8th September 2023
A question we have been getting a lot recently is, given prevailing wide investment trust discounts, is there an opportunity to switch out of an open-ended fund into a mirror investment trust to benefit from discount narrowing? In short – it depends!
Today, there are numerous examples of mirror funds and trusts on discounts managed by the same manager that on the surface looks like an obvious and easy arbitrage. However, there are several things to consider as there is no such thing as a free lunch, particularly in today’s environment.
We will focus this article on listed equity focused investment trusts as there are no suitable equivalent open-ended funds investing in less liquid including infrastructure, renewable energy or music royalties.
According to Numis, the average discount on equity investment trusts is 12%, compared to a long run average of 9% since 1990, and just 6% over the last 10 years. This suggests there should be lots of opportunities that investors can exploit.
There are several questions that should be front of mind when deciding whether to switch out of an open-ended fund into a closed ended vehicle, including:
- Are the two portfolios mirror images or are there important differences between the two (ie exposure to unlisted/less liquid holdings or differing fee structures)?
- Is there an acknowledgement from the board of directors that the discount is too wide and are they prepared to do something about it?
- Is there a discount control mechanism that is strictly adhered to?
- Is there a catalyst such as a continuation vote or similar realisation event on the near-term horizon?
- Is the trust a likely target for a takeover or merger?
You may want to switch into an investment trust regardless of the potential of a narrowing discount as there are some clear advantages of investment trusts over open-ended equivalents that could result in better performance over the longer term (indeed, there have been many studies over the years showing that investment trusts outperform their OE equivalents over the long run). These features include the use of gearing, the ability to have a more concentrated portfolio in less liquid parts of the market, the ability to hold back surplus income in the form of revenue reserves to maintain or grow the dividend, or pay dividends out of capital, aiding total shareholder returns.
It is worth bearing in mind that the nature of an investment trust trading on the stock market means it is likely to be more volatile than its open-ended sibling, with the use of gearing having a similar impact. Finally, any short-term arbitrage requires two trades, the initial switch and then the switch back, so timing the entry on the wide discount and then the exit on a narrower discount is crucial. Dealing charges and the ability to complete both sides of the trade (liquidity in the sector is very poor at present) are also important factors to consider.
Conversely, on the basis that only 6% of all investment trusts are trading on a premium, there are few short-term arbitrage opportunities the other way – switching out of an investment trust on a premium or narrower than usual discount into an equivalent open-ended fund. Many investors look at the Z score to see if a trust is trading more cheaply or more expensively than its 12-month range and look to buy or sell depending on that trend. Whilst a useful starting point, it is a very basic analysis that will miss a fundamental change to a trust such as a new investment manager, a new investment mandate, a new policy by the board/manager (such as a new buyback programme), and therefore selling an investment trust on a narrower discount to history might mean missing out on further gains.
From our perspective, we remain very selective on our investment trust exposure with most of our holdings focused on the deeply discounted alternative asset classes unavailable in open-ended funds. The equity investment trusts we do own are focussed on less liquid smaller companies where the fixed capital advantages of the closed-ended structure are most apparent. While there are other UK, Asian and Japanese equity trusts trading at attractive discounts, our preferred open-ended funds in those areas have such cheap underlying portfolios (and are run by talented managers who do not run equivalent investment trusts) that the recovery will be pleasing enough for our investors without needing to sacrifice the plentiful liquidity open-ended funds offer and without having to cross our fingers that the discounts on similarly exposed trusts will narrow. To conclude, we are not necessarily salivating at the value available in investment trusts holding conventional assets. That might change if discounts widen further and whether there are positive answers to the questions we posed earlier in this blog.
Daniel Lockyer – Senior Fund Manager
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