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Multi-manager View: Out for the discount

Given the market correction, multi-managers should make a tactical switch in direction and increase their exposure to closed-end funds. Historically, discounts have moved in line with sentiment within the London stockmarket so it is not surprising that they have widened since the market peaked on May 11.

For some time, iimia has held the view that discounts are effectively trending towards zero. The benign effects of a rampant three-year bull market have obscured structural changes within the investment trust market brought about by the activities of activist investors such as hedge funds and arbitrageurs.

The availability of sophisticated hedging techniques means it is no longer sustainable for an investment trust to trade on much of a discount. Investors can simply accumulate sufficient shares to force a trust into a reconstruction or wind-up. By simultaneously owning derivatives that offset the market risks acquired along with the stake in the trust, these traders make straightforward profits from the elimination of the discount.

Hedge funds need to keep the action going as investors are fickle. They will welcome the sharp markdown in investment trust share prices as an opportunity to reload and target their next victims. Shareholdings now being acquired will form the platform from which the next round of attacks will be launched. Once these come to fruition, the boards of many trusts will react to seeing their peers being broken up by introducing much tighter discount control mechanisms. If they fail to take this action, they run the risk of seeing their own shareholder registers fill up with aggressive holders. This process will continue until discounts are too tight to generate profits for these traders. Therefore, anybody buying into this sector at the current depressed levels will see their investments outperform the underlying portfolios.

The new breed of closed-end fund also offers excitement for the medium term. Numerous funds have been launched during a period of frenzied activity, nearly all of which have more specialised and focused mandates than in the past. This reflects the move away from closet tracking towards more adventurous strategies. This trend has led to illiquid portfolios so a closed-ended structure is natural for many new ventures. However, we doubt that the industry will be able to value this new breed properly. Analysing the likes of wind farms, venture capital in India and retirement property is more akin to assessing smaller companies. Share prices will move out of sync, offering a fantastic opportunity.


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