Investment companies, like most risk assets, have had a volatile start to the year – both January and February were challenging for investment companies, and the beginning of March saw further uncertainty as investors remained puzzled about the health of the US economy and whether or not the Federal Reserve will be able to implement further interest rate rises this year.
More recently they have benefited from a broader ‘risk on’ rally, as Mario Draghi and the European Central Bank (ECB) exceeded expectations at the March policy meeting, albeit seemingly ruling out further large cuts to interest rates. So what is the outlook for the sector from here?
Investment companies tend to be more volatile than open-ended vehicles such as unit trusts and open-ended investment companies (Oeics), because they are allowed to use gearing (borrowing) in order to boost their returns. While this characteristic is beneficial in rising markets, it can be unhelpful in periods of market stress or market uncertainty. By definition, investment companies are closed-ended vehicles (that is, it is not possible to create extra shares when someone wants to buy, or cancel the shares when someone wants to sell). As a result, building and liquidating positions can sometimes take time. For example, for one fund manager, it recently took a few days to build a £200,000 position in a decent-sized investment company. Building a similar position in a unit trust or Oeic (where units can be created or liquidated as required) would usually happen on the same day, unless the underlying assets were particularly illiquid (for example, commercial property).
Despite this, investment companies offer other several things that open-ended funds cannot. As already mentioned, there is the ability to produce geared or ‘levered’ returns. While that may be a disadvantage in periods of market uncertainty, buy-and-hold investors can sometimes get much more bang for their buck with an investment company than they could with an open-ended vehicle. This is particularly important in a world where returns from mainstream bond and equity markets look set to remain modest.
Investors in investment companies also benefit from a dedicated board of directors, who are responsible for looking after shareholders’ interests. Open-ended vehicles are not subject to the same level of scrutiny, and consequently there is not quite the same level of pressure on the investment manager to deliver value on a regular basis.
Moreover, when investment companies trade at a discount to their net asset value (NAV), the boards will be under pressure from shareholders to do something to close that discount. If the shareholders do not like the board’s response, they can remove directors and push to appoint new management. It is impossible for unit holders in an open-ended investment scheme to exert the same level of influence.
Prior to the period of recent market volatility, discounts across the sector had been historically narrow – indeed, some market participants had argued that we had moved into a world of permanently tight discounts. However, as we have seen recently, all that needs to happen is for markets to become more uncertain for discounts to widen again. This is a double-edged sword, as it can create opportunities for long-term investors who are looking for an attractive entry point, but it can be frustrating for investors who are already invested.
One area of the investment trust arena that has seen widening discounts recently is the private equity sector. These offer access to an asset class that is usually subject to large minimum investment sizes. However, investors have long memories, and this sector suffered particularly badly in 2008/9. Given how far private equity vehicles have come post-crisis, it is not surprising to see investors look to lock in profits. However, this is frustrating as the sector is in far better shape than it was eight years ago. For private equity fund of funds, for example, discounts of 25 to 30 per cent are not uncommon now, even though over the past 12 months discounts have averaged just under 20 per cent. Direct private equity investment trusts are also trading at a discount, albeit a much smaller one of 9.3 per cent, having been closer to asset value over the last year.
Private equity investment trusts are a subset of the ‘alternatives’ grouping, and to some extent alternatives have been a victim of their own success. The sector has grown rapidly because alternatives offer the prospect of returns that are less correlated to broader equity markets, often with relatively low volatility compared to equities. This means that they can hold up well during periods of uncertainty, but then face selling pressure – purely because they have done their job and outperformed.
A lack of liquidity means that marginal selling can have a disproportionate impact on the prices of investment companies. One cannot ignore the fact that liquidity (or lack of liquidity) is a much bigger consideration than it once was and investment companies reflect a broader trend across the entire financial market. Bank trading of investment companies (using their own balance sheets) has been significantly curtailed, so we tend to see greater volatility in times of stress, even on minimal volumes. Institutions are not operating in the sector in the same way that they were, which means that flows can be sensitive to the actions of retail investors, who tend to be much more ‘flighty’ in times of market stress.
Discounts are an undeniable frustration, but they should not obscure the fact that the structure of investment companies allows long-term investors to buy good-quality assets cheaply, something that is simply not possible with open-ended funds. This means there are three potential sources of return: the underlying assets; the measures taken by the board to close the discount to NAV (for example, share buybacks, where some boards have hard targets); and the gearing (borrowing) that will allow the board to magnify returns in rising markets. In a low growth, low-return world, investment companies – particularly those investing in alternatives and uncorrelated assets – can and should be an important part of an investor’s toolkit.
James Burns is a partner at Smith & Williamson Investment Management
| Key Points |
Investment companies, like most risk assets, have had a volatile start to the year. An area of the investment trust arena that has seen widening discounts recently is the private equity sector. A lack of liquidity means that marginal selling can have a disproportionate impact on the prices of investment companies. |
