Investment trust liquidity can come at a price

According to one institutional investor: “On day one of an investment trust there should be low expectations of liquidity. Maybe even none. Everyone has bought into an idea. The shares are trading at or around net asset value (Nav). Expectations are high.”

What happens next depends on a combination of skill, luck and sentiment. If the timing is good for the asset class, and the manager does a good job, the shares remain popular and in demand. Roughly two years out, however, investors’ objectives may begin to change.

For an institutional investor, the real value of the closed-end fund structure today is in the conversion of illiquid or esoteric strategies into marketable securities. This means investing for cashflows with the prospect of realisation of the investment at some point in the future, as opposed to trading.

For an individual private investor, the value may be stability and lower ongoing costs.

Investment trusts typically weather market volatility better than their open-ended counterparts because they are not forced sellers of assets at exactly the wrong point in the market cycle.

Two years out from launch, normal turnover commences in the trust’s shares. An investor is able to obtain a ‘daily mark’ by reference to the price on the exchange (the share price) and to discover some liquidity when it really matters.

According to a specialist broker in alternative investment companies, the ‘daily mark’ is particularly valuable for an illiquid or esoteric underlying asset class where a regular valuation mechanism does not exist, for example, secondary interests in private equity funds.

Whether the shares trade at a 5 per cent premium or a 20 per cent discount, all investors have the opportunity to trade at that level. That is, assuming that the market price is a fair reflection of the value or prospects for the underlying portfolio. Unfortunately, shareholder communication can get stale and portfolio information and prospects fall out-of-date leading to share price ratings that are worse than reality.

So shares showing a ‘daily mark’ on a 40 per cent discount may not actually trade because no-one is willing to sell, even though there may be buyers. Share price volatility dramatically reduces liquidity, since there are fewer investors willing to deal with an unstable discount rating. This is one of the conundrums of investment trust investing and one of the issues that vexes investors.

Looking at the liquidity of investment companies generally, one adviser said that for a £100m investment trust he expects to see 0.15 per cent to 0.25 per cent daily turnover (£150-250k) whereas for a conventional smaller trust he would expect turnover of five times that amount.

That equates to roughly 3 per cent turnover per month for a £100m investment trust. Here are further statements from the same adviser: “liquidity is always a function of price” and “Liquidity may be obtained at the expense of value”.

He exemplifies these statements with an example: “How quickly could I sell the Ritz Hotel on Piccadilly if I needed the cash? If the price was £10m it would trade in an instant; if asking £500m it would take a little longer or not trade at all.”

In other words, there is always a clearing price at which willing, rather than forced, sellers and buyers will meet, price being a perception of future value.

The adviser said that, in his view, the single most important responsibility of the board of directors of an investment trust is to “steer the share price to a level where volumes can be transacted”. Some believe that level should be Nav.

For financial products, liquidity is principally determined by two sets of factors, the qualities engendered by the product itself that make it attractive as a potential investment, and the mechanism by which the product may be discovered and dealt in.

For an investment trust there are considerably more moving parts determining the share price than for an Oeic. These can affect liquidity markedly.

Simon Coulson is the author of the report ‘Secondary liquidity in the investment company sector’ published by the Association of Investment Companies in December 2012

The liquidity of investment trust shares Product quality factors

• Performance

• Discount volatility – more important than absolute level of share price discount, although if this is large it is telling the board that the market has doubts about the veracity of the net asset value valuation or the prospects for the company going forward

• Marketing efforts of the board, the manager and the company’s broker

• Availability of accurate price and Nav information

• Availability of up-to-date portfolio and performance information through a number of portals and third party research providers

• Reputation of individual manager and investment house against competitor managers and competitor products (Oeics, ETFs, structured products)

• Structure of the company (debt, subscription shares, performance fee – any prior charge that makes simple evaluation of share price and net asset value performance more complicated)

• Market capitalisation – absolute level, including whether the investment company is a member of the FTSE 250 or Small Cap index

• Presence of buy-back programme

• Presence of continuation vote

• Tax and regulation (eg lack of ‘ISAbility’)

Source: Secondary liquidity in the investment company sector report December 2012