Whether it has been due to the implementation of the retail distribution review (RDR), the increased use of discount control mechanisms by trusts’ boards or the general upward movement in global equity markets, discount value has been much harder to come by over recent years.
That being said, a very strange phenomenon has been occurring in certain parts of investment trust world – most notably in the three UK sectors.
While the FTSE 100 has broken its record level in 2015, a high not seen since the peak of the dot com bubble of the late 1990s, and has even gone on to break through the psychological barrier of 7,000 over the last week, UK investment trusts are now better value than they have been for a number of years.
According to data from the AIC, 21 out of the 25 trusts in the IT UK Equity Income sector (or 84 per cent) are now trading on wider discounts than their three-year average. The three-year average discount is 1.80 per cent, but the sector’s current discount is now a much wider 4.80 per cent.
It is a similar story in the IT UK All Companies and UK Smaller Companies sectors as 76.9 per cent and 61.5 per cent of trusts in those two sectors, respectively, are now trading on wider discounts than their average over the past three years.
It means that when you compare UK trusts to other popular closed-ended equity sectors, they seem to offer particularly good discount value both on an absolute and relative basis as illustrated in the table below, which shows the percentage of trusts in the various regional IT sector trading on discounts wider than their three-year average and the current average discounts in those sectors.
Source: The AIC
It is understandable why demand for UK equity trusts has been falling. There is, after all, what is expected to be one of the most hotly contested general elections in a generation taking place in less than two months while, at the same time, the FTSE is by no means cheap.
Also, full-blown quantitative easing in the eurozone will have undoubtedly led to many investors to take profits from UK equities and put that cash to work into the liquidity-fuelled European market.
Whether or not it is related, each trust in both the IT Europe and IT European Smaller Companies sectors is now trading narrower discounts than its three-year average.
The average discount in those two sectors over the last three years has been 8.6 per cent but today the average European trust is trading on a 4.7 per cent discount to NAV.
However, while the positive sentiment towards the continent may explain why discounts have widened within the UK growth sectors, it seems strange that investors have been dumping equity income trusts.
Performance of sectors versus index over 1yr
Source: FE Analytics
Widening discounts have certainly impacted on the performance of trusts within the sector, as the graph above shows. According to FE Analytics, the IT UK Equity Income sector has underperformed against its open-ended counterpart and the FTSE All Share by 4 percentage points so far this year.
Nevertheless, it seems strange that closed-ended income funds have fallen out of favour, particularly as there is still the worldwide hunt for yield.
A large number of industry experts have warned that bond markets are now very overvalued. Ten-year gilt yields have fallen once again over recent weeks on the back of lower inflation figures, to now yield just 1.4 per cent.
Also, given the lower oil price, the threat of temporary deflation and the upcoming election, the consensual view is that interest rates will continue to stay low for some time to come so investors are getting nothing from holding their cash in the bank.
Our data shows, on the other hand, that the IT UK Equity Income sector is yielding 3.7 per cent.
On top of that, income investors are constantly reminded that equities are an attractive asset class as companies can grow their dividends. However, while open-ended funds have to pay out all of their income each year, closed-ended funds can ‘smooth’ their dividend by withholding 15 per cent of their annual earnings to make sure they can hold or increase their pay out in bad years.
The likes of JP Morgan Claverhouse, Murray Income and Merchants trust have all increased their dividends in each year for more than three decades, for example.
Source: The AIC
As a result of those wider discounts, Ewan Lovett-Turner – associate director of investment companies research at Numis – says a decent buying opportunity has opened up within the sector.
“We had become wary when many of the trusts were on premiums and if you had the opportunity to use open-ended funds instead, that was the time to look to do so. However, they are certainly looking more attractive than they were and some of those trusts have very, very good track records of growing their dividends,” Lovett-Turner said.
He added: “They certainly look attractive when you look at the yields available from bonds.”
Simon Elliott, head of research at Winterflood, also thinks now is an attractive entry point for long-term investors.
“I don’t think it is just an investment trust issue though, as the flow of money into the IA UK Equity Income sector has slowed,” Elliott (pictured) said.
“I think is more a call on the UK market more than anything else because, with the FTSE reaching 7,000, investors are starting to get a bit concerned about valuations. However, if you can take a longer term view, I think now is a good time to look closely at the sector.”
Elliott doesn’t forecast discounts to tighten instantaneously within the IT UK Equity Income sector, but given the nature of the asset class and the quality of managers on offer, he thinks there is decent value available.
“Does this represent a buying opportunity? Yes, I think it probably does,” he said.
“I suppose the question is will discounts widen from here, but it’s very difficult to call the market and we don’t try and predict when it will turn. However, if investors were happy to pay a premium for these trusts a few months ago why wouldn’t they take a look at them now they are on wider discounts?”
“You’ve got the likes of the Aberdeen trusts, Murray Income and Dunedin Income & Growth, on 7 per cent discounts and Temple Bar on a 6 per cent discount – which is nose-bleed territory for that trust as it consistently traded at or close to NAV.”
While Elliott says it is hard to call what will happen over the short term, he says investors can take comfort as he believes investment trust boards, which have issued a lot of stock over recent years, will be minded to start buying back shares if discounts continue to widen so that they protect their existing shareholders.
In the next article this morning, we will take a closer look at three UK equity income trusts which look particularly good value following the recent widening of discounts within the sector.