Investment trust discounts: problem or opportunity?

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Activist investor Saba Capital has put investment trust discounts in the spotlight. In its view, discounts can leave investors trapped. In this episode, we take a deep dive into discounts, examining whether they are a problem or opportunity for investors. Joining Kyle to discuss this topic is Charlotte Cuthbertson, co-manager of MIGO Opportunities Trust Ord (LSE:MIGO), which specialises in hunting for investment trust bargains.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello I'm Kyle Caldwell and this is On The Money, a weekly look how to get the best out of your savings and investments. Today we're going to be covering investment trust discounts, examining whether they are a structural issue or opportunity for investors. Joining me to discuss this topic is Charlotte Cuthbertson, co-manager of MIGO Opportunities Trust, which specialises in hunting for investment trust bargains.

We're recording this episode shortly after seven investment trusts were targeted by a US activist investor called Saba Capital. Saba Capital requisitioned general meetings that called for the removal of each board and it was also aiming to install two new directors of its choosing. Shareholders in all seven investment trusts that were targeted rejected Saba's proposals, which ultimately would have led to a new investment approaches.

Central to the campaign was investment trust discounts being at historically high levels, which has been the case for a couple of years now. At the moment, the typical investment trust excluding 3i is trading on a discount of around -15%.

The US activist investor has now launched a new campaign targeting three investment trusts and it wants these three investment trusts to become comparable open-ended funds. It says that open-ended funds, which have a single price, are free of the structural issues that plague closed-ended funds, which are investment trusts.

So, Charlotte, let's unpick this. I wanted to ask you firstly for your views on the fact that Saba has [said] investment trust discounts are a “structural issue that can leave investors trapped”. What are your thoughts on that?

Charlotte Cuthbertson, co-manager of MIGO Opportunities Trust: I think in your intro, you described is it an opportunity or a structural issue. I think as somebody who's looking to exploit discounts, we'd count it mostly as an opportunity. One of the things about investment trusts is that they can trade at discounts and therefore, you can buy great funds and great assets at a fraction of a price of maybe an open-ended [fund] or something similar. We do think that trusts can fall on to discounts to represent an opportunity.

However, we do have a lot of sympathy with Saba and other members of the industry that have said, well, as you said yourself, discounts have been at historically wide levels and they've stayed very wide in the last few years. And so, we do have a lot of sympathy with the fact that investors do feel quite trapped maybe at the moment, stuck in these wide discounts, and they can't see how things are going to work themselves out. For us, we do think that it provides an opportunity set.

Going forwards, we're optimistic that trusts should either, whether it's narrowing their discount through things like buybacks or mergers or more likely corporate activity. We've seen a lot of realisations and we've seen trusts being taken out by private companies, for example. We do think that going forward we should see these discounts narrowing, but we can understand the frustration for investment trust participants at the moment.

Kyle Caldwell: Of course, there's not one single reason as to why, over the past couple of years, investment trusts have been on stubbornly wide discounts. Could you summarize in your view what the main reasons have been?

Charlotte Cuthbertson: Sure, so we describe it as the perfect storm and this has been the toughest period for investment trusts that we've really ever seen. And it's been a combination of lots of different factors. So, one of the factors that we've had for many, many years has been the consolidation in the wealth management industry. So, more mergers in these big wealth managers means larger pots of money, means that trusts have to be bigger and bigger in order to be on central buy lists. It removes a natural buyer in the sector. That's been a headwind for a while, but what we've seen is trusts managing to find different buyers and new buyers, for example, on platforms or smaller splintering wealth managers. We have seen some mitigation for that headwind, but more particularly over the last couple of years has been the interest rate increases.

Lots and lots of investment trusts were launched over the last 10 to 15 years in order to provide income to income-starved investors. And while interest rates have risen and investors have gone back to more traditional sources like gilts, that means that they've been leaving the investment trust sector.

So, it's just a classic example of a supply and demand problem, where you've got excess supply as people have moved to investing in gilts and more traditional sources of income. So, the demand is going, but you've still got that huge amount of supply. So, that's weighed heavily, particularly on those alternative asset trusts, where actually we think there's quite an interesting opportunity set there.

And then finally, we think that the ongoing charges, the OCF issues, have been really problematic. Interest in the trust got caught up with some EU legislation, which meant that trusts had to put out really, really high costs, which meant lots of them were pretty uninvestable for a large swathe of the industry because it made their own products look very expensive.

Some of the private equity trusts were having to put out OCFs of 7%. And so these unfair charges, and they weren't indicative of really what was going on in the trust themselves. Again, that was a huge headwind. So, it's been a really, really tough period, a real perfect storm for the industry.

Kyle Caldwell: And at the moment, the majority of investment trusts are trading on discounts. There's around 350 investment trusts that are members of the Association of Investment Companies (AIC), the trade body. When you're examining the whole market, how do you decide whether a discount is a potential opportunity? And how do you decide, actually, it might potentially be more likely to be a value trap?

Charlotte Cuthbertson: So, the thing that we're really looking at when trying to ascertain whether something's an opportunity or a value trap is looking for a catalyst. There are lots of investment trusts that have sat on wide discounts, even before this period. And they will continue to do so going into the future because there's no catalyst for something to change.

We're always looking for a reason of why that discount would narrow. At the moment, it's corporate activity. We're looking at trusts that are most likely to be taken out by private buyers, most likely to be merged with other trusts, for example, something like that, that's corporate activity. It might be something as simple as what we describe as an arbitrage between perception and reality. The market's got a perception of something, but the reality is very different.

Something that we had last year was Schiehallion Fund Ord (LSE:MNTN). The market believed that the net asset value was too high, that the underlying companies were very immature in their life cycle, that they might struggle in this new interest rate environment. And, actually, the truth was very different. And the sentiment towards Baillie Gifford, Baillie Gifford-run trusts, was very poor as well. And we actually thought that once the market got more comfortable that that NAV was much more resilient, and also once people kind of started coming back to Baillie Gifford, we thought that actually that would change. So, that's the kind of catalyst as well.

So, it's all about, ‘is something going to change?’ Is there a reason why that discount will narrow? And that's hopefully how you avoid some of those value traps.

Kyle Caldwell: And how do you try and get your market timing right? Because obviously there is a danger that you could buy at a big discount, a bit too early and that discount widens out even further.

Charlotte Cuthbertson: Yeah, that's very difficult. And I think what we've seen over the last sort of 18 months has been some of the, more the macro catalysts that we've seen. So, we thought some interest rate cuts would be helpful for the industry. Ongoing charges being resolved, that would be very helpful for the industry. Those things have taken longer to come through than we necessarily anticipated. So, we certainly don't get it right. But if you've identified the catalyst and you keep reassessing and you say, this is how you're going to extract the value, you can be too early. But I think that is also the nature of investing.

You do have to try and think, well, when I'm putting money into the industry, where am I finding the best opportunities and where is the catalyst more nailed on?

Kyle Caldwell: And, of course, if you buy an investment trust on a discount and that discount narrows, then you make a profit irrespective, even if the net asset value doesn't move, then you're going to make money.

I was wondering if you could run through a worked example of how much an investment or share price total return would benefit from, say, a discount narrowing from 20% to 5%?

Charlotte Cuthbertson: Sure. So, if you think about buying say a pound’s worth of assets for 80p. So, we've spent 80p and, as in your example, that discount's narrowed to 5%. So, my 80p is now worth 95%. So, that's a nearly 19% uplift just from that 80 to 95.

I mean, total return, that's not including any dividends you might get along the way. So, certainly when we're looking at infrastructure, renewables, property, you often get a dividend as well, depending on your holding period. So, that can also add to those returns.

For MIGO, what we're really looking for is that double whammy. What we're looking for is a net asset value going up and that discount narrow. And that, I think, is the really powerful combination for returns.

Kyle Caldwell: In terms of investment trust discounts, when we cover them at interactive investor, we regularly point out that with an investment trust discount, they do tend to converge more to the mean discount rather than the net asset value. Is that something that you agree with?

And also when we're pointing out to retail investors investment trust discounts, we suggest that they look at the one, three, and five-year historical discount figures and also take a view on the wider sector to see whether the discount is out of kilter, normal, or actually lower than the sector average.

Charlotte Cuthbertson: I think that's certainly been true. I think the market does sort of range-buy investment trusts around a certain point. So, if something's been trading for a long time around a 20 discount, 18 looks expensive and 22 looks cheap. And there are people who will play that move.

But I do think with what's going on with trusts at the moment, that that actually may change. I mean, if you think about MIGO, for example, about seven, eight years ago, we traded around that sort of mark where 10% was our average, people bought us on a 12 and sold us on an eight.

But there are things that investment trust boards can do. I think we'll probably talk about it a bit later, but I think investment trust boards are probably a bit under the cosh to be doing some of these things.

What we did for MIGO was we introduced a three-year realisation option. We improved our marketing. We identified that platforms as more wealth managers is probably more of our market, more of our area. We brought in a buyback and an issuance to keep that discount reasonably narrow.

There are ways that trusts that are a bit range-bound can break out of it. I think it's important to be thinking about whether boards might be doing something around that.

Yes, I think lots of investors and lots of people look at ‘is this looking expensive in comparison to its history? Is it looking expensive in comparison to the wider market?’ But you have to drill down on the specifics of what's going on with the trust as well.

Kyle Caldwell: So, in terms of the investment trust opportunities you're seeing at the moment, obviously you invest in multiple investment trusts, are there any sectors or themes of particular focus you mentioned earlier? Some of the alternative income areas are interesting you, perhaps that could be a place to start?

Charlotte Cuthbertson: Yeah. So, if we look at where our portfolio was 2022 to 2023, particularly 2022, we had a lot of cash to the market, it was very expensive. And if you looked at the breakdown of what was in MIGO's underlying portfolio, the segment that was alternatives was very, very small, and private equity we had a bit of, but again, that wasn't necessarily a huge part of the portfolio. Fast forward to where we are now, alternatives make up over 30% of the underlying portfolio.

And we've increased our exposure to private equity, in particular in that growth equity space. Schiehallion we actually have sold out off because the discount narrowed considerably and we've moved on to other areas, but we still have Augmentum Fintech Ord (LSE:AUGM), Seraphim Space Investment Trust Ord (LSE:SSIT), Chrysalis Investments Limited Ord (LSE:CHRY), and that sort of more early stage growthy basket. Chrysalis arguably is a bit further on in that life cycle, but also we've moved into having more in that alternative income space.

So, some renewables, some infrastructure, leasing, so Tufton Oceanic, for example. And it's those areas that historically have traded on premiums and at net asset value, and have now been really hit very hard by what's gone on in the industry, where actually we're seeing those discount opportunities.

Kyle Caldwell: And say a sector like renewable energy infrastructure, which obviously carries a very deep discount at the moment, and a lot of those investments are on very high yields. Would you pick a couple of them, or would you have multiple exposure to the same theme?

Charlotte Cuthbertson: I think if we're looking at something like renewables, it's quite important to be looking at the trusts themselves. So, not all trusts are created equal. You have to be looking at what they're invested in, where they're invested. Geographics is very important. What kind of assets they're invested in. So, we do have that bucket of renewables or that bucket of infrastructure, there's lots of different parts of that. If you look at something solar versus wind, there's lots of those different assets. We do have several in that bucket, but we wouldn't necessarily assume that all of them would move in the same way and necessarily all have the same catalysts.

But I think going back to your question on where we saw the opportunities, I think properties are also very interesting at the moment. Unlike renewables, where we've seen some disappointing pricing, [for] property, the pricing has held up very, very well. And the transactions in property, in that space, have been much closer to the underlying net asset value than we've seen necessarily in some of the sales in renewables.

Kyle Caldwell: As a sector we’ve seen some M&A activity in, which I'm assuming is more likely to pick up than not pick up?

Charlotte Cuthbertson: Do we think if we’re looking two years down the line, we’re going to have the same amount of investment trusts in the sector as we do now? I think it’s highly unlikely. We’ve seen lots of headlines about, ‘is this the end of the trust sector? Is it in a death spiral?’ We don’t think it’s the case at all. What we think is there was over-issuance due to certain macro factors. We're in a period of clean up and it's very healthy, and it's a very normal part of any investment cycle and it can be very profitable, there are lots of opportunities, there’s lots of value out there, and it’s identifying the best value opportunities and where a discount is warranted or unwarranted.

So, we think there’ll be continuing M&A, we think there’ll be continuing takeouts, we think there’ll be continuing realizations, because trusts have to do something. It's been two to three years now where trusts have been on very wide discounts and shareholders are no longer prepared to just hope for better days.

Feet are being held to the fire with both managers on boards about, well, if you're trading on a 30 discount, what are you doing to close this discount? How are you looking after your shareholders? And reality is probably either wind-ups, asset sales and buybacks, mergers, but some kind of corporate activity we think is probably where these trusts need to go.

Kyle Caldwell: You just touched on how you think the investment trust industry will change. It'll consolidate even more over the next couple of years. I’ve seen some investment trusts introduce tender-linked performance offers. I'll probably not explain that very well in a phrase, but essentially, if they don't deliver a certain level of performance or outperform over a certain time period, then they're going to give investors the opportunity to get out at close to net asset value. Do you think we might see more of this trend as well?

Charlotte Cuthbertson: I think so, yes. I think there's so many levers that boards can pull in order to be giving shareholders the best value for money and whether you agree or not, and there was lots of numbers and arguments flying around the Saba proposals, but should a trust that's underperformed over the space of three, five years, I think you need to give trusts decent time to turn things around. I think you need to give managers the opportunity to work through cycles within their own investments. But chronically underperforming trusts, should there be a catalyst that the board puts in?

Absolutely. You can debate the hows, whether it's performance-related tenders or just general realisations. Should you wait for a trust to underperform necessarily before you give the opportunity for shareholders to get their money back? I think I would argue that a three-yearly realisation would actually help keep discounts narrower anyway, regardless of performance.

Kyle Caldwell: And another lever that boards can pull is share buybacks. Now, of course, they are no panacea. It doesn't ultimately lead to the discount narrowing. I think, as you've mentioned, there needs to be a catalyst and there needs to be more buyers than sellers for that discount to reduce. We have seen an uptick in share buybacks over the past couple of years. Do you expect that to continue?

Charlotte Cuthbertson: I think the thing with share buybacks is that sometimes the arguments around them become a bit confused and conflated. So, I think there's two things around share buybacks. First of all, as you said, they're not this silver bullet, if your trust is trading on a 30 discount, they're not a silver bullet to be able to just suddenly narrow your discount. Because share buybacks only really work if you've got an overhang of 10% of shareholders that are selling and want out and need to get out for whatever reason, and your buyback is only 7%, then yes, it’s not gonna move the needle because you've still got a 3% overhang.

However, if your buyback is 11%, then actually you've taken out that overhang and that share price can move. So, there’s that side of things.

The other side of things is looking at the maths of doing a buyback versus reinvestment. Because if you look at, and as a fund manager, we're all really excited, or mostly we're all really excited about doing investments in our area of the market that we find interesting, where we can see opportunities.

And I speak to lots of managers who want to be doing that investment and they may be seeing really great opportunities. But if you break it down to the maths, there is no better investment that they can be doing than buying back their current portfolio, which you would assume they really like, on a very big discount. That's the maths. Because you get that NAV uptick as well from doing a buyback. So, there's some confusion necessarily about the fact, oh, well, but the buyback didn't stop us trading at 30 and there's expectation that a buyback will change you from trading at 30% discount to 5% discount. That's not necessarily what the buyback is there to do.

I think that, especially in alternative asset trusts, and I can see why managers don't want to do it and I can see why boards don't want to do it, there's a lot of nervousness about shrinking a trust, but the reality is the longer you leave your trust trading on a big discount, the longer that people want to get out and can't, the more likely it is that your trust will either get taken over or shareholders will vote to wind it up.

Selling off assets and buying shares back, I think actually gives you more of an opportunity to fight another day. It feels like you're going backwards, but actually gives you the opportunity to go backwards, to go forwards.

Kyle Caldwell: As you mentioned earlier, one of the trends as to why investment trusts have been out of favour over the past couple of years is the fact that there's been consolidation in the wealth management industry. And what this means is that they increasingly only look to invest in an investment trust of a certain size. I've heard certain people say it's around £250-£300 million and they won't look at investment trusts below them. Do you have a size limit when you're looking at the market? Is this something you factor in?

Charlotte Cuthbertson: No, we are very happy to invest in very small trusts. We have the liquidity capabilities to be able to invest down the smallest area of the market. We would say that we tend to be looking at stuff that's £500 million below. We do have quite a few that are above that size, but where the discounts they tend to be bigger as you go further down the market cap spectrum, as you say, because there’s fewer wealth managers that can invest in them. For us, that size just isn't as important.

But for trusts that are much smaller, the focus on finding investors needs to widen out from those traditional sources because these big, big wealth managers just can't use a trust that's £250 million. I would say that actually the size is probably bigger that they're unlikely to be looking at at the moment because it's not just about the size of the trust, it's also about the liquidity. And if liquidity is poor even if a trust £600, £700 million in size, then actually I think these bigger wealth managers would be very nervous about using trusts that are that size as well.

Kyle Caldwell: Finally, I was going to ask for your views on the future of the investment trust industry. You've pretty much already covered this in that you think that there will be more consolidation, there'll be less trusts in a couple of years compared to what there are today.

In terms of boards and investment trust managers in general, do you think there will be a more concerted effort to try and get across their strategies and communications to the end investor, particularly younger investors?

With interactive investor, a lot of our young customers, they mainly will buy index funds or exchange-traded funds (ETFs). And I think the message does need to be made loud and clear about how investment trusts are a benefit for investors of all ages.

Charlotte Cuthbertson: Yeah, I think it's really important that investment trusts look at and target younger investors, because they are, maybe bracketing myself into it as well, we are the future of this industry. In order for us to be a vibrant section of the UK market, we need people that like them of all ages. I think it is important, but I can see because of where the market's been over the last five, 10 years, people really only wanting ETF index funds because if they just buy a US index fund, it goes up and then they don't have to worry about it and all the rest of it.

But I do think that for investing in asset classes that you just can't access in any other structure, there is nothing but an investment trust. I know we have these long-term vehicles, but investment trusts, and I appreciate I’m probably speaking my own book here, but investment trusts are the vehicle to access lots and lots of asset classes that you just can't in open-ended, for example.

So, I think it is very important, but I think boards need to be doing more. But I think with what's gone on in terms of activism over the last year or so, I think that's coming through more and more, but we continue to have conversations with boards about what's the right thing for shareholders and what's the right thing for the end investor.

With where we are in the cycle over the next two years on the consolidation of the trusts taken off the market, that's normal, that's healthy. Where do I see them in five years? That's actually a really interesting thing to look into the future because there will be IPOs coming. It doesn't feel like it now. It doesn't feel like it in this part of the cycle. But if we're sat here in five years’ time, I can absolutely imagine that there will be IPOs of whatever asset class that people are interested in, and is popular and they want access to.

We have to go through this stage. It should and hopefully will be profitable. I think investment trusts will be seen as attractive investments once people start making some money out of them again and that will come as this clean-up happens. Five years’ time? That's a very different story and I'm hopeful that it will be a vibrant sector.

Kyle Caldwell: Thanks to Charlotte and thank you for listening to this episode of On The Money. If you enjoyed it please follow the show in your podcast app and do tell a friend about it. If you get a chance, leave us a review or a rating in your podcast app too.

You can join the conversation, ask questions and tell us what you'd like to talk about via email on OTM@ii.co.uk and in the meantime you can find more information and practical pointers on how to get the most out of your investments on the interactive investor website, ii.co.uk and I'll see you next week.

On The Money is an interactive investor (ii) podcast. For more investment news and ideas, visit https://www.ii.co.uk/stock-market-news.