The investment trust (IT) sector has faced a number of headwinds of late.
The discounts at which many are trading have come under scrutiny, while regulations governing cost disclosures mean they appear expensive relative to open-ended vehicles, making them less appealing to wealth managers.
Indeed, a recent survey conducted by Winterflood Securities found appetite for ITs among its clients to be at its lowest point since it first started surveying some 12 years ago.
Despite this, every investor has a specific set of needs and there are times when ITs may be a more suitable option than open-ended funds. Both have very different characteristics, not least when it comes to their structure.
ITs are publicly traded, limited companies with a board of non-executive, independent directors. They have a fixed number of shares issued through an IPO, traded on a stock exchange throughout the day, creating daily liquidity.
Their share prices can fluctuate independently of the net asset value of the strategy’s underlying assets, creating discounts and premiums. Their structure also enables their managers to make use of gearing through various debt instruments.
As ITs operate as closed-end strategies, with shares listed on the stock exchange, they can experience short-term, equity-like volatility. While this may be a deterrent to some, it does mean managers are not constrained by the same considerations over redemptions as their open-ended counterparts, which can make them forced sellers of assets.
It is this key difference which can make them a better vehicle to invest in assets or projects whose value may take several years to be realised. While the Financial Conduct Authority recently approved the launch of long-term asset funds to enable a broader range of investors to access the potential returns from illiquid assets requiring a longer-term investment horizon, ITs have always been a viable option in this respect.
This is particularly evident in many infrastructure projects associated with the transition to clean energy. For example, a manager may identify a wind farm development scheme that has the potential to produce meaningful returns while also helping to reduce carbon emissions and tackle climate change.
However, those returns will only be realised several years into the future, as the farm not only has to be built, but the payback period for wind farms is typically lengthy. Once the project does start generating returns, though, the predicted cash flows should be stable, with demand for renewable energy sources steadily increasing.
A manager of an open-ended fund would likely have to pass on the opportunity. The investment would not only be capital intensive but it is also an asset that cannot be sold easily. A manager of an open-ended fund needs the flexibility to exit positions quickly, to meet any large-scale redemptions. An IT does not have that problem and can take advantage of the opportunity to invest in infrastructure projects which are inherently illiquid.
An ITs structure also means there is no cash drag on returns. An IT can invest 100% of its capital in underlying assets, whereas an open-ended fund investing in property or infrastructure might only ever be 80% invested, keeping the remaining 20% as a buffer to manage cash flows and maintain liquidity.
This means that even if an open-ended fund did invest in a long-term asset such as a wind farm, it could only ever achieve a maximum 80% of its return. The resulting cash drag can have a significant impact on long-term returns, creating a material difference in performance.
Another differentiating feature is an IT’s ability to use gearing or leverage. While this does create a level of additional risk, it can also potentially amplify returns. Gearing enables ITs to take increased advantage of capital-intensive opportunities for growth, providing a potential edge for long-term investors. It can also enable a manager to make new investments without having to sell existing holdings, enabling them to participate in new ideas while keeping conviction in existing investments.
Finally, having an independent board, who can oversee the long-term strategy of the company and hold the fund manager to account, with the ultimate sanction of firing them should they fail to deliver, should give investors comfort that the manager’s interests are closely aligned with their own.
While this may make ITs appear more complicated at first glance, what it in fact means is there is much better price transparency, an independent body looking after shareholders’ interests and the ability to borrow money to increase exposure to the underlying investment returns where appropriate.
Ultimately, then, the closed-end structure of ITs makes them well-suited for long-term investments. With no cash drag, the ability to use gearing and being able to invest in various asset classes regardless of their return time horizon, they should be incorporated into a portfolio with long-term investment objectives.
Jock Glover is strategic relationships director at Square Mile Investment Consulting and Research
Please see the past Aberdeen IT for reference of what ACTUALLY happens under IT management… Perhaps the losses and censures were the reason they had to economize… like dropping letters for starters… They have never really recovered… see MM recent passim…
ITs are much more open to conflicts of interest than fund based stuff – like VC and the like – bonuses are paid for performance within the underlying co.s…the independent (?) board of the IT should be scrutinized often! Funds usually have trustees who are actually awake these days… now the Trustees are personally liable…
Personally, I think a degree of cash/call is ok for most situations – if you do want 100% ‘all in’ why not take positions on shares of better quality and liquidity? Better tax aspects too.