NICK GREENWOOD, manager of the Miton Global Opportunities fund, explains some of the new dynamics shaping the investment trust market and why sudden share price movements may not be all that they seem. This article was first published in the 2019 edition of the Investment Trusts Handbook and has not been updated.
An evolving sector
The investment trust sector continues to evolve. A key driver remains the rapid consolidation of the wealth management industry. Until recently wealth managers had been the key owners of closed-ended funds. Last year there was an aborted merger between Rathbones and Smith & Williamson. This would have created a business managing £52bn. In any walk of life, when an organisation becomes truly vast, staff at the sharp end are no longer allowed to use their initiative. Otherwise, someone somewhere will abuse that freedom.
The sheer size of funds now managed by a small number of houses makes it difficult for investment trusts to figure within these portfolios. Those trusts which continue to find favour are likely to be the very largest where the major chains feel comfortable that they will be able to source sufficient shares in the open market. A number of quite well-known funds are beginning to find that they need to grow if they are to retain their place on buy lists; a message we were getting some years ago. In the meantime, it is likely that some medium-sized trusts derate. At that point, they will be of interest to us, increasing our pool of opportunity.
Closed-end funds are a natural structure for alternative asset classes which are less liquid than equities. Examples include property, peer-to-peer lending and forestry. Until relatively recently the vast majority of trusts were equity funds.
The calculation of the stated net asset value for a portfolio of stocks and shares is straightforward. They are daily traded and the resultant figure gives a fair representation of the true value of the portfolio. Calculating a net asset value for an alternative portfolio is a far more subjective exercise.
The adopted methodology can over time fail to replicate the asset’s real-world value or may purely have become stale, not incorporating recent developments. Nevertheless, past experience of only handling equity trusts has left investors tending to treat stated net asset values as verbatim. An extreme example within our portfolio has been residential property in Berlin; our estimates of true value have on occasions been in excess of 50% higher than the official figure.
While the bulk of opportunities continue to come from the disruption of supply and demand and alternatives, recent additions have come from new sources. These trends may well prove to be enduring. There has been increased volatility due to the heightened ownership of the sector by self-directed investors, who typically trade through platforms such as Hargreaves Lansdown, AJ Bell and Alliance Trust Savings. As a result, a greater proportion of trades are now smaller and electronic.
In the past market makers could effectively close the market in medium and smaller trusts by posting bids and offers only valid in modest size. Electronic trades are typically smaller than the minimum size the market must make. Therefore a market maker remaining on the bid will quickly find themselves on the receiving end of multiple sell orders. They will soon find themselves with more inventory than they would like. This soaks up the limited capital they commit under current business models. As a result prices will quickly fall. Competitors will follow suit, as they also do not want to receive multiple sale orders. Thereby a Dutch auction ensues and trust share prices can now fall suddenly and sharply. Once buyers are attracted or the market rallies, this process rapidly reverses.
Events in 2018
There were two market declines in the first half of 2018. At the end of January, there was a global sell-off where a number of trusts popular with private investors quickly fell. In March, trusts where individuals had unrealised gains were hard hit by a flurry of capital gains tax selling. This triggered significant falls as it coincided with a market wobble when buyers were delaying purchases. A number of trusts fell more sharply in the March sell-off despite the general fall in markets being more modest than in January. These declines occurred in the absence of much movement in underlying portfolios.
INDIA CAPITAL GROWTH saw its discount widen from 4.7% in January to 19.9% on 3 April, much of the widening coming in March. This decline bottomed out hours before the tax deadline. India Capital Growth’s discount had rapidly narrowed to 8.3% by 18 April. PHOENIX SPREE saw its shares oscillate between 337p and 380p during April despite its estimated NAV remaining static around 355p. Meanwhile we saw our own shares move from a 2% premium on 14 March to a 5% discount on 4 April. This discount had narrowed to less than 1% by 18 April and at the time of writing is trading at a premium. Given the significant increase, over recent years, of our shares held via platforms, it should not have been a surprise that we have become a textbook example of the new trading pattern.
The other development is that a number of closed-ended funds listed overseas are moving to London. In the United Kingdom we have a vibrant market in trusts which does not exist elsewhere. Funds that trade on a wide discount locally can list in London where, if they have a good story to tell, there are investors that will listen. The resultant demand should allow their discounts to narrow. Two recent entrants to our portfolio fit this theme.
STENPROP moved to London this summer. We accumulated a position via its existing listing in Johannesburg at a substantial discount to the latest NAV of 135p, despite an indicated 6.5p-a-share dividend which the company hopes to grow. The other new entrant that has recently transferred to London is LIFE SETTLEMENT ASSETS (LSAA). Funds that specialise in secondhand life policies have tended to be disappointing in recent years. This is largely because life expectancy has until recently been steadily increasing. This means that investors not only have to wait longer than expected for the policies to mature but also that they have to keep paying premiums for a longer period than anticipated. We acquired our initial stake in LSAA at 140¢ a share at a time when NAV was 210¢. At that price we believe that most concerns are reflected in the price.
The trust is refocusing its portfolio on UK mixed light industrial properties. These are located in unfashionable urban locations such as Mytholmroyd and Huddersfield. There is little new supply as new builds would be worth less than the cost of construction. Furthermore, incentives to turn these sites into housing reduces the availability further. Demand is increasing, the arrival of the internet means some business models no longer need to locate close to customers. Some activities can now be performed using cheaper provincial properties.
We undertake a significant number of meetings with managers of closed-ended funds. Many of these look uninspiring on paper and indeed the vast majority prove to be just that. Nevertheless, despite initial appearances, some prove to be gems. Our holdings in TALIESIN and DUNEDIN ENTERPRISE started with just those types of meetings. It would be nice to think that recent entrants such as Stenprop and Life Settlement Assets will pick up the baton and drive future returns.
Outlook
It is ten years since the global financial crisis. It is a sobering thought that somebody who joined the City in the immediate aftermath would now have a decade’s experience but have barely seen an interest rate rise let alone a cycle. Therefore, complacency abounds within the financial community and any change of scenario is likely to cause upheaval. Inflated asset prices are predicated on exceptionally low interest rates. Investors have few ready alternatives. This scenario may continue for a while yet. Looking forward, the biggest risk to the atmosphere of calm is rising interest and bond rates.
Since the end of March the US ten-year bond yield has risen from 2.7% to 3.2%. If this trend continues and investors find they can source a measurable yield from conventional sources of income, they will return to them. This would trigger volatility within the trust sector where ‘income manufacturers’ have been extraordinarily successful in raising capital. The combined market capitalisation of infrastructure and renewables alone is many billions. Such a figure dwarfs the clearing mechanism for trust shares. A modest decline in appetite for this type of fund would dramatically alter the short-term balance of supply and demand. Should the market in these trusts be overwhelmed, this would represent an opportunity.
NICK GREENWOOD is a former private client stockbroker who has been managing the Miton Global Opportunities trust since 2004, joining Miton after its merger with Exeter Fund Managers. Miton Global Opportunities invests primarily in other investment trusts.