Discount tightening, Brexit and an overweight position to mid and small-caps have meant there has been a drastic swing in the performance of investment trusts in the UK over the past year.
Conventional wisdom suggests closed-ended investment trusts should perform better than their open-ended counterparts over the longer term, with the ability for share price gains adding to investors’ returns.
But over the last decade the average investment trust in the UK All Companies and UK Equity Income sectors has underperformed the funds in the equivalent Investment Association sectors.
During the timeframe, open-ended funds in the IA All Companies sector have beaten their investment trust counterparts by 8.09 percentage points, while in the UK Equity Income sector the gap is wider at 10.91 percentage points.
Performance of sectors over 10yrs
Source: FE Analytics
However, had this study been conducted this time last year, investment trusts would have outperformed their open-ended peers on a 10-year view, as the below graph shows.
Performance of sectors over 10yrs from 10 Nov 2015
Source: FE Analytics
Alex Paget, research analyst at Kepler Partners, said: “There are a number of reasons behind this – but it basically boils down to discounts.”
He says trusts have historically outperformed open-ended funds in rallying markets thanks their ability to use gearing, as well as their structural overweight in mid and small-caps.
“When looking on a 10-year view this time last year, you were including a rallying market of late 2005 through most of 2006,” he said.
“On a 10-year view now, though, you are only looking at the very tail end of the pre-crisis rally before the market impact of the global financial crisis began to kick in 2007.
“Plus, you are also obviously now including the past 12 months, a period in which UK trusts have underperformed open-ended funds for a variety of reasons.”
This year has been particularly difficult for investment trusts, with the impact of Brexit causing share prices to fall – particularly in the mid-cap space, which has been slower to recover.
Innes Urquhart, research analyst at Winterflood, said: “I think that discount widening will certainly explain an element of the underperformance over the last year.”
Over the course of the year, the open-ended funds in the All Companies sector have beaten their investment trust counterparts by 6.72 percentage points, while in the UK Equity Income sector the gap is narrower at 1.74 percentage points.
Performance of sectors in 2016
Source: FE Analytics
Charles Cade, head of investment companies research at Numis Securities, added: “Discounts tightened for a number of years, but have widened over the past year.
“The UK Equity Income IC sector is now trading on a market cap weighted average discount of 5.5 per cent, having traded at a premium earlier in the year.”
The other factor has been an overweight position in mid and small-caps, which Winterflood’s Urquhart noted “underperformed large caps, particularly post Brexit”.
This mid to smaller company bias has not been favourable in 2016, with the Numis Smaller Companies Index (ex ICs) up 4.1 per cent in 2016 versus a total return of 11.4 per cent for the FTSE All Share, which is largely weighted to the FTSE 100. 
Paget (pictured) added: “Market cap weightings have played a significant part. The FTSE 100 has outperformed mid- and small-caps over the past year as it has benefitted from sterling’s plunge, while investors have feared about the impact the EU referendum would have on the UK economy and therefore the high proportion of FTSE Small Cap and FTSE 250 stocks that are heavily exposed to it.”
Sterling has fallen 15.65 per cent so far this year against the US dollar, though this rebounded slightly following the news that Donald Trump had won the recent presidential election.
Performance of sterling vs dollar in 2016
Source: FE Analytics
While many FTSE 250 and smaller companies are domestically focused, the large FTSE 100 stocks are generally international with much of their earnings coming from overseas.
As a result, the large companies have performed better this year, with investors particularly looking to any firms that report in dollars or euros.
“Largely due to the benefits of the closed-ended structure, the ‘average’ UK trust has a higher allocation to small and mid-caps than its ‘average’ open-ended rival,” Paget said.
However, he notes that while trusts offer more exposure to domestically orientated mid- and small-caps and investors are clearly shirking those areas of the market, there is also a more general sense of nervousness that could impact the wider UK market as well.
Urquhart says despite the underperformance this year, being able to invest in smaller companies over a longer period of time should benefit investment trusts in the long run.
“The closed-ended structure of investment trusts means that they are ideally suited to investing in smaller less liquid stocks and, in general terms, we see this as an advantage, given smaller companies often better growth prospects,” he said.
However, there will obviously be periods, as has been the case in the UK more recently, where mid- and small-cap companies underperform.”
And with many funds now trading at large discounts, as already mentioned above, it could arguably be a good time to add exposure to investment trusts.
Kepler’s Paget suggests the Fidelity Special Values trust as one that is particularly attractive at current prices.
“It does have overweight positions in mid and small-caps, but we believe the current discount of 10 per cent is very attractive,” he said.
“Not only is it far wider than its longer term average, but the board has stated its intention to buy back shares if the discount moves into double-digit territory like it is today.”
The trust, which currently sits on an 11.1 per cent discount to net asset value, according to figures from the AIC, has been a top quartile performer in the IT UK All Companies sector over five and 10 years.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
Over the last five years, the trust, run by FE Alpha Manager Alex Wright, has a total return of 131.17 per cent, beating the sector and benchmark by 66.16 and 72.40 percentage points respectively.
Paget said: “It’s run by contrarian manager Alex Wright, who has built up a good track record both on the trust and his two open-ended funds.
“Not only do we rate the manager and his process, but we think there is certainly scope for that discount to narrow no matter which way the market turns.”
The trust, which is 11 per cent geared, has a clean ongoing charges figure including performance fees of 1.13 per cent and currently yields 1.8 per cent.