Mechanism can guard against discount volatility fears while enabling growth

For some advisers, part of the attraction of buying investment trusts is the ability to buy a pound’s worth of assets for 85p or 90p. Some like to try to make money from trading discounts – buying wide and selling narrow, adding extra alpha on top of any gain in the net asset value. 

For others though, the fear they might buy an investment company at a premium or narrow discount and find it is trading at a much wider discount when they want to sell is enough to make them favour an equivalent open-ended fund instead.

Investment companies have been concerned about their discounts for many years and, since 1999, it has been tax efficient for them to buy back shares.

Pressure from activists led many investment trusts to adopt discount control mechanisms and others followed suit. The majority of investment companies now have a policy of using share buybacks to help moderate their discount and the most popular trusts issue shares to moderate their premium.

Sometimes these policies are articulated clearly but some boards like to keep the market guessing, possibly worried about arbitrageurs trying to game the discount control mechanism.

Adopting a ZDCM should allow the fund to expand gradually and new shareholders can buy into the trust with some comfort that discount volatility should not have too much of an impact on their return.Matthew Read, QuotedData

In recent years, a few funds have adopted zero discount control mechanisms (ZDCMs). In practice, these aim to keep the shares trading in a narrow range around zero – issuing shares at a small premium to meet demand and buying back shares at a small discount when necessary. By trading at a small premium or discount, the trust covers its costs in relation to the ZDCM and makes a small profit for the benefit of the other shareholders.

Using a ZDCM makes the investment company much more like an open-ended fund. The investment manager must ensure that he or she has liquidity available to fund buybacks, though one possible advantage of the closed-ended structure is that these funds could be made available through a credit line.

Likewise, to avoid too much cash drag on the portfolio, cash coming into the fund needs to be deployed quickly. This means ZDCMs are most suited to funds with fairly liquid underlying portfolios. 

A good example of a fund that has adopted a ZDCM recently is Seneca Global Growth and Income. This is a relatively small fund that has been performing well and wants to grow.

Expanding an investment trust while it is trading at a discount is very hard. One-off large capital raisings, such as C share issues, are feasible but the timing has to be right and it is not uncommon for these issues to be scuppered by short-term market jitters.

Adopting a ZDCM should allow the fund to expand gradually and new shareholders can buy into the trust with some comfort that discount volatility should not have too much of an impact on their return.

The Seneca fund can cope with the liquidity impact of the ZDCM because much of its multi-asset portfolio is relatively liquid. The ZDCM is operated in this instance by Personal Assets Trust Administration Company. Personal Assets Trust was one of the first funds to adopt this policy. Over the past 15 years the number of shares it has in issue has expanded almost five-fold despite extensive periods when it was buying back many more shares than it was issuing.

However, adopting a ZDCM is no guarantee of growth for an investment trust.

For example, one fund that has gone down this route and is smaller today than when it implemented the ZDCM is BlackRock Income and Growth. This is now one of the smallest funds in its peer group. That is unfortunate as it has the effect of pushing up its ongoing charges ratio, as fixed costs are spread over a smaller base. It may need a sustained burst of good performance if it is to grow.

One other consideration that investment companies adopting ZDCMs need to take into account is what happens in times of extreme stress in markets. 

The way the ZDCMs are constructed, the buybacks and issues of shares are at the discretion of the directors. Part of the attraction of closed-ended funds is that they can avoid involvement in panic selling to fund redemptions when everyone is rushing for the exit. This allows their investment managers to take a long-term view. 

Different boards may take contrasting views about whether ZDCMs will be suspended in ‘fast markets’ so it is worth investors checking if they are unsure. 

Matthew Read is senior analyst at QuotedData