Investment Trusts Are Trading at The Biggest Discounts In More Than a Decade

It comes down to the way the funds are structured. Unlike open-ended funds — unit trusts or Oeics — investment trusts are listed on the stock exchange, with the sole purpose of raising money from shareholders to invest in other assets. This can be anything from UK or Japanese stocks to US corporate debt to infrastructure investments.

The unit price of an open-ended fund tracks the value of its underlying portfolio (its net asset value, or NAV). When a new investor wants to buy in, new units are created and the fund manager has to buy more assets. If an investor sells out, units are redeemed and the manager has to sell some of the underlying portfolio.

The share price of an investment trust though trades independently of the value of its underlying portfolio. If a new investor wants in, they have to buy shares from an existing shareholder and the portfolio itself remains untouched.

The share price of a trust should reflect its NAV. But because the price of the shares is set by supply and demand, investment trusts frequently trade at a discount (with the market cap below that of the underlying portfolio) or more rarely, at a premium.

With markets facing a torrent of pressure from rising bond yields and fears of an economic slowdown, discounts have blown out to their widest since at least 2012, according to the Association of Investment Companies, an industry group. The average investment trust is now trading at a 15% discount to the value of its underlying assets. In other words, investors can buy a pound’s worth of assets for just 85p.

That can present patient investors with opportunities to buy in at unusually wide discounts, with the aim of benefitting from them narrowing if and when markets calm down again.

It can cut both ways, of course. A trust may look cheap, but a discount can continue to widen, or narrow because the NAV is falling rather than the share price rising.

Tread carefully

Fund manager Nick Greenwood of Premier Miton believes the move to higher interest rates is a “permanent change” and one that should be approached with caution. While “there is bound to be opportunity before the wheat and the chaff are sorted out,” sectors which have been chased higher by yield-hungry investors may continue to struggle for now, he said.

Take listed debt funds. Investment trusts in this sector invest in portfolios of loans, or even lend money directly to companies. Examples include CQS New City High Yield (NCYF), whose portfolio consists mostly of high-yield corporate bonds, and Sequoia Economic Infrastructure (SEQI), which helps to fund infrastructure projects across the globe, ranging from data centers to private schools.

So far, the sector has weathered the current turmoil, according to analysts Sachin Saggar, Iain Scouller and William Crighton at Stifel in London.

“While there are pockets of stress in certain debt funds, by and large they have generally been well managed and at this point there are no material issues across the sector,” they wrote in a research note.

However, “if cash is going to yield more than 4% then what credit premium should investors demand to hold riskier assets? In our view, a dividend yield of 7% is not sufficient,” they said. As a result, the team’s “enthusiasm for the sector is cooling until portfolio turnover and underlying yields increase to provide a sufficient premium to cash.”

Similarly, rising rates have hit investment trusts investing in property, infrastructure and renewable energy “particularly hard”, according to analysts led by Ewan Lovett-Turner at broker Numis Securities.

That’s partly because these funds have also been popular with income-seeking investors, and also because rising interest rates push up the discount rate that needs to be applied to property valuations (in other words, the underlying assets lose value).

The Numis analysts note that the property sector in particular hasn't traded at such sharp discounts to NAV since the 2008 financial crisis.

“Signs of improvement in the macroeconomic picture would present a buying opportunity for investors willing to tolerate near-term volatility.” That said, “a narrowing of discounts in the near term is likely to be driven by NAV declines rather than share price strength.”

Hollands of Bestinvest notes that investors should also watch more generally for how highly “geared” a trust is (investment trusts can borrow money to invest, which boosts returns on the upside but can also amplify losses on the downside). However, he points out that the discount can also provide a margin of safety.

“If you can pick up a decent trust on a wide discount to NAV, that does give you a little bit of a downside buffer too in the current febrile climate,” he said.

Bargain Hunters

Hollands said that trusts focused on UK equities, particularly those which largely own small and medium-sized companies, have seen discounts steepen due to the exposure of their holdings to the UK economy.

“Contrarians might be tempted by well-managed trusts such as Fidelity Special Values (LN: FSV), JP Morgan Mid Cap (LN: JMF), and Mercantile (LN: MRC),” all of which trade at or close to discounts that haven’t been seen since the Covid-related crash in 2020. “But I think it may be a bit too early yet given the challenges from rising borrowing costs and declining real incomes.”

A better option might be to focus on trusts that invest in “large, international earners.” Finsbury Growth & Income (LN: FGT), run by Nick Train, one of Britain’s best-known fund managers, is currently trading on a 6% discount. That may not sound like a bargain but going back five years, the trust has typically traded just below its NAV.

What about investors in the market for more exotic ideas? Greenwood runs the MIGO Opportunities Trust with Charlotte Cuthbertson. MIGO is a specialist investment trust that looks for opportunities to buy other trusts at a large discount, as long as there is a “catalyst for change” that can drive the narrowing of this discount.

One area Greenwood likes is activist investment trusts in Japan. These trusts mostly focus on finding small and mid-cap companies that trade on low valuations and carry lots of cash. They then actively get involved with management to help, persuade, or pressure them into making better use of their resources and unlocking the value in their companies.

The macroeconomic picture plays a role — the Japanese yen is one of the few currencies giving the pound a run for its money in the race to the bottom against the US dollar this year. But the main attraction, said Greenwood, is that activists are starting to get genuine traction.

“I’ve been too cynical on these funds,” he said. “I’ve been told regularly over the decades that corporate governance in Japan was changing and it never did, but these activists now seem to be making a bit of headway. Those who put up pragmatic proposals may get listened to, and the weight of numbers helps — if a company has five activists on its share register, it’s harder to ignore them.”

One fund Greenwood highlights is Nippon Active Value (LN: NAVF), which currently trades on a discount of around 15%. That’s well above the average 5% discount at which it’s traded since listing in early 2020.

Bloomberg News provided this article. For more articles like this please visit bloomberg.com.

Read more articles by John Stepek