We need to talk about discounts

Discounts are the problem, and the solution…by Alan Ray

 
My career in investment trusts started in the 1990s. and I can’t remember a time when the sector wasn’t fighting against or lobbying over some aspect of regulation in order to ‘level the playing field’ with competing products.

And here we are in 2023 still having to ask our regulators and legislators for a bit of help to level that playing field. I, therefore, offer my heartfelt congratulations to a determined group of investment trust enthusiasts who have been working very hard behind the scenes and recently gained acknowledgement in the chancellor’s Autumn statement.

The topic in discussion is around cost disclosures and I certainly don’t want to steal their thunder by jumping on the hindsight bandwagon and recounting the whole issue, not least as you can find lengthy write-ups elsewhere.

Instead, let’s look at a key phrase from the policy note accompanying the Autumn statement (which you can read in full here with the key relevant passages on pages 13 and 14). “The UK has a world leading investment company sector, which is highly aligned with the government’s priority to promote long term, productive investment. Representing over £260 billion of assets, investment companies provide a key source of capital and liquidity to support economic growth.” My response is, well thanks, I’m glad you noticed.

While HMRC uses the technically more correct “investment companies” phrase, for our purposes the phrase is interchangeable, and Investment trusts have among other things, built schools, hospitals, bridges, roads, houses, solar farms, onshore and offshore wind turbines, redeveloping unwanted offices, upgrading logistics hubs to be more energy efficient, and providing long-term finance for UK SMEs well before they are ready to list on a stock market, and they’ve done all of that while at the same time casually offering one of the most effective ways to buy equities in an actively managed fund.

They’ve managed to do this without any particularly constructive regulation that recognises their strengths. Imagine what they could do if they were given proper recognition with some well-thought-out changes to regulation.

Readers will know that I and my colleagues are very enthusiastic supporters of the sector’s role in renewable energy, which is now a substantial group of investment trusts that on a standalone basis are a meaningful part of the UK’s energy mix. Greencoat UK Wind (UKW) and TRIG – Renewables Infrastructure Group (TRIG) are amongst the oldest and most well-established, but the trust space is home to a variety of portfolios contributing to our Net Zero goals.

It would be easy to pick that as an example of where I think regulators could do better, not by levelling the playing field, because frankly, what other widely available fund structure is even on the playing field, but by sitting down and asking, “how can we do more to help you access more capital, more quickly?” In 2023 I don’t think one even needs to be very engaged or worried about climate change to see that renewable energy ultimately offers a level of national security and, quite likely, low-cost energy that can only be a good long-term outcome.

But I’m not going to pick renewable energy as an example, although perhaps I just did, and instead, let’s think about regulation and property funds. Here we are again in 2023 with open-ended property funds having tied up investors’ money for months, while assets are sold into a weak market, gradually eroding the net asset value.

This has happened before, and if anything, it was worse in the GFC, and yet regulation hasn’t made any serious inroads into the matter. Despite my long career in investment trusts, I do understand why some investors prefer open-ended funds, but I think that if investors must continue investing in property through this structure, then the regulator should consider very seriously the idea that open-ended property funds should, a bit like banks, be compelled to have a “living will” that encompasses a fast route to them listing as REITs in order to give investors the option to swap to a tradeable security.

I know very well what objection number one to that idea is. “You are asking investors to consider swapping units priced at NAV into shares that, in any likely scenario, would go straight to a discount? Really?”. I’d just say, “Well, first, let’s make it a choice, and second, yes, but at least there’s a price you can trade at and you don’t have to sit there suffering a fire sale of assets. Oh, and maybe that also opens the door for some M&A that gives shareholders their money back.” 

REITs like UK Commercial Property REIT (UKCM) and Balanced Commercial Property (BCPT) may suffer from wide discounts, but they at least allow the little investor to realise their investment when they like. Meanwhile, Ediston Property Investment Company (EPIC) is amongst the companies that have seen their boards take radical action to unlock value and sell the whole portfolio at a premium to the share price.

It’s also quite possible that I’m putting this idea forward simply to help illustrate that open-ended property funds are just a bad idea. And while those open-ended property funds are busy trying to raise cash, REITs have got important jobs like upgrading buildings to meet new energy efficiency standards, repurposing offices no longer needed, or building new homes. Things that matter to the economy and society.

I don’t want to labour this point, and I do understand a simple concept comes with a hundred complications. My big worry for the wider investment trust sector is that, despite the potential opportunities that come from finally being recognised as important, the word “discount” puts us on the back foot. “The problem with investment trusts is that sooner or later they go to a discount.”

So, I think it’s important for the investment trust sector to feel it can be a bit more robust in its own defence. Yes, no one wants something they’ve bought to go to a large discount, and I don’t want in any way to diminish the problems that this is causing all kinds of investors, and of course, some investment trusts have just gone wrong, which is a whole other topic for another day about risk and why it’s important to take some.

I’ll admit that at the start of the year, looking at the news every morning and seeing that a continuation vote has been lost, or a merger has been announced, or a trust is selling its portfolio and returning money to shareholders or buying back shares, my initial reaction was “oh no, not again”. But as the year has rolled on, I’ve come to realise that the system is working.

Yes, it’s messy and takes time to get into gear, old lessons are being relearned by new boards, and not everyone is driving at the same speed, but so-called corporate activity has ramped up and shareholders are being listened to and acted upon and investment trusts who try to bluff their way through the whole thing this time probably won’t get a sympathetic hearing from investors in future.

This series of safety nets is unique to the sector. Lots of people want simple investment solutions, and a lot of regulation over the last twenty or more years has been driving in that direction, reducing everything to a unified number or risk score.

That just isn’t realistic for many kinds of investments, regardless of what kind of fund or trust structure they are held in, and I think reducing things in this way disguises risks that investors should be aware of. Investment trusts might be messy, non-homogenous, and a bit complicated, but in my view, they provide a much more effective way to price and deal with risk and costs, and that’s something the sector should embrace and not feel compelled to defend.
 

 

Disclaimer

Disclosure – Non-substantive Research

This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. With this commentary, Kepler Partners LLP does not intend to influence your investment firm’s behaviour.