The boards of investment trusts are in danger of destroying one of the greatest advantages of the products in the bid to make them retail-friendly, according to FE Alpha Manager James Henderson
Many trusts have implemented discount control mechanisms to keep their share prices trading around NAV, which usually involves buying back shares when their price falls too far from the value of the portfolio’s assets, usually as a way of placating major shareholders.
) says that this is the wrong way to go. By buying back their own shares with their cash the boards of investment trusts are denying themselves the chance to back their best ideas and limiting future returns, he warns.
“Some people in the investment trust industry are going the wrong way [by implementing discount control mechanisms] because it gives away your freedom to buy things when you think they are cheap,” he said. “You have to buy back and can’t get on the front foot.”
“With investment trusts people have to put up with this swing between discounts and premiums but you have to make it count.”
Monica Tepes, investment trust analyst at Cantor Fitzgerald, says Henderson has a point.
“The rationale for buying back shares from an investment perspective is that you can say if you have a good portfolio at NAV if you buy back shares it’s equivalent to buying your portfolio on a 10 per cent discount.”
“But you might not want to buy back your portfolio – there might be some stocks you hold that are more attractive than the portfolio as a whole.”
Narrowing discounts is one of the features that allows investment trusts to outperform over the longer term. By removing this factor from play boards risk limiting the advantages it can bring to investors.
Another factor in their outperformance is that unlike open-ended funds, trusts don’t have to sell their stock when investors want to sell down their position, meaning they are immune from the need to sell their best ideas at a time and a price they don’t like.
By committing to buying back stock boards are limiting the manager’s freedom in this regard to ignore market sentiment and buy what they want at the prices they find attractive.
Henderson says that his freedom to invests his cash in the market rather than use it to buy back shares is one of the reasons the Henderson Opportunities Trust
has done so well in the five-year rising market.
The fund is up 443.79 per cent over five years as the sector is up 155.34 per cent and the FTSE All Share 120.84 per cent.
Performance of trust versus sector and index over 5yrs
Source: FE Analytics
“One of the reasons for my trusts having good period was I was able to buy recovery situations, knowing no money was going to go out,” he said.
“Where the real value was was in companies people said were selling out of illogically, people were scared of, particularly smaller companies.”
Henderson says that Senior is a good example of an unloved stock he bought in the depths of the 2009 crisis.
Data from FE Analytics
shows that the stock is up by more than nine times since March 2009, way ahead even of the FTSE 250 which has tripled in value.
Performance of stock versus index over 5yrs
Source: FE Analytics
“We bought Senior when it hit 60p, it fell to 40p and we bought more, it fell to 25p but it’s £2.90 now and our largest position,” he said.
RWS is another stock that the manager bought in the market trough and has paid back his faith handsomely: the stock is up 314 per cent over five years.
Henderson’s co-manager Colin Hughes said: “It was completely clattered. It was entirely inappropriate for that business to be significantly de-rated during that period.”
Tepes says that buybacks are often ineffective anyway, and when a trust is on a discount because of underperformance a board and the manager should focus on turning around NAV performance rather than buying back.
“When a trust is on a discount there’s a reason,” she said. “If the sector is out of favour it won’t do anything.”
The danger is that the trusts are reducing the differences between them and their open-ended peers, Tepes agrees.
By limiting the effects of discount movement boards could be effectively working against the interests of long-term private shareholders, it could be argued.
The impetus behind buybacks comes largely from institutional shareholders such as wealth managers, which are taking greater notice of investment trusts after the retail distribution review.
“Share buybacks are suggested by the largest shareholders who want to sell their shares and are shorter term shareholders,” Tepes said.
“When you have investors going in to see you all the time asking will you be narrowing the discounts you won’t say you are doing what is good for your investors whether they want it or not,” she said.
“Often the managers and the boards will only meet with the largest shareholders. It’s not easy to access the smaller investors and find out what each one thinks.”
Similarly, wealth managers are behind much of the impetus to remove performance fees from investment trusts, which some managers suggest could also harm the interests of small shareholders.
Performance fees offer managers a significant incentive to outperform and ensure that they are paid less if they achieve worse results. A number of managers have told FE Trustnet in recent months that they would personally much prefer to buy funds with performance fees and lower standard charges.
Some say they believe that there is an inevitable psychological bias towards favouring a fund with a performance fee for managers who run a whole suite of funds.
However, recent polling evidence suggests that wealth managers are pressuring boards to remove these fees in favour of fixed ongoing charges.
A recent FE Trustnet poll suggested that the private shareholders who read Trustnet are more well-disposed to performance fees
, with a majority saying they preferred them coupled with lower standard charges.
Ultimately, by shifting to standard charges in line with their open-ended peers and limiting discount movements trusts could be removing their key distinguishing features which give them their advantages.
Nick Greenwood, manager of the Miton Worldwide Growth fund, says that the consolidation in the wealth management industry is also having an effect on the market.
Greenwood says that the minimum size that investment trusts need to be for many of these institutional investors is growing, now up to £200m from £100m already, thanks to the large number of funds they are investing at the same time.
This could potentially lead to a situation where the smaller trusts retain more of the flavour of the traditional investment trusts and display more of their differentiating characteristics, while the larger, more liquid trusts become less distinguishable from their open-ended cousins and offer less of the outperformance potential.