The popularity of investment trusts reached a new high in 2021 as the investment vehicles, an alternative to traditional funds, attracted a record £15.1 billion of new money. That far surpassed the previous record of £10.2 billion raised in 2014. Figures published by the Association of Investment Companies, the UK’s closed-ended investment industry trade association, show total assets in the sector have increased by over 250% in the past decade.
Investment trusts have plenty going for them to back up that popularity. Essentially stock-exchange traded companies whose units can be bought and sold like shares, investment trusts give investors the built-in diversification of a fund but with liquidity.
But unlike traditional open-ended funds which are obliged to distribute all income generated by underlying assets to unit holders, investment trusts are allowed to hold back 15%. That allows them to build up a buffer to maintain the payment of dividends during tough years, like this one.
Investment trusts, which are closed-ended and issue a fixed amount of non-redeemable shares which are then traded like those of a public company, also have more flexibility in what they can invest than mutual funds and unit trusts. The fact the shares of an investment trust are liquid means they can, if they choose, invest in more illiquid assets than traditional funds.
Closed-ended fund managers are limited in what they can invest in by the need to maintain enough liquidity to meet potential redemptions. Investment trusts don’t have that problem. Investors selling out simply puts downward pressure on the unit price value and the fact they can do so at any time during market opening hours at the click of a button ironically means they are less likely to do so. That means investment trust managers can take a longer-term view. They can also borrow or “gear up” to a pre-agreed level to enhance performance.
Investment trusts have independent boards that can replace managers if performance is persistently poor and can also negotiate lower fees. Two boards have changed managers and 26 have reduced fees this year.
These features and benefits appear to be giving investment trusts the edge and in the past decade, they have outperformed open-ended funds in 11 out of 16 sectors.
Investment trusts can be an inflation hedge
The kind of illiquid and alternative assets like infrastructure and property that investment trusts can invest in can benefit from an inflationary environment. Annabel Brodie-Smith, the AIC’s communications director explains:
“In the current inflationary environment, investment companies investing in assets like infrastructure or property can offer an income contractually linked to inflation. The infrastructure sector currently has an attractive, relatively stable yield of 4.6%…”
“We have already seen existing alternative investment companies raising money [in 2022] – Cordiant Digital, which invests in digital infrastructure, the ‘plumbing’ of the internet, recently raised £200 million.”
Investment trusts are trading at an average discount of over 14%
The closed-ended nature and liquidity of investment trusts are also why they look particularly interesting right now. Because their units are exchange-traded, their valuations are not a precise reflection of the net asset value (NAV) of the investments they hold. The units of a popular investment trust can trade at a significant premium to its NAV when demand is high. The flip side of the coin, however, is that they can also trade at a discount to NAV.
As of November 18th, the average London-listed investment trust was trading at a discount of 14.2% to NAV compared to 3.6% at the beginning of the year and, excluding VCTs, a premium of 0.2% at the end of 2021. Of 38 investment trust sectors, 37 are currently trading at a discount with only the hedge funds sector at a premium.
However, like any traded company, sometimes what looks like an attractive discount can prove a value trap. Illiquid assets may not, in reality on the open market, fetch the price they are valued at on an investment trust’s books. Even liquid assets such as equities held by many investment trusts could fall in value, dragging down NAV further. Or investors in the trust itself could lose faith in the management’s strategy, reducing demand for units and dragging down their valuation.
How to judge if an investment trust trading at a discount to NAV is really undervalued?
Generally speaking, an investment trust trading at a discount or premium to its NAV indicates how popular it is. But as with publically traded company stocks, investors have to try to judge if the market is assigning fair value in light of all currently available information, or is under or overvaluing the present reality and future potential.
Ideally, investors would buy into an investment trust at the point it is being undervalued by the market for one reason or another and benefit from the positive correction when that is realised. The trick is avoiding “value traps” – a valuation that at first glance looks discounted but on further examination is justified.
What are the warning signs an investment trust is trading at a discount to its NAV for good reasons and not simply because it is a bear market or there has been an overreaction to factors that shouldn’t have a long-term impact on its future prospects?
In isolation, an investment trust trading at a hefty discount of 10% or more to its NAV doesn’t offer much information that can be acted upon. There has to be a catalyst that will close the gap in future.
The first question to ask is at what level is the discount happening? The three main levels valuations are influenced at are market, sector and trust. If the market is generally bearish it negatively impacts most investment vehicles. At a sector level, there might be macro factors affecting a particular asset class or group of trusts. Or the discount might be because of circumstances around the specific trust.
Investment trusts with a focus on real estate are currently trading at particularly steep discounts. At the end of last year the average discount for trusts in the UK commercial property sector was -4%, which had extended to almost 25% by October this year. Investment trusts in the UK residential property sector fell from a 3.7% premium at the end of 2021 to a 25% discount by autumn of this year and the European property sector has swung from a 0.8% premium to a 36% discount over the same period.
The main factor for the sharp drop in valuations of investment trusts in property sectors is rising interest rates and the impact that will have on both the cost of servicing debt, which is usually high for property investment vehicles, and the future value of assets.
Illiquid assets like real estate, especially commercial real estate, can be hard to value accurately as there is a lag between changes to market conditions and book values. That can leave investors wondering what the impact of external market factors will be for months and the impact on an investment trust’s valuation to NAV will be based on investor sentiment, which can be both overly optimistic or pessimistic.
AIC data also shows investment trusts in the growth capital sector swung from an average 0.8% premium at the end of 2021 to a 37.4% discount by the end of September. These trusts invest in early-stage private companies that are capital intensive and often struggle during bear markets. Private equity trusts are also discounted by an average of over 20% with the bear market the primary catalyst for their decline.
Once investors have identified sectors whose declines in valuation appear to be the result of temporal factors that are not expected to persist indefinitely, it is a case of assessing individual trusts.
Arguably the most important factor here is to look at the track record of an investment trust’s board. Not every board demonstrates a strong desire to narrow discounts to NAV and it is worth looking at how long previous periods of trading at a discount have lasted and what measures have been taken to close the gap. A proactive approach to buybacks is one positive sign as it shows commitment to the vehicle.
Investment trusts the experts consider good value
Investors have a lot of choice when it comes to investment trusts listed in the UK or internationally but here are three investment trusts regularly highlighted by analysts as currently looking like they represent good value:
Scottish Mortgage
Scottish Mortgage, which invests in high growth tech companies has been one of the UK’s most popular investment trusts over the past decade and benefitted greatly from the surge in tech valuations over that period. It has inevitably suffered this year with the growth tech sector among the worst hit by the bear market and its share are trading at about 45% lower than they were a year ago. It also trades at a NAV discount of almost 8% compared to an average 3.9% over the last year.
The trust’s management are highly experienced tech investors and insists the vast majority of its holdings are in profitable companies that generate cash. However, it does have around 32% of assets tied up in a portfolio of 52 still private companies whose real value and future prospects are hard to judge. Significant write-downs over the next year are a risk.
However, while risky, the trust has a good track record and it wouldn’t be a surprise to see it to bounce back to trading at around its NAV when the tech sector returns to a bull market.
Digital 9 Infrastructure
Digital 9 was launched in early 2021 and invests in digital infrastructure assets that facilitate global data transfer and help meet the need for faster, more reliable and more accessible internet connectivity across the globe.
It has delivered annualised returns of 10.7% since flotation and paid out 6p of dividends, representing a yield of over 6%. Recent acquisitions for the investment trust will result in the dividend being almost twice covered by cash flow. Over half of investments are UK-based.
The trust’s investment director Andre Karihaloo says the portfolio valuation relative to cash flow
“is well below that of listed peers and comparable transactions” and that it has “acquired businesses on very value-accretive multiples of cash flow.”
25% of assets are accounted for by a stake in Aqua Comms, a leading provider of subsea fibre services globally. A 52% stake in the telecoms company Arqiva was recently acquired for £300 million and the Icelandic data centre Verne Global represents 33% of assets.
While the company holds significant long-term debt Karihoo describes the portfolio as
“very cash generative, has low capital expenditure requirements and long-term contracts.”
AEW UK REIT
In the property sector, investments expert Ian Cowie likes the look of the AEW UK REIT, which currently trades at an 18% discount to NAV. It is the top-performing investment trust in the UK property sector over the last five years, delivering total returns of 54% over that period, While it is down almost 14% over the last year it now yields just over 8% dividend income.
Its portfolio is based on smaller commercial properties led by Central Six Retail Park in Coventry; Eastpoint Business Park, Oxford; and Gresford Industrial Estate, Wrexham.
