Widening discounts shift open vs closed ended fund debate

The Association of Investment Companies (AIC) released statistics last week that showed 37 of the 38 investment company sectors – excluding those with fewer than three constituents – were trading at an average discount to NAV.

This reflects a trend of widening discounts across the board so far in 2022, from an average of 3.6% at 31 December 2021 to 14.3% at 18 November 2022.

As of 29 November, the picture is little changed; of the 38 sectors, only the small group of hedge funds still stood at an average premium to NAV, although the average discount for the universe as a whole had narrowed a little to 11.8%.

Drivers unlikely to reverse

The ability to trade above or below NAV in response to investor demand is one of the defining features of closed-end funds, making the structure particularly suitable for holding less liquid assets, such as physical real estate.

The AIC figures illustrate this starkly in the case of two property sectors – UK Logistics and UK Residential – which have declined from average premiums of 14.3% and 0.4%, respectively on 31 December 2021, to average discounts of 34.6% and 39.4% on 29 November 2022.

Dividend yields of between 5% and 10% are now common across these sectors, and given that the driving forces of the shift to online retail and the need for social or affordable housing are unlikely to reverse entirely, advisers may see value in some of these funds at such low valuations.

Just as the closed-end structure may suit real assets, the open-ended fund universe has far better representation in areas such as government and corporate bonds, which for historical reasons regarding tax treatment have largely been absent in the investment trust sphere.

However, in the realm of equities and multi-asset investment, the two structures arguably compete on a level playing field, meaning widening investment company discounts could offer opportunities to investors willing to consider the closed-end space.

Retail sales figures from the Investment Association for September 2022 (the latest available – although with the caveat that the Truss/Kwarteng mini-budget meant the month ended very differently than it started) show net inflows across an eclectic handful of sectors in which open- and closed-ended funds compete.

Most notable among these were the IA Specialist sector (+£365m) and IA Global Equity Income (+£126m), although Japanese Smaller Companies, Commodities & Natural Resources, Flexible Investment, Healthcare and Infrastructure also saw net inflows.

Across these groups we have identified 11 open-ended funds where there is a closed-ended equivalent managed by the same team. In the table we compare fund sizes, performance and yields, as well as providing the latest discounts for the closed-end funds.

Funds and trust discounts

Given the popularity of these sectors – net inflows were far from the norm among open-ended equity funds in September – it is perhaps unsurprising that the discounts on offer from the closed-ended equivalents are generally quite modest, with three trusts trading at a small premium to NAV.

By contrast, in the UK All Companies sector – where open-ended funds saw over £1bn of net outflows in September – investment trust discounts are mostly in double digits.

Across the group, the average discount of circa 4.5% is substantially narrower than the 11.7% average for the closed-end universe.

Worth considering

While the NAV performance of the trusts is most comparable with the Oeic performance – reflecting the returns on the investment portfolio, and therefore the stockpicking skill of the manager – it would be disingenuous in a discussion about discounts not to include share price returns, which reflect the actual outcome for investors.

However, it is notable that even in a widening discount environment, both the price and NAV total returns of the closed-end funds – averaging 28.2% and 30.9% respectively – are ahead of the 24.8% average return of the Oeics. This may be as a result of gearing, another defining feature of investment trusts, which averaged a little under 6% for the group, in a range from 0% for Pacific Assets Trust and Personal Assets Trust to 13% for Shin Nippon and GCP Infrastructure Investments.

In many ways GCP is the outlier in the group, also displaying the widest discount despite having traded at an average premium since launch, the highest yield, and the biggest divergence both between Oeic and investment company NAV performance and between NAV and share price performance.

The open-ended version has circa 8% of its portfolio in cash and near-cash, in contrast to the closed-end fund’s geared exposure, again illustrating the potential benefits of the investment trust structure when investing in real assets.

It is hard to say definitively whether investment company discounts are a ‘good’ or a ‘bad’ thing. They can undoubtedly present investors with opportunities in out-of-favour sectors, although for those who invested before a sector was out of favour, they can make for uncomfortable reading (or worse, if the need to sell is pressing).

However, when faced with broadly similar investment strategies in open- and closed-ended structures, the ability to buy in at a discount – particularly given the potential for higher yields, better performance and greater flexibility through gearing – has to be worth factoring into any investment decision.