profit and ultimately in the share price, which embodies investors’ assessment of the company, including its underlying costs.
“However, the IA guidance instead equates investment trusts with open-ended funds, requiring internal running costs incurred at the investee investment trust level to be aggregated as a cost, setting aside the fact that, unlike with units of open-ended funds, investors have already factored such charges into the price that they are prepared to pay for the shares of the investment,” she said.
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Baroness Bowles says this means that costs are being duplicated by being put under an “ongoing charges” figure, which means that some funds that own trusts are coming up against cost ceilings by showing charges that are not accurate.
“Hence, there became a disincentive to invest in investment trusts to avoid these unexpected changes, questions about them or hitting cost ceilings. A great deal of investment choice follows the headline and not deeper analysis, which separates and explains the varying nature of costs.”
Bird also points out that a lack of demand for investment trusts is an important cause of the wide discounts.
She says: “This is likely caused by a number of factors, including: some investors favouring fixed income over equities, institutional investors experiencing outflows from their own funds, retail and institutional investors awaiting more macroeconomic certainty before (re-)entering the market, and concerns over the perceived costs of investment trusts in light of cost disclosure rules, particularly following the publication of Investment Association guidance last year.”
Will discounts narrow?
Wide discounts could point to a rebound in share prices and narrower discounts, according to Nick Britton, from the AIC.
He looked at three discount “troughs”, based on month-end figures: March 2003 (-12.8%); February 2009 (-16.4%); and June 2016 (-11.9%).
He found that the annualised returns of the average investment company in the three years following each trough were 34%, 22% and 9% respectively.
“Clearly, some of the difference is explained by the fact that the first two troughs occurred towards the end of major bear markets, while the third came after the ‘leave’ vote in the EU referendum, which was hugely significant for the UK but less so for global markets.”
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Looking at which sectors performed best in these recoveries, growth was the standout theme for Britton.
“Smaller companies is a common theme, and especially UK smaller companies which outperformed the average investment company in all three periods. Global emerging markets and private equity also did well. For all these sectors, narrowing discounts provided an extra boost to returns,” he said.
Carthew says that discounts are now way too wide and it could be a good buying opportunity, particularly in the renewable energy sector.
“Renewables and infrastructure funds on 6%, 7%, 8%, even 9% yields – and often from dividends that are growing, frequently helped by strong inflation linkage in their revenues – are worth locking away now we think,” he said.
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