Confession time. Over the last few columns, I’ve probably come across as something of an investment trust curmudgeon, fretting that the sector is facing structural headwinds which could cause permanent damage. In truth though I’m still an enormous enthusiast for London-listed closed-end funds and think the future is bright if there are some structural changes.

More to the point, I think it’s always coldest before dawn and we may just be inching towards light without any deep structural changes I’ll suggest below.

I’d point to three tailwinds that could lift spirits.

Hedgies hover

The first is that a multiplicity of hedge funds are eyeing the closed-end fund space. Over the last few months, I’ve been contacted by or talked to, a wide range of UK and US hedge funds who are taking a keen interest in the discounts on offer. Some of the players have already been reported on such as Boaz Weinstein’s Saba Capital but there are more lurking in the wings, with some private equity houses also thrown in for fun. Put simply, there are lots of UK investment companies out there with quality assets at bargain prices.

Another tailwind is that investment company boards are getting more active, alive to the fact that their share prices have derated badly. We’ve seen a cascade of proactive initiatives ranging from director purchases, share buybacks and manager purchases through to ever more effective communications plans to reach out to private investors.

More communication

On the last point, I’d suggest that it is worried private investors who are frequently the prime movers on thinly traded secondary markets. The more communication to neglected retail investors the better, as it will help steady a troubled, drifting share price.

The last tailwind I’ve already discussed is that I think we are much closer to key triggers in varying markets. The core measure on most investors’ minds is the peak rate for interest rates and long-term bond prices. My guess is that we are close to and may even have already reached peak rates. While the next move, downwards, is probably some way off, the idea that we’re near the peak might start to concentrate minds on what happens next. Logically, the more likely outcome is declining rates which should flatter many income-producing funds.

Another area worth watching is the venture capital cycle which has suffered from precipitous declines as investors have rightly pulled out their red pens and pruned back valuations on risky private businesses. While I sense that we may have more pain to come for seed and Series A valuations, my own guestimate is that we are much closer to realistic valuations for many later-stage businesses, helped along by some evidence that the flotation market is starting to reopen for business in the US at least. This will help the wide range of listed venture capital and private equity funds as well as venture capital trusts (VCTs).

There’s no need for despair but there is a need for substantive change. Some of the changes are already in motion, notably more active boards taking more pro-active positions.

Consolidation is key

Another key outcome is on its way – a smaller number of funds. A handful of investment companies are rightly taking the decision to either wind up or seek a merger. In far too many segments and niches, there’s a multiplicity of funds, more than three or four in some cases, where to be honest one or two would suffice.

Overall, my sense is that the whole investment trust and closed-end fund space could – at the present stage – do with a 10% to 20% culling, which would imply that up to a hundred funds might not be around in a few years’ time.

However, it’s important that the funds that remain provide real ‘alpha’ ie, outperformance versus their passive index-tracking rivals. There are far too many underperforming actively managed investment trusts that now boast year after year of weak sub-par returns charging a quantum more than their ETF peers. This simply won’t do any more.

More alternatives

All of this brings me to another key change I think is long overdue. During the next phase of the investment trust evolution, real consideration should be given to getting more traditional equity (and multi-asset and bond) funds into the market mix.

In my mind, the sector faces a real choice. Does it refocus on the competitive advantage of alpha outperformance in traditional markets such as equities, or does it start to stage a retreat from equity alpha and focus on growing the book of alternative assets in a closed-end structure?

The challenge of the alternative assets is that during stressed markets these alternative assets, be they real estate or infrastructure, are subject to brutal haircuts as investors worry about the underlying liquidity.

There’s a reason why the average global or UK equity income trust trades at a 5% discount while many alternative asset funds trail over 20% below net asset value. Despite my enthusiasm for ETFs, I still think there is a space for active equity fund managers – and even active fixed-income managers – but we need these strategies and funds to be more prominent in the investment trust space.

Another area where investors are keen for more competition – and more alpha generation – is in multi-asset funds.  A handful, such as Capital Gearing (CGT ), Personal Assets (PNL ), RIT Capital Partners (RCP ) and Ruffer (RICA ) currently dominate, but there’s room for much more choice, differentiated strategies and new ideas.

I’d observe that CGT’s strong focus on bonds – alongside a varied portfolio of funds and equities – shows that there’s still keen interest in a fund that has fixed income as a major component of its alpha. I’d also observe that one of the few investment trusts that still trades at a premium is CQS New City High Yield (NCYF ), alongside Invesco Bond Income Plus (BIPS).

My last suggestion is that while the specialist funds segment on the London Stock Exchange has been successful on one level, it needs a radical rethink. It has become something of an incubator for fund managers with new ideas and relatively untested reputations. If we are entering an era of fewer, larger funds that tick the minimum threshold level for fund selectors – rumoured to be around £500m now – we also need new structures that can act as incubators for innovation, uncovering new forms of alpha generation.

SFS serves that need but its focus on institutions has left retail investors in the dark – many of these funds are difficult to trade in and spreads are painfully wide in many cases. Surely, it’s not beyond the intelligence of the regulators and LSE to come up with an alternative feeder structure that allows wider access to innovative new ideas in a closed-end format?

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