When investors get over-excited, it’s time to worry – but we’re not there yet

Investment trusts have become increasingly popular among private investors and wealth managers, who have largely replaced the insurance companies, pension funds and other institutional investors that used to be their main holders.

This popularity has seen discounts of share prices to net asset values (that is, the gap between the price investors pay and the value of the underlying portfolios) fall to historically low levels.

This has encouraged the launch of new trusts, and enabled existing ones to issue new equity.

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When trusts buy back their own shares at a discount, or close themselves down and return capital to investors, it reduces net issuance. But it also encourages more issuance by giving investors confidence that directors will act to keep discounts low, even if it means winding up a trust, encourages investors to believe they will not be left with a lame duck if they invest.

This growing popularity can be a warning sign. When inflows into investment markets turn into a stampede, it is time to worry.

Inflows into both open-end funds and investment trusts this year have been strong – but are they yet too strong?

Fund flows have been strong – but not that strong

Numis reports that total funds raised by investment companies in the first nine months of 2021 reached £10.9bn. That’s more than double the amount raised in the comparable period of 2020, and 65% ahead of 2019. Capital returned to shareholders was £3.2bn, 17% ahead of 2020 and 27% ahead of 2019.

Of that money, £1.4bn was invested in seven new issues; the rest was for additional shares in existing trusts. Moreover, the new issues have done well; Literacy Capital has appreciated by 78% and Taylor Maritime 27%.

The cynical fund manager who observes that “the stockmarket is forever coming up with new ways for investors to lose money” is not yet being vindicated though the problems of the aircraft-leasing trusts and the disaster of Catco Reinsurance point to some truth in this observation.

Net inflows into open-ended funds have also been strong, totalling £30.7bn in the first eight months, including £5.3bn in August, compared with £12.2bn in the first eight months of 2020. The August figures, however, include £1.6bn into almost risk-free money market funds, though monthly in-flows had been negligible in the previous 12 months.

Inflows also include those into lower-risk fixed income, absolute return and mixed asset funds (these sectors have their counterpart in the alternatives area of investment trusts).

Sales of Isa products in the last year jumped 79% to a five-year high but this data includes cash Isas, surely one of the most pointless investment products around, given current interest rates.

Given that UK households are estimated to have saved £184bn in bank accounts since March 2020, these fund in-flows are not as impressive as they might seem. Existing investors may be increasing their exposure to stockmarkets – but other savers are cautious.

The legion of online traders which, we are told, is regularly creating havoc in the stockmarket appears to be exaggerated and does not represent significant inflows to the market. London Stock Exchange data does not show a surge in volumes, for example.

The poor historic performance of the UK stockmarket may be one factor holding investors back. Flows into UK equity funds have been persistently negative for a long time.

Although £10bn was raised on the London Stock Exchange in the first half of 2021, according to Dealogic, there were 124 take-overs and purchases of minority stakes by private equity companies totalling £41.5bn. In addition, share buy-backs in just the FTSE 100, according to the Financial Times, are likely to reach £25bn this year. The UK market is still shrinking fast.

There just isn’t as much irrational exuberance as you might expect

In the US meanwhile, flows into mutual funds have done no more in recent months than become less negative than they were earlier this year and last, despite the strong performance of Wall Street.

There, many investors follow an indicator called the bull/bear ratio, which is published weekly by the Investors Intelligence weekly survey. The ratio measures how investment professionals feel about investing in equities. As such, it is relatively short term and does not necessarily reflect the longer-term views of private investors.

The indicator was at historical highs until recently, but has now dropped to more cautious levels. Market analyst Ed Yardeni regularly points out that low readings are a much better “buy” signal than high ones are a “sell” signal.

A deeper dig into the UK data shows that there may be areas of dangerous euphoria – but it is not widespread. Nearly three quarters of the money flowing into investment trusts which are closed-end, are in the “alternatives” segment. This consists mostly of lower-risk property, infrastructure and renewables funds offering generous yields but modest prospects for capital appreciation.

Admittedly, £1.5bn flowed into new and existing private equity funds and there is considerable concern about valuations of those that are technology-led. Against this, the established funds usually trade at generous discounts to net asset value. Inflows into traditional equity funds, especially the once-popular area of emerging markets, are low.

In a world in which the media stories about the pandemic, inflation, a new Cold War, the retreat of free trade, market economics and democracy, impending climate disaster and popular anger about the way of the world are relentless, it is not surprising that investors are a bit cautious about putting their savings to work in long-term investments.

Stockmarkets had a yo-yo ride last year, and although Wall Street was until recently hitting new highs, this was largely justified by rising earnings. Other markets have been more subdued.

Bear markets are often but not always preceded by an avalanche of money from over-enthusiastic investors, swept along by the herd, who tend to buy high, and sell low. That warning signal may come next year or the year after – but it isn’t there now.

The resilience of markets this year against a background of relentless pessimism does not point to vulnerability. The time to worry will be when the clouds clear and investor euphoria takes hold.