Are investment trusts trading on big discounts 'bargains'?

Many investment trusts are trading on huge discounts to their net asset values at the moment – meaning their share prices are worth significantly less than the value of the investments in their portfolios. Such discounts can be tempting to private investors on the lookout for ‘bargain’ funds.

The average investment company discount has widened more than 10 percentage points from 3.6% on 31 December 2021 to 14.3% on 18 November 2022, the Association of Investment Companies revealed recently. The most deeply discounted equity sector was North America, on a 26.5% discount, followed by India on a 14.9% discount and Global Emerging Markets on 12.4%.

Remarkably, the only AIC sector not trading on a discount overall was Hedge Funds, which highlights the popularity of these vehicles in times of economic uncertainty and market volatility.

Jason Hollands, Managing Director at Bestinvest, the online investment platform, says that investment companies have long had a fan club among private investors, but have enjoyed a bit of renaissance in recent years.

‘The booming success of Scottish Mortgage and other growth-orientated trusts during the pandemic – and their more recent reversals – have certainly raised their profile,’ he says. ‘And in recent years there has been growing interest in alternative, and in some cases esoteric, assets classes – e.g., physical property, infrastructure, funds of hedge funds, private equity, music royalties, and even shipping assets. These can be illiquid and are therefore more appropriate for being accessed via closed-end fund than an open-ended one.’

But as trusts again come under the spotlight for their widened discounts and perceived bargain status, Hollands cautions that this alone should not be taken as a ’buy signal’ and investors must judge a trust on all its merits: ‘First of all, like any investment, it must fit into your overall strategy and play a purposeful and useful role in a balanced portfolio – it can be too tempting to collect investments that for whatever reason seem like a great idea at the time, and you end up with a bit of unbalanced jumble.’

In terms of assessing the trust or investment company itself, Hollands recommends seven points to consider:

1. Manager Most investment trusts and investment companies are actively managed and so the fund manager with overall responsibility for the portfolio really is key. When considering a trust, it is important to check who is in the driving seat and how long they have been in situ. If there has been a recent change, the past track record may be of little relevance, and you should seek evidence of how the current manager has done in the past on any similar funds they may have managed. We also like to see managers who have a personal shareholder stake in their trust, as this aligns their interests with those of investors.
2. Process As with any actively managed fund, it is important to be comfortable about the investment approach taken as this will help you understand how the portfolio might perform in different market environments. Some managers focus heavily on identifying undervalued investments, others on momentum or future growth potential. Do they pursue a highly diversified or very concentrated approach? The latter is especially important with investment trusts. Whereas open ended funds have a limit of holding no more than 10% in an individual holding under UCITS rules, investment trusts are less constrained and therefore if a trust is very heavily exposed to a single big position, this is a potential risk to consider.
   
3. Discounts/premiums. Whereas the performance of an open-ended fund is a direct reflection of the value of the underlying portfolio, investment trust share price performance can deviate from that of the underlying investments – sometimes considerably. The shares of trusts can therefore trade at both a higher value (a premium) to the Net Asset Value (NAV) of the portfolio, but more commonly a discount. Buying a trust at a large premium, essentially means you are paying more than the portfolio is worth. Buying shares at a steep discount can represent a great buying opportunity as over time the gap may narrow. However, in some cases – such as trusts that hold illiquid assets such as private company shares – the discount may also reflect market scepticism towards the valuations being placed on the underlying holdings.
    
   Many trusts have the authority to buy-back their own shares to cancel them, to try and limit the extent of any discounts. This is a sign of being shareholder friendly and so it is important to scour the annual reports for indications of whether such policies are in place. Buying a trust at a big discount may be great but having to sell your shares for less than they are worth is not 
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4. Gearing. A feature that can be employed by investment trusts is “gearing”, the ability to borrow cash against the value of the portfolio to make additional investments. Used effectively, this can really help boost returns, enabling managers to scoop up extra investments at times when the manager feels there are opportunities available, without having to find new investors. However, high gearing is also a risk, and in extreme circumstances if the value of the trust’s assets plummets, the banks who have lent the trust money could pull the plug. Always check whether a trust uses gearing and be wary of those with very high levels of gearing.
   
5. Fees Many people perceive investment trusts to be relatively low cost compared to open ended funds, a hangover from the long-gone days when unit trusts and OEICs had much higher fees than now because they included now banned adviser commissions. That’s no longer the case. In fact, we have previously studied investment trusts and open-ended funds with similar strategies, managed by the same teams and there was no convincing evidence that trusts were overwhelmingly the lower cost option. You must look on a case-by-case basis. One thing to be wary of is that some trusts, particularly those focused on niche areas, do incorporate performance fees and sometimes these can be heavily loaded in favour of the managers so that they could get a big cut of the returns over and above a certain target. Check you are comfortable with any performance fees.
   
6. The Board. As public companies, investment trusts have Boards of directors whose role is to look after the shareholders’ interests and evaluate the managers. In the past trust Boards were often loaded with grandees and perceived as too close to the management companies. Thankfully this has changed, with Boards learning to bare their teeth. The quality of the Board matters as ultimately, they have the authority to change the manager if they are not delivering on expectations, as well as drive fees down. Look at the experience of the Board.
   
7. Finally, dividends matter to many investors and investment trusts have some flexibility here. Whereas open ended funds might pay out the natural income delivered by the underlying portfolio – which will vary from year to year – trusts have the scope to hold some cash back in reserve to sustain payments during tougher years, to create a smoother income profile. If income is part of your objectives, check for how frequently distributions are made (annually, twice yearly or quarterly) and how consistent a trust has been in paying out and growing their dividends.