Investments  

SNAPSHOT: Investment trusts

Last year was a difficult year for many investment trusts. Trusts underperformed versus open-ended funds in 10 out of 17 sectors during the year.

The disparity was due to investors selling out of trusts, causing the share price to fall relative to the underlying value of their stocks.

Historically, investment trusts tend to do better than funds in rising markets, thanks in no small part to the impact of gearing and narrowing discounts. However, worries on valuations, rising interest rates, and the end of quantitative easing led to more muted returns in 2014, particularly in the UK. So looking ahead, does 2015 represent a buying opportunity?

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As with any discussion on market opportunities, one should be wary of generalisations – this is particularly relevant with regards to trusts. Research and a deep understanding of the sector are of paramount importance. For instance, sector averages can be distorted by one large company – one example here is private equity, where discount narrowing on most names has been overwhelmed by a huge rerating of 3i, which has taken the sector to a massive premium. The average discount excluding 3i is 22 per cent.

In terms of buying opportunities in 2015, relative to their own recent history some trust sectors currently look cheap – for instance, Asian Smaller Companies – while others looks expensive, such as UK Property.

By definition, buying a trust on a discount means you are buying assets at less than they are worth. However, the value of those assets declines, it is certainly not cheap. Over the long term the most important guide to performance is net asset value (NAV), so your first consideration must be to invest in areas which you think will benefit from NAV growth, and with managers you think will outperform the benchmark.

Even if investors believe NAV growth will be good, the principal top-down consideration is that if the asset class is out of favour or sentiment is poor, premiums may still narrow and discounts may widen. One must be prepared to be early into the trade.

At its simplest, buying a trust at a discount to NAV represents a good value opportunity, as can buying a trust on a premium if its gearing will generate sufficient excess returns to justify that premium. But there are also plenty of reasons why a trust’s discount can get wider or indeed its premium larger.

Take two sectors on big premiums – Social Infrastructure and UK Property. In terms of the former, investors are effectively being paid cash flows from the UK government, and premiums tend to result in very attractive yields and internal rates of return (IRRs) for long-term investors. There is no reason why this should change. In the case of UK property, with strong NAV growth expected and decent levels of gearing, the market is calculating that yields and IRRs remain attractive even when buying at a reasonably high premium.