Rising markets have led to strong investor appetite for high-growth areas such as small and mid caps, causing discounts to narrow.Cockerill (pictured) warns that if there is a significant market correction in 2014, many investors will be caught out as these discounts balloon back out.
“If there is a meaningful market correction, one that people think will stick, trusts will come off – in some cases quite a lot,” Cockerill said.
“Discounts have closed in and some of these charts do have a toppy feel to them. The discount on BlackRock Smaller Companies has come right in to 5 per cent whereas it was over 15 per cent 12 months ago. And the discount on Schroder UK Mid Cap has come in from 20 per cent to 6 per cent.”
“The closing of discounts has enhanced performance by a lot this year, but we won’t get that again next year,” he added.
In addition to the BlackRock and Schroders investment trusts, Cockerill says the Baillie Gifford Shin Nippon trust, which has benefited significantly from a rally in Japanese equities, and the JP Morgan European Smaller Companies trust both have a history of steep share price rises and then falls and that discounts on both of these have come in a long way.
“I know this is simply looking at a chart but it does make me wonder,” he said. “Any upset in the outlook/recovery could easily send these south.”
“It would need to be an event or series of events or news items that makes investors believe more than a basic correction is occurring, so I do think they look vulnerable at these levels unless the economic outlook continues to pick up strongly.”
The £182.5m, four crown-rated Schroder UK Mid Cap trust is trading on a narrow discount of 3.21 per cent, in nearly 7 percentage points from its one-year average of 10.12 per cent. Over the last three years the trust has typically traded on a discount of roughly 14 per cent.
The trust has benefited significantly from the mid cap rally in 2013, picking up 58.91 per cent since the start of the year, more than doubling the returns of both the FTSE 250 ex IT index and the IT UK Growth sector.
Year-to-date performance of trust vs sector and index
Source: FE Analytics
It is a similar story for the Baillie Gifford Shin Nippon trust, which is trading on a premium of 6.7 per cent. While the trust has tended on an average premium of 4.07 per cent over the last 12 months, over three years the trust’s average discount is 2.11 per cent.
The Japan-focused trust has blazed ahead of its peers in the IT Japanese Smaller Companies sector since the start of 2013, gaining 54.64 per cent. The sector made 37.14 per cent over this time while the MSCI Japan Small Cap index picked up just 20.92 per cent, according to FE Analytics.
As Cockerill warns, the trust can be caught out when the market turns against it. In 2008 the trust fell in line with the sector, shedding roughly 40 per cent of its share price. The index made 9.18 per cent that year.
However, in the down markets of 2011 the trust managed positive returns of 0.47 per cent, compared with a 3.94 per cent loss from the sector and 3.17 per cent loss from the index.
Other trusts Cockerill said could be in danger in a risk-off environment include the BlackRock Smaller Companies trust, run by Mike Prentis, and JP Morgan European Smaller Companies, headed up by Jim Campbell and Francesco Conte.
Both trusts are trading on a narrower discount than their one- and three-year averages. The BlackRock trust can be bought at a 6.09 per cent discount to its net asset value (NAV) while the JP Morgan portfolio is trading at an 8.38 per cent discount.
Both trusts have rallied strongly in 2013, contributing to the narrowing of their discounts. The BlackRock trust has made 57.59 per cent since the start of the year while the JP Morgan trust has made 52.06 per cent. Both are well ahead of their respective sectors and benchmarks over the period.
Performance of trusts vs benchmarks in 2013
Source: FE Analytics
Another trust Cockerill warns could see its share price come off in a correction is Electra Private Equity.
It has been a volatile year for the private equity trust, but it is still up 23.06 per cent, compared with 16.72 per cent from the FTSE All Share.
The trust is trading on a discount of 15.98 per cent, which is wider than its one-year average, but far narrower than its three-year average of 23.47 per cent.
Year-to-date performance of trust vs sector and index
Source: FE Analytics
Cockerill is also worried about the Mercantile Investment Trust, which has seen its discount narrow to as low as 8.2 per cent in the last 12 months. The trust is currently trading on a discount of 9.84 per cent, narrower than both its one- and three-year average.
The trust has also had a strong year, picking up over 10 percentage points more than the IT UK Growth sector, at 38.48 per cent.
However, it is another that had difficulties in the market crash of 2008, falling in line with the sector, and in the down markets of 2011 when it came off 17.68 per cent. The sector lost 11.06 per cent that year.
