My guess is that at the moment many investment trust boards are asking themselves the same question – do buybacks work? With discounts on both mainstream equity funds and alternative funds near historic highs and signs that many traditional investment trust buyers are becoming much more discriminating about the closed-end funds they buy, a real sense of nervous energy has washed across the sector.

It’s fair to say that this is more than just a board level exercise – if you’re an investor in investment trusts, arguably you too should be interested in the outcome of this debate as a narrower discount, all things being equal, equals an improved return.

So, what’s the evidence? There have been lots of studies over the years and the Association of Investment Companies (AIC) does a very respectable job of tracking the numbers, but I’m slightly wary of longitudinal academic studies conducted in the not-too-distant past largely because there have been some deep structural changes that have impacted the market.

I think three stand out. The first is that investment trusts were traditionally dominated by equities-oriented funds whereas discount control via buybacks worked perfectly well in liquid markets. That’s changed now we’ve moved into a new world of alternatives, not least because it is not terrifically easy to suddenly sell a private asset to realise the cash to buy back shares.

The next structural change is that the pool of buyers in the advisory space – by which I mean the big wealth buyers – is thinning out and the smaller number of players is becoming picky about what they buy, not least by demanding higher minimum market caps for funds.

A related change is that most private investors have also, I would contend, become more discriminating – if only because they now have many more index-tracking options available to them where discount control via liquidity operations is much more systematic (through authorised participants).

In my experience, far too many experienced private investors have become jaded with persistent share price discounts that don’t seem to go anywhere despite active board measures. I’d also mention one side observation – traditional investment trust value houses (the buyers of last resort for funds with big discounts) are thinning out, again diminishing the liquidity pool for investment trusts.

Add these all up and I think we should take any research and data from more than a few years ago with a generous pinch of salt. Luckily there have been some more recent studies of which the most recent is from the funds’ team at Liberum, led by their alternative funds’ analyst Shonil Chande.

The alternatives space

In a paper from early April Chande focused his analysis on the alternatives space where discounts have become common and persistent and his conclusions though not entirely surprising, do offer some clues as to what works.

After discussing the topic with Chande, several points became clear. The first is that share buybacks probably work best when they are used in combination with some other measures, not least active buying by directors and the fund manager – as well as maybe an asset realisation or selling down a stake in a key holding.

Next up little and often beats big, blockbuster single buybacks – the evidence does suggest that regular interventions in the market frequently works wonders. Thus, the sweet spot seems to be for funds in the 15% to 30% discount range where a thought-through campaign that includes buybacks, disposals and manager buy-ins seems to be the most effective outcome.

Once discounts go above 30% then I would suggest the argument becomes more nuanced. In sheer capital allocation terms, a buyback where the discount is above 30% is almost certain to make sense in capital return terms ie, it’s incredibly unlikely that the internal rate of return from the underlying investment will beat the return from buybacks. But, and it’s a big but, the issue then becomes the size of the fund and back to my point about the narrower pool of more discerning trust buyers who might run a mile once a fund starts to progressively shrink its capital base.

I’d also add another key consideration from my perspective – the liquidity of the shares in the secondary market. If a fund buyback improves the underlying market for the shares and thus narrows down the bid-offer price spread, then I think that could constitute a win for many boards.

But if the buyback tightens the liquidity pool and the bid-offer spread starts to widen out again past say 3% or even 5%, then I think the fund will find itself in a sticky position. And this is all doubly true if the buyback – or more likely tender – is focused on taking out a key, possibly unhappy, institutional shareholder. One could imagine a situation where if this was attempted, the fund gets materially smaller, and the liquidity pool tightens aggressively.

So, from an investor perspective I think the most interesting funds are those in the Goldilocks zone I mentioned earlier – discounts in the 15% to 30% range, where the board is authorising little and often buybacks, alongside fund manager buy-ins and an activist portfolio management policy.

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