What to make of idle trust discounts in Red October

Investors mull whether the relative calm is a blip or a long-term trend

Discounts on investment trusts were surprisingly resilient during Red October but investors warn a prolonged bear market will really test whether this is a long-term trend or simply due to idiosyncrasies of the sell-off.

The average investment trust discount at the end of October was 2.6% on a weighted basis, marginally higher than at the end of September, when it averaged 2.3%, and the same level as October 2017, Association of Investment Companies chief executive Ian Sayers said in a presentation in Edinburgh in November.

Over the same month, the FTSE All Share and MSCI World fell 5.19% and 5.43% respectively.

Historically during a market sell-off investment trust discounts would widen by “one, two, three or however many percentage points”, says Peter Hewitt, who runs a portfolio of closed-ended funds through the BMO Managed Portfolio Trust.

But this was not the case in October.

“Investment trusts seemed to ride that out and I think they probably would do again in a similar situation,” Hewitt says. “The danger is a more prolonged downturn in which sentiment changes to be quite negative about equities generally. I think that would begin to take its toll on discounts.”

Baillie Gifford marketing and distribution manager James Budden (pictured) agrees a sharper sell-off is needed to test whether investment trusts have truly become more resilient. “Discounts are driven by a combination of performance, sentiment and demand. I don’t think any of these factors are necessarily less volatile than they have been in the past,” Budden says.

UK and emerging markets dominate trusts

Asset classes represented in the investment trust sector could explain relatively idle discounts over October, says Tilney managing director Jason Hollands. “It is quite diverse, with a number of trusts focused on alternative assets classes and relatively few US-focused products.”

Indeed, the North America sector discount widened from 8.48% to 9.23% in October while the North America Smaller Companies sector was more exaggerated hitting 10.58% from 9.01% at the end of September, according to data from the AIC.

In contrast, Hollands says UK products and portfolios exposed to Asia and emerging markets are well represented among investment trusts. All UK equity sectors enjoyed tightening discounts during October with discounts in the UK Equity Income sector tightening the most from 6.08% to 4.77%. Both the pan Asia Pacific and Asia Pacific ex Japan sectors enjoyed shrinking discounts.

The Global Smaller Companies enjoyed the highest shift in discount, albeit from one of the highest levels among equity sectors, moving from 18.14% to 14.17%. The sector is home to Smithson, which became the most successful UK-domiciled investment trust IPO ever when it launched on 19 October. It now trades at a 3.9% premium, the only trust in the sector not trading at a discount.

Sayers says investment company sectors are less exposed to equity markets than in the past. However, even within equity sectors discounts remained stable in October widening just 0.14% to close the month at 7.02% on an unweighted basis.

In the BMO Managed Portfolio Trust, 3i Infrastructure and Renewable Infrastructure Group were the strongest contributors to performance during the month while the Allianz and Polar Capital Technology trusts were among the portfolio’s largest detractors. “Those not directly sensitive to equity markets held their value quite well,” Hewitt says. However, within equities, he points out the Woodford Patient Capital Trust delivered positive returns ending the month up 2.56%.

Discount control policies double

The rise of discount control mechanisms could partly explain why investment trust share prices have been less affected by volatility than in the past, says AJ Bell head of active portfolios Ryan Hughes.

Since 2008, the prevalence of discount control has almost doubled with 72% of boards employing policies today compared with 38% a decade ago, according to the AIC. Over the same period, discounts on equity sector investment trusts have narrowed from 19.17% to 7.02%, albeit Hughes notes this partly reflects firstly how extreme discounts were a decade ago.

“Trusts permanently sitting at a big discount has also been a dissuader for investors and boards have recognised that managing this well may improve the marketability of the shares,” he says, pointing to the F&C Investment Trust as an example of a closed-ended fund that historically traded at a big discount but now trades close to net asset value.

Investment trust discounts since 2008

Source: AIC

The prospect rather than the implementation of buybacks may have been enough to support share prices in the October sell-off, says Hewitt.

However, if market fears over Brexit, Donald Trump or the US Federal Reserve take hold, investment trusts will need to decide whether to put policies into action, he says. “Are investment trusts really prepared to step in and buy those shares? That doesn’t really halt a widening discount. If it’s going to widen, it will widen,” he says. “But at least it will provide some liquidity to those who wish to exit.”

Retail investors sit tight

However, Budden reckons shareholder registers are more aligned with trust aims than before as long-term retail investors buy into the sector.

“Unenthusiastic institutional holders have sold out of the sector. The shareholder base is generally more diverse nowadays and we are less likely to see the sellers of large stakes overhanging the marketplace,” Budden says.

Traders and global investors slashing positions drove equity markets downwards in October, says Hollands. “There was, however, little evidence of frenetic selling by retail investors who invariably do not sit glued to a screen watching their portfolio on a daily or weekly basis but review once or twice a year, maybe quarterly.”

Retail investors also stick by investment trusts due to their advantages over open-ended rivals when it comes to income, where there is still considerable demand, Sayers adds.

Buying opportunities reduce

Historically, volatility provided an opportunity for investment trust arbitrage, says Hughes.

“The way we used to do that back in the day was that where there was an equivalent investment trust and unit trust we would switch between the two, for example Fidelity Special Situations and Fidelity Special Values,” Hughes says. “Those opportunities have pretty much disappeared now.”

In fact, Alex Wright’s closed-ended fund narrowly outperformed its open-ended counterpart by 0.30% during October, falling 6.55% compared with 6.85% in the Special Situations fund. The performance differential was even wider in February and March, when the investment trust delivered a return of 1.16% while the Oeic fell 3.23% over the period.

Hollands questions whether discounts could yet widen due to the lag effect from retail investors. But he adds: “With valuations now a lot more appealing across most equity markets I wouldn’t bank on it as we might actually see cash that has been sat on the sidelines funnelled back in.”

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