A high number of investment trusts are considering their futures. Faith Glasgow explains why those with assets of less than £200 million are considered ‘subscale’.
A recent research note from broker Winterflood focuses on the growing number of relatively small investment trusts having to contemplate merging with other trusts or even winding up.
As Winterflood reports: “Over the remainder of 2023, at least 25 funds face a continuation vote, several are currently undergoing a strategic review and some have already decided to propose a wind-up.”
Their problem is that they are typically ‘subscale’ - with market capitalisation below £200 million or so, stuck on a persistent discount, struggling with liquidity issues and often trading on a wide spread, making them expensive to buy.
Most are also long-term underperformers relative to their peers or benchmark. All those factors also make growth by issuing new shares very difficult.
In part, says Winterflood’s Elliott Hardy, these problems reflect the deterioration in the investment environment over the past 18 months, as inflation has bitten, interest rates have risen and investor sentiment has cooled.
Size matters for wealth management industry
But it is also underpinned by more structural problems that are being baked into the situation as the wealth management industry – one of the biggest players in the investment trust market – continues to grow, consolidate and scale up.
The proposed takeover of Investec by Rathbones, which it is estimated would bring total assets under management to over £100 billion, is an obvious example.
Why is that trend causing problems for investment trusts?
The Financial Conduct Authority (FCA) requires wealth managers to treat clients fairly by putting everyone with a certain risk profile into the same portfolio holding the same investments. While that does not impact investment choice for boutique managers, the wealth management giants running tens of billions of pounds find themselves restricted to those investment trusts big and liquid enough to accommodate positions without the share price being meaningfully affected.
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Peter Spiller, the veteran manager of Capital Gearing (LSE:CGT) trust and a strong advocate of consolidation among small trusts, explains: “If you’re Rathbones, say, with £60 billion under management, you just can’t buy an investment trust where only £100,000 of stock is available at a time. The result is, broadly, that trusts with assets of less than £400 million to £500 million have become unviable.”
Winterflood’s 2023 industry survey found that “the number of respondents prepared to invest in investment trusts with market caps of less than £150 million had fallen from 93% in 2013 to 63% in 2023, driven predominantly by a search for greater liquidity”.
Scale has plenty of benefits for private investors
For investment trusts, there are obvious advantages to being bigger, in terms of lower costs, greater liquidity and smaller spreads, all of which help to attract investors. They are also better placed to buy back shares if need be, and to issue new shares.
But there are no hard and fast rules about what size constitutes ‘sufficient’ scale, or conversely ‘subscale’. As Hardy acknowledges, a £500 million fund with just a handful of large institutional investors might be considered subscale for their requirements, while another fund half its size with a diverse base of small shareholders might be much more liquid and efficient.
Nor is scale equally important for all sectors. “Different investment opportunity sets mean that what is considered to be sufficient scale will differ between funds (eg global equity is likely to be larger than micro-cap),” Hardy adds.
Indeed, says Andrew McHattie, publisher of the Investment Trust Newsletter, there is a clear argument in favour of smaller trusts when it comes to investing in smaller companies.
“For managers seeking to invest in illiquid markets – in microcap (sub £100 million market capitalisation) UK shares, for example – it is impossible to take meaningful stakes with a large pool of capital,” he argues. “This is why River and Mercantile UK Micro Cap (LSE:RMMC) actually has a mechanism to cap its size, and why larger trusts can find themselves at a disadvantage in certain sectors.”
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It’s also true to say that although wealth managers are important players in the investment trust market, private investors - who don’t have the same constraints in regard to accessing small trusts – are becoming increasingly important as the long-term advantages of the closed-ended universe gain mainstream traction, particularly on online investment platforms such as interactive investor.
A drive to wind up or consolidate small trusts “will inevitably restrict choice for retail investors and deter newcomers”, warns McHattie.
He makes the additional point that as new ideas emerge and the investment trust industry evolves, new, relatively small trusts are likely to be launched to embrace those opportunities.
“The investment trust industry has always been good at embracing new themes and making niche institutional mandates available to all, and sometimes that means starting small,” he says.
The renewable energy sector is a great example. “Take the example of Gresham House Energy Storage (LSE:GRID), now seeking to raise an extra £80 million to take its total assets over £900 million. It started with £100 million from its IPO in late 2018.”
It’s a complex and nuanced discussion. However, Peter Spiller argues that the adoption of a zero-discount mechanism (ZDM) whereby the board issues or buys back shares to manage the discount can help small trusts remain liquid and attractive to a wider range of buyers.
“If people know that a trust’s discount is not a threat, then if it has a good manager they’ll be comfortable buying,” he says.
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