2008 was a terrible year for investment trusts – which are basically collective investment funds structured as companies and listed on the stockmarket. They managed to perform more poorly than the FTSE All-Share, which ended the year down 30%.
Not only have most trust share prices fallen, but average discounts – which reflect the difference between what you pay for a trust and what the investments are actually worth – have increased markedly too, particularly in certain sectors.
But while widening discounts tend to be bad news for existing trust investors, they can present some interesting opportunities for new investors. Be warned – you will need either a long timeframe or a pretty strong stomach, and preferably both, because the outlook for the coming year is by no means a rosy one. But shrewd choices at this time of general market depression and heavily discounted investment trust share prices could pay off in the long term.
How do investment trusts work?
An investment trust is similar in many ways to a unit trust or an open-ended investment company, in that investors pool their money and give it to a professional manager to buy a basket of shares. But a trust is known as a closed-ended investment, because only a certain number of shares are issued.
When that trust is thriving, demand from investors will drive its share price up, regardless of what is happening to the value of the underlying assets, known as the trust’s net asset value (NAV). Similarly, an unloved trust will see its share price fall, regardless of NAV movements, as shareholders bail out. In contrast, the price of units in a unit trust goes up and down according to the value of its assets. If demand for the fund increases, more units are created, but it doesn’t affect the price.
Discounts and their movements are an intrinsic part of investment trust structure. In an improving economic climate and strengthening stockmarket, a trust’s discount can play a key role in its performance, and help it to do better than a comparable unit trust.
That’s because not only is the underlying NAV rising, but demand for the trust grows as investors gain confidence. As the discount closes, trust shareholders feel the benefit of both upward movements. So a wide discount can work to your advantage – if it’s moving in the right direction (see box right). The flip side is that trusts are harder hit when the mood of the market turns sour.
The future for investment trusts
Bearing in mind the performance of investment trusts in 2009=8, what does it all mean for investors in 2009? In fact, for much of last year, discounts remained fairly stable, according to the broker Cazenove. But the collapse of Lehman Brothers in October sent the markets wild, and investment trust share prices moved more slowly downwards than did the plunging prices of their underlying holdings.
The result was a sharp narrowing of discounts before trust prices caught up again. Discounts shot out as investors scrambled for the exit, pushing share prices down; they reached their widest point in early December. The move prompted some deeply gloomy comments from experts, concerned that investment trusts as a whole might be struck down.
But it’s important to get this widening into perspective. First, as Simon Elliott, head of research at WINS Investment Research, points out: “Investment trusts are classic bull market vehicles because they use gearing and run discounts [to enhance their gains], so naturally they tend to see greater setbacks when markets falter. At this point in the economic cycle you’d expect to see trusts on quite wide discounts anyway.”
Secondly, the most dramatic movements were concentrated in just a few specialist sectors. The average investment trust share price at the end of 2008 stood at -17% to NAV, which is a marked widening against the -11% discount of December 2007. However, if you take out the three worst-hit sectors – property, private equity and hedge funds – the 2008 average narrows to -13%.
The three problem sectors
Property, private equity and hedge funds are relative newcomers to the investment trust universe, which until recently was dominated by giant global plodders such as F&C and Witan. But with the rise of interest in alternative assets (after equity investors lost so heavily in the dotcom crash) came a spate of new investment trusts in fashionable areas such as commercial property, private equity and hedge funds.
Those three sectors performed very strongly for several years, and by early 2007 they accounted for a whopping 25% of all trusts in terms of market value. But the credit crunch caused chaos, particularly as many of them had borrowed heavily to boost their returns, and the illiquidity of their assets then made it difficult for them to cope when investors fled the market.
By the end of 2008, the Hedge Fund sector was on an average -26% discount, Property was on -44%, and Private Equity on a massive -51%. No wonder they made such an impact on the overall discount average.
Depending on where you stand, these colossal discounts could represent the end of the road for many trusts, or a tremendous opportunity to scoop bargains that in due course will see a recovery.
“There are clearly some very interesting investment opportunities in these three sectors for investors prepared to do their research thoroughly,” says Annabel Brodie-Smith, a spokesperson for the Association of Investment Companies (AIC). “The closed ended structure is particularly suitable for these types of illiquid assets, allowing managers to take a long-term view and ride out dramatic market slumps.
But Mick Gilligan, head of research at broker Killik & Co, sees little joy for many trusts in these sectors. “I’m very negative about hedge funds and property in particular – anything where there’s a question mark over the reliability of the discount, or a mismatch between the liquidity of the shares and that of the underlying holdings,” he says.
Having said that, he sees some interesting opportunities. “Some hedge funds are single management investments rather than funds of hedge funds, and they have much more ability to liquidate their assets easily and quickly [which means in effect that the trust shrinks rather than the discount widening to scary levels],” he comments.
One he likes is BH Macro: “The discount is bigger than it should be, given the quality of the fund. It has historically done very well when times are tough – the NAV is up 19% over the last 12 months, yet the share price has fallen 3%.”
If you believe that the commercial property sector will recover in due course and that now could be a good time to position yourself for when it does, Simon Elliott, head of research at WINS Investment Trusts, recommends TR Property, which invests primarily in pan-European property shares but also holds some UK bricks and mortar.
“Over 2008, the fund’s NAV fell by 26%, compared with a fall of 47% for the FTSE Real Estate index. We rate Chris Turner highly,” says Elliott. The discount stands at a relatively healthy –16%, which has narrowed over the past 12 months from a high of -24%.
In the private equity sector, Elliott picks out HgCapital. “2008 was a terrible year for closed-ended private equity funds. But the private equity industry has forecast that investments made in 2009 and 2010 are likely to prove highly attractive, and funds such as HgCapital with cash on their balance sheets or with unused facilities should be able to take advantage of this,” he says.
What about conventional investment trusts?
Discounts here are much less extreme – in fact some sector discounts, including Global Growth & Income and UK Growth & Income, actually narrowed over the year. “That might reflect investors’ quest for income, which has led to strong demand for some of the more traditional income sectors,” suggests Annabel Brodie-Smith.
The UK Growth & Income sector, for example, is yielding an average 6%, but average discount stands at just -1.3%. However, Andrew McHattie, director of trust specialist the McHattie Group, picks out Schroder Income Growth, 2008’s top performer in the sector. It is yielding 5.7% and trading at a relatively decent discount of -5.2%.
Indeed, in the current grim economic climate, share prices are so low that decent income yields can be found beyond the boundaries of the conventional income-producing sectors. One interesting example is Ecofin Water & Power Opportunities, also recommended by Simon Elliott.
“It aims to produce a secure yield – currently 6% – as well as capital growth from a global portfolio of power and water companies,” he says. It has a strong track record and an experienced team, though because the fund is geared, its NAV has been relatively hard hit in market falls. On a discount of -22%, Elliott says the shares are “highly attractive”.
There are also growing income opportunities abroad, says Bruce Stout, manager of Murray International trust in the Global Growth & Income sector. “The UK used to have the monopoly on dividend-producing companies, but not any more – Asia is now one of the highest yielding areas.”
Another consideration for income-seekers is put forward by James Saunders Watson, head of sales and marketing for investment trusts at JPMorgan Asset Management. He points out that investment trusts are companies, and therefore (unlike unit trusts) are allowed to hold on to up to 15% of the revenue earned each year; some of the big, older ones have built up significant reserves.
“They may not be specifically income-oriented trusts, but if they have a policy of increasing dividend payouts each year, they will use those reserves when necessary to weather challenging periods such as the coming year,” he explains.
For example, Mercantile, one of the biggest trusts in the UK Growth sector (on -11.5% discount) and run by JPMorgan, is paying 6%; what’s more, it has reserves worth 1.6 times the dividend paid out last year, so even if the trust earned no dividend income at all this year, shareholders would not lose out. But you’ll need to do some homework on a trust to find out if it has a policy of growing dividends each year, warns Saunders Watson.
The outlook for investment trusts is a difficult one. Katherine Garrett-Cox, chief executive of Alliance Trust, comments: “We anticipate that global economies will continue to slow and market conditions will remain very challenging in 2009.” And the alternative assets sector in particular will struggle: Charles Cade of Numis Group anticipates that “numerous funds will disappear and many others will be forced to return capital to shareholders”.
But canny investors can find buying opportunities. The AIC’s annual poll of fund managers’ views found blue chips tipped as the sector most likely to outperform, and the US the most promising region.
Further, says Simon Elliott: “Trusts have historically been popular as ‘recovery plays’ with investors prepared to buy when the market is low.”
The question is when that recovery will happen. Some experts believe the stockmarkets have now bottomed, but few see much improvement on the horizon yet – so be prepared to sit tight and wait for the upturn.
Gearing: Investment trusts are, unlike unit trusts and open-ended investment companies, allowed to borrow money in order to take advantage of good buying opportunities. That means that each share earns more when markets are strong, but losses are greater in falling markets.
Discount: The net asset issue per share minus the share price, expressed as a percentage of the NAV – so if the NAV per share was 100p and the share price was 90p, the trust would be trading at a 10% discount.
Net asset value: The value of the underlying investments held by a trust.
Liquidity: A liquid asset is one that can easily be bought or sold without affecting the price. Illiquid assets are difficult to buy or sell quickly.
Investment trust recommendations
Alan Brierly, head of investment company research at broker Collins Stewart, likes the following trusts on attractive discounts:
Global Growth: Alliance Trust is being overhauled by its new CEO Katherine Garrett Cox and has a discount of almost -15%.
UK Growth & Income: Edinburgh Investment Trust, recently taken over by Neil Woodward at Invesco Perpetual, is now trading on a -9% discount. It’s yielding a 6% dividend.
Specialist: Finsbury Worldwide Pharmaceutical, on an -11% discount. After several years of underperformance, the pharmaceutical sectors have finally begun to deliver. This is a highly rated trust.
Double whammy for discounts
Discounts can work for you in the right circumstances. If you buy a share for 80p on a discount of 20%, then you are getting 100p worth of assets for your 80p investment.
If the net asset value per share goes up to 110p on the back of a strengthening market, demand for the trust may increase too, narrowing the discount.
If the discount narrows to -15%, your 80p share will now be worth 93.5p (110 minus (110 x 0.15)). You’ve made a total gain of 13.5p on a market move of 10p.