Are investment trusts the best way to get exposure to alternative assets?

Open-ended funds recently garnered attention for the risks they posed to investors by holding some illiquid assets such as property.

Does this mean investment trusts are the ideal vehicle in which to hold alternatives?

David Hambidge, director of multi-asset funds at Premier Asset Management, observes: “Given that liquidity on the majority of alternative assets is poor or in some cases virtually non-existent, then an investment trust with its fixed (or semi-fixed) capital structure is the best structure for these investments.

“Alternatives have gained in popularity since the financial crisis, largely as a result of plummeting bond yields, and investment companies have raised huge sums, particularly in the income space.”

The Association of Investment Companies (AIC) notes increasing adviser interest in alternative asset classes.

In recent years, managers of alternative asset classes have increasingly used closed-ended fund structures to hold their assets, which we believe may provide investors with a potentially attractive way to access these types of alternative investments.Paddy Dear

“Interestingly, recent research from Matrix Financial Clarity has revealed that the most popular sector for financial adviser purchases in the first quarter of this year was an alternative asset class, Sector Specialist: Debt.

"This is now the fifth largest investment company sector by assets,” Annabel Brodie-Smith, communications director at the AIC, points out.

“It has seen increasing demand over the last few years, with 22 investment companies launching in the sector in the last five years.

"Property Direct – UK was the second most popular sector for adviser purchases and it had been the most popular sector for the last half of 2016, no doubt due to the problems suffered by the open-ended property funds after the referendum.”

More on the issues faced by open-ended funds in the aftermath of the EU referendum later.

Listing the pros

There are several reasons why the structure of investment trusts makes them so well suited to alternative assets like infrastructure, debt and property.

Ms Brodie-Smith explains: “Investment companies are listed companies on the stock exchange so investors can always buy and sell shares freely. 

“Due to their closed-ended structure, investment company managers do not have to manage inflows and outflows and can take a long-term view of their portfolios, without being constrained by the illiquid nature of the asset class.”

Figure 1: Property Direct UK Investment company vs open-ended performance – share price total return (%)

Source: AIC using Morningstar (to 31/3/17) showing arithmetic average returns. Clean share classes used for open-ended funds.

Paddy Dear, co-founder of Tetragon, adds: “In recent years, managers of alternative asset classes have increasingly used closed-ended fund structures to hold their assets, which we believe may provide investors with a potentially attractive way to access these types of alternative investments. 

“Listed closed-ended investment companies and similar vehicles may enable a wider investor base to access exposure to more illiquid assets and may also provide liquidity through the purchase and sale of interests on the listed exchange.”

He notes assets such as real estate, solar, wind farms and other renewables, infrastructure, hedge funds, private equity, and even more niche asset classes like aircraft leasing, collateralised loan obligations (CLOs) and bank loans, are all accessible in these types of listed investment companies.

What are the cons?

This is not to say investment trusts are a perfect structure – there are some issues which advisers should ensure their clients are aware of prior to investing.

The investment trust structure does have “complexities and challenges”, according to Alex Scott, deputy chief investment officer at Seven Investment Management.

He explains: “IT share prices can diverge significantly from underlying asset valuations. It’s important to understand the drivers of this – not only supply and demand for the shares, the timeliness, accuracy and conventions of valuation methodology used for calculating NAV, any discount control or redemption mechanisms that an IT may have, the structure and strength of the board, the nature of the shareholder register and so on.”

He continues: “Discounts may mean that there’s value on offer and an investment trust is unjustly neglected by the market; or they may simply mean that NAVs have not yet caught up with reality – it’s important to be able to understand which is which. 

“Similarly, premium valuations can be a warning that a fund or strategy is excessively popular, they may be justifiable pricing for hard-to-access assets or they may, on occasion, reflect conservative or slow-moving valuation methodologies such that the real underlying value of the assets is well above the NAV. Again, it’s critical to be able to understand the difference.”

Mr Hambidge also cautions although the volatility of the underlying assets in many alternative assets is relatively stable, the closed-ended listed structure can result in significant share price volatility at times. 

Open-ended vehicles trade at NAV, but can be forced to suspend redemptions if too many investors want out at the same time.Mike Pinggera

But he sees this more as an opportunity than a threat, as investors are able to buy when share prices have fallen and wait for them to recover.

Referendum chaos

The difference between the open-ended and closed-ended structures was brought home after the referendum on EU membership last year.

The surprise win for those who voted to leave the union caught many investors unawares and they tried to redeem their money from UK property funds, only for the managers to close to redemptions in many cases.

Ms Brodie-Smith recalls: “After the UK referendum last year we saw a number of open-ended property funds have to suspend trading, meaning that investors weren’t able to buy or sell them and this has happened before during the financial crisis. 

“While sentiment towards property changed and property investment companies’ share prices suffered, investors could still sell their shares if they wanted to and investors were able to buy them.”

In response, the FCA launched a discussion about “some of the risks created when consumers use open-ended funds to gain exposure to assets that may be difficult for the fund manager to buy, sell or value quickly”.

It published its findings in July this year, telling fund managers to improve practices, and criticising firms for “inadequate” planning.

Ahead of the publication of those findings, the AIC called for clearer disclosure of the risks to investors of open-ended funds which invest in illiquid assets.

Ian Sayers, chief executive of the AIC, said in a release in May: “The arguments in favour of using the closed-ended structure for illiquid assets are so strong that you have to question why the open-ended sector’s assets in UK Direct Property are four times bigger than the investment company sector.  

“So we are calling for clearer disclosure of the risks associated with a mismatch between the liquidity of the fund and its underlying assets, as well as asking fund promoters to justify their reasons for the fund structure chosen, and not simply to default to the open-ended option.”

Weighing the differences

Advisers are often more familiar with the open-ended fund structure than with investment trusts but for many, the issues after the referendum highlighted the differences.

Ultimately though, it is at the adviser and their client’s discretion.

Mike Pinggera, manager of the Multi-Strategy fund at Sanlam Four, points out: “As with many investments it is simply a matter of preference.

"Permanent capital vehicles, such as listed infrastructure or Reits, do not have to sell underlying assets when investors sell their holding because the liquidity is provided by the stockmarket. 

“However, these vehicles can trade at discounts and more recently at premiums to NAV. Open-ended vehicles trade at NAV, but can be forced to suspend redemptions if too many investors want out at the same time.”

He adds: “There is no right answer but generally it is good to avoid a liquidity mismatch.”

eleanor.duncan@ft.com