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With frenzy like this…

Investment trusts are experiencing a period of evolution and the cull of funds that add little value will go on

Until quite recently, many in the fund management industry regarded invest-ment trusts as captive funds. They were insulated from the pressures of the commercial world as investors could not vote with their feet and redeem.

The only course of action available was to sell in the open market at any price they could get. Often, this meant accepting an offer which was 20 per cent or so below the underlying value of the trust’s portfolio. This dissuaded many from using investment trusts and hence they have become the last corner of inefficiency within the stockmarket.

Now that the hedge fund community has discovered it, the sector is now experiencing a period of accelerated evolution. An investment trust is structured in the same way as any industrial stock. If an investor has a big enough shareholding, they can force through change.

Quite simply, activist investors have bought big positions in trusts such as Discovery, Henderson absolute and Invesco continental at big discounts and subsequently forced them to liquidate, pocketing the profit from eliminating the discount. Meanwhile, their market risk had been hedged away via derivatives.

In response to seeing their peers being broken up by the arbitrageurs, boards of trusts have been bringing in discount pricing mechanisms. A topical example is the commitment from the board of Foreign & Colonial to buy back shares at a 10 per cent discount which has led to a general narrowing of discounts.

A recent circular from the AITC highlighted that the average trust discount has fallen to 7.4 per cent, the lowest level for 10 years. We believe this represents structural change rather than cyclical. Discounts are effectively heading for zero.

In the current environ-ment, if a trust allows its shares to drift onto a double-digit discount, it will soon find itself with a hostile shareholders register. Therefore, in the not too distant future, discount protection mechanisms will become virtually universal. Investors will have the opportunity to exit trusts at a price which bears a relationship to its net asset value.

Some familiar names, have been cast into oblivion but new issuance is strong. There have been more than a dozen new trusts launched in the past month alone. Schroder Oriental, economic lifestyle, Morant Wright Japan and Aberdeen Asian income were among these floats. The common denominators are the innovative use of capital structures or a niche investment policy that is more efficiently executed without having to suffer the disruption of short-term inflows and outflows.

One of the past mistakes made by the investment trust industry was to respond to the success of its unit trust cousins by mimicking them. Even now, many fund management groups still run open-ended and closed-ended mandates in parallel.

There is no reward in exchange for assuming the risk of a widening discount and the possibility of not being able to sell if desired. In such instances, investors are better served by buying the open-ended fund.

Looking forward, the investment trust sector will look very different. There will be a continuation of the cull of funds that add little value. Conversely, specialist funds will flourish as sophisticated investors seek new avenues. The new breed may not be called investment trusts but they will be closed-ended with an independent board and trade on a yellow strip. They will look feel and smell like an investment trust.

New issue activity is frenzied. Among the current offerings, there are some property funds, a Japanese specialist, a high-yield commodity fund, an Asian income fund an alternative energy specialist and more.

What all these portfolios have in common is that they could not offer what they are within an open-ended format. The trend away from mega-fund management groups offering closet tracking towards boutiques with conviction portfolios has closed-ended funds in the right place at the right time. The outlook is exciting. The only question is, when will perception catch up?


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