Have larger mid-cap trusts found themselves in ‘the danger zone’?

Increasing consolidation in the wealth manager market, combined with persistently wide discounts across the sector, could spell danger for investment trusts in the £500m-1bn market cap bracket, according to trust specialist and MIGO Opportunities fund manager Nick Greenwood.

Wealth managers are among the key holders of investment trusts, but the rise of centralised buy lists in recent years has meant an increase in the perceived minimum size an investment trust needs to be in order to attract interest. Just a few years ago, an oft-quoted figure was £250m, then £400m, but increasingly, says Greenwood, larger mid-sized trusts – many of which feature in the FTSE 250 index – may find themselves deemed too small to compete for wealth manager attention.

Of around 400 trusts in the investment company universe, only 51 (as at 10 August 2023) have a market cap above £1bn. With a further 49 in the £500m-1bn bracket, that means three-quarters of all trusts are probably almost completely off the table as core holdings for today’s larger wealth managers. However, many of these may still be enthusiastically backed by private investors – as well as value-seeking fund managers like Greenwood – while, for those that offer a less compelling proposition, ‘natural selection’ is increasingly being seen through a number of corporate actions such as mergers and voluntary liquidations.

See also: Consolidation, overcrowding and widening discounts: Do investment trust boards need to step up?

Greenwood points to a ‘perfect storm’ underlying the current wider-than-average investment company discounts (16% across the sector compared with a c 14% 12-month average, according to data from Winterflood Investment Trusts). Wealth manager consolidation is just one part of this, along with US investors short-selling the FTSE 250 index using its pure form rather than the version excluding investment companies, a cost disclosure regime that makes investment trusts look unappealing for multi-asset investors, and higher risk-free rates, meaning the returns on some alternative asset funds that were launched in an era of ultra-low bond yields now look less appetising.

We have taken a dive into the data on larger mid-sized investment trusts, some of which is summarised in the table below. The 49 trusts with a market cap of £500m-1bn are spread across 27 of the 49 AIC sectors, split roughly evenly between equity and alternative assets. In 16 of these sectors, there is only one trust with a market cap of £500m-1bn, so in the interests of space we have summarised only those sectors containing two or more of these funds.

One point of interest is that in many of the sectors, these ‘mid-sized’ players are in fact among the largest options available (measured by total assets rather than market cap, in all cases with a maximum of one other fund being larger). These include Asia Pacific, Asia Pacific Equity Income, Europe, European Smaller Companies, India & Indian Subcontinent, Japan, UK Smaller Companies, UK All Companies and Property – UK Commercial. In these sectors, therefore, it is unlikely that such trusts would be automatically deemed uncompetitive by professional buyers of investment trusts, even though they may struggle to build meaningful positions quickly.

Conversely, the biggest candidates for consolidation may be in some of the alternative asset sectors. Infrastructure and Renewable Energy Infrastructure have been among this fastest-growing areas in the investment trust world in the past decade, dominating the IPO and secondary fundraising markets as investors sought higher income streams. In both these sectors, more than a quarter of constituents are in the larger mid-sized bracket by market cap, yet in both cases there are at least three larger funds that could prove the long-term winners in a more size-conscious market environment.

See also: Momentum’s Parfect: ‘Terrifying’ FCA guidelines are forcing a shrinking allocation to investment trusts

It is notable that the £500-£1bn players in these sectors are trading on average discounts wider than those for the sectors as a whole – something that is also true in the Property – UK Commercial sector, another area that has been hit by higher financing costs and the availability of better risk-adjusted returns elsewhere. In both infrastructure and property sectors, wider discounts may be indicative of a lack of confidence in the valuations of underlying assets; Greenwood comments that while he has been doing “a lot of work” on infrastructure trusts recently, he has only found two he wanted to buy.

Private Equity may be more of a conundrum: although all the six larger mid-sized trusts are outside the top three (excluding the giant 3i) in the sector, most of them are in fact trading on narrower discounts than their largest peers. The really extreme (50+%) discounts to NAV tend to be clustered around the bottom end of the sector by total assets, and (excluding those whose small size reflects an advanced stage of portfolio realisation) it is these trusts that may be more vulnerable in the near term.

Interestingly, perhaps the clearest example of a sector with multiple funds that could be at risk of being deemed ‘sub scale’ by wealth managers is UK Equity Income, a firm favourite among retail investors. Here, there are three trusts with a market cap of £500m-1bn, which by total assets are ranked fifth, sixth and seventh of the 21 funds in the peer group. However, while two also trade at wider-than-average discounts to NAV, one of them – Merchants Trust – remains at a small premium, and according to Winterflood has been one of the 10 largest issuers of equity in the past 30 days. Proof, perhaps, that in the investment trust world, the larger wealth managers are not the only audience to be considered.