A perspective from James Carthew, research director, QuotedData.
Recent stock market volatility has caused some to panic that the investment company market could come up against the same liquidity problems as it is feared will face some open-ended fixed income funds if investors all rush for the door at exactly the same time.
Everyone who buys an investment company wants to be reassured that they will be able to sell it again – ideally at the same or a narrower discount or higher premium than when they bought it. One of the key distinctions of choosing a closed-ended over open-ended investment is this discount element, which means that supply and demand factors can be a key contributor to investor’s total returns.
QuotedData’s monthly reports on the industry show that 17 new investment companies and REITs have been listed on the UK market this year, with many of them offering something different for investors. Each of them is much better suited to be a closed-end fund than an open-ended one because of the limited liquidity of their underlying investments or the long-term nature of their investment approach.
If you are thinking about dealing in a closed-ended fund and the size of your position for client portfolios is likely to be a large proportion of the company’s total size, it is right to give some thought to whether your trade will move the market and whether liquidity problems could surface in volatile market conditions.
Hence why some institutions and lately some large private client brokers have decided that they won't buy investment companies for their clients. We are talking about firms whose minimum position size is in the tens or even hundreds of millions however. Most of us, investing in most funds, won’t face too many problems.
It is also worth remembering that shying away from closed-ended funds does not mean liquidity is no longer an issue. Open-ended funds are known to restrict liquidity for investors when they see big outflows and in some cases to introduce spreads on buying and selling.
Advisers concerned about liquidity can easily look up the average daily trading volumes of investment companies on the AIC website. There is a fair degree of variation between one company and another, with size being the most important factor as previously mentioned. For example, the biggest three investment companies in the AIC Infrastructure sector see an average of £1.48 million of shares traded daily. For the smallest three, the level of trading is less than a tenth of that (around £120,000).
Premiums and discounts
One factor that plays a big part in regulating liquidity is the premium or discount at which an investment company trades. This is because, to some investors, a widening discount is in itself a signal that a company may be cheap. This will tend to stimulate demand that partly offsets the selling pressure.
The reverse is also true of premiums. As they grow, certain investors will take the view that the company is becoming increasingly expensive and will look to sell their shares. This is why premiums and discounts tend to be mean-reverting over the longer term.
Investment trusts have a range of tools at their disposal that they can use to influence supply and demand for their shares, and hence improve liquidity.
When demand exceeds supply, trusts often end up trading at a premium to asset value. Excessive premiums are bad news for new investors and so, when the managers are happy that they can deploy fresh cash in new investments, it makes sense for these investment companies to issue stock to help control the premium.
Many boards and investors have decided that the quid pro quo for this is that the boards should buy back stock if the fund goes to a discount and some trusts have adopted a zero discount policy, committing to ensuring that the trust trades neither at a discount nor at a premium by issuing stock and buying it back as necessary. This policy blurs the lines between closed and open-ended funds.
Buy-backs, hard discount controls and zero discount mechanisms work best where the underlying investments are liquid (such as large cap. equities, government and investment grade bonds) – so the manager can quickly sell off the portfolio to fund the buy backs and invest new cash to avoid cash drag. This need to hold cash to fund possible redemptions, may be one reason that open-endeds tend to underperform.
Accessing illiquid assets through investment companies
However, it is worth remembering that the reason why many investment companies exist in the first place is that they can hold illiquid investments that a unit trust couldn’t. Therefore, investors and advisers should accept that the price for being able to have relatively liquid exposure, through a closed-ended vehicle, to otherwise illiquid investments is that your investment may trade at a discount to asset value.
Even funds investing in illiquid investments have the option of offering shareholders an exit close to NAV periodically and many now do. This goes a long way to solving the discount/liquidity problem. The trust will give itself time to realise the underlying assets in an orderly manner before handing back the cash. The creation of liquidation pools, for some investment companies, has a similar effect. A good example of a recent new issue that has adopted this approach is GLI Alternative Finance. From early 2017, shareholders will be offered regular, six-monthly, redemption opportunities.
A fire sale of assets is almost never a good idea. Many boards with funds that seem to have fallen permanently out of favour with investors have shifted to liquidation mode, gradually selling off the portfolio and returning the proceeds to shareholders. This is what many private equity funds did in the credit crisis. Arguably, though, some of these funds that are still liquidating assets five years later should be asking shareholders if they have changed their minds now given the recovery in the sector’s fortunes.
At the end of the day though, I think the most important thing is that investors and advisers should adopt long-term investment horizons that see through discount volatility and varying levels of liquidity, which are often driven by short-term factors. After all, over the longer-term, the performance of the investment trust industry has truly shone versus its open-ended counterparts.
James Carthew is research director at QuotedData, which provides sector and fund-specific research, up-to-date information, key documents and regulatory news announcements on London-listed investment companies.