Andrew Van Sickle: Peter, your fund is among the relatively few investing solely in a collection of investment trusts. How did you come to set it up?
Peter Walls: My background is entirely in the world of investment companies. I was on the sell side with a couple of investment trust broking houses for 18 years before joining Unicorn. I had come to admire the structure of investment companies and noted how it facilitated good, solid returns for investors across an array of assets, regions and industries. So I thought the best way for me to channel my enthusiasm and knowledge was to set up a fund.
The fund itself is actually open-ended rather than closed-ended like the trusts it holds. Unicorn Asset Management set up an OEIC, an open-ended investment company, in 2000 and it was convenient to hang a fund of investment trusts off this umbrella company at launch. The fund, which reached its 25th anniversary at the end of December, has fulfilled its founding objective – to achieve long-term capital growth.
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Had I gone down the closed-ended route, I would have had to go through a process of fundraising, and it might have proved difficult. Investment trusts are relatively obscure and poorly understood compared with their open-ended counterparts, so raising money for them is always a hard sell. And if my fund had been an investment trust, I could have ended up with a double discount to net asset value (NAV), making it an even more complicated proposition. The fund is now worth £130million.
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Andrew Van Sickle: What are the key advantages of investment trusts?
Peter Walls: The structure of an investment company is semi-permanent, in that a fixed number of shares provides a pool of capital for the manager to invest. In an open-ended fund, money is constantly coming in and out as units are created and cancelled when investors buy and sell, respectively.
The permanent capital makes it easier for the manager to take a genuinely long-term view and take positions in less liquid stocks and asset classes. Investment trusts can use leverage to enhance returns and can smooth dividend payments because they can build up reserves with their holdings’ dividends or distribute capital by way of the dividend. It’s a safety net to help them ride out tough times. Finally, many investment trusts deliver superior long-term returns relative to the open-ended funds in their respective sector.
Investment trusts – good for illiquid assets
Andrew Van Sickle: In which areas does the investment trust structure help most?
Peter Walls: Where investments are illiquid, I’d say: smaller companies, property, infrastructure, private equity. These are dangerous for open-ended funds if there is a stampede out of the sector, as we saw a few years ago with commercial property. They end up in a vicious circle of price declines, forced sales and redemptions, leading to value destruction.
The data show that the illiquid asset classes have historically outperformed, as the study of long-term global asset returns by Elroy Dimson, Paul Marsh and Mike Staunton has shown in the case of small-cap stocks, while private equity also boasts a very good record. But as specialised, obscure areas of the market tend to be highly cyclical, with investors rushing in and out, long-term investors should avoid open-ended structures, as the capital in them can suddenly disappear.
Andrew Van Sickle: The areas you highlight are well represented in your top-ten holdings, I noticed, with HarbourVest Global Private Equity, Oakley Capital Investments and ICG Enterprise Trust covering private markets. You have Aberforth Smaller Companies, too. Japan and Asia, with AVI and Invesco, provide some geographical diversification.
Moving on now, investors seem to have soured on investment trusts in recent years. Discounts to NAV in the investment trust sector are still large, and have been for three years or so. What are the main challenges? Are there just too many investment trusts?
Peter Walls: Consolidation is ongoing; it’s happening every week. Over the past few years, I have tended to lose 10% of my holdings to some form of corporate action every year. There have been more and more mergers between investment companies in recent years, while returns of capital via share buybacks, tender offers and managed realisations are at a record high.
Andrew Van Sickle: We hear a lot about buybacks to shrink discounts to NAV. But does there come a point when you’re essentially shrinking the fund until it’s barely viable, and you’re hastening its demise without narrowing the discount?
Peter Walls: Buybacks are no panacea but can help to moderate share price volatility and manage short-term fluctuations in supply and demand. Some trusts will inevitably dwindle to an unviable size where a more radical solution will be needed. It is, and always has been, a process of natural selection which I see as healthy. The wide discounts that have attracted increased activism in the sector will eventually narrow.
Andrew Van Sickle: I understand there are now quite a lot of bigger trusts and relatively few flotations, skewing the market towards the larger names.
Peter Walls: Yes, a key factor is that consolidating wealth managers are increasingly focusing on larger trusts and are often disinclined to look at smaller ones. Their idea of the minimum size an investment trust should be is always being nudged upwards. Consequently, there is less appetite to support smaller initial public offerings (IPOs), while some minnows will struggle to survive.
Andrew Van Sickle: Could active ETFs pose a risk to trusts? They seem to have become increasingly popular.
Peter Walls: So far, we have only had one trust change its structure to become an active ETF, and it was persuaded to do so by an activist investor. No other investment trusts have gone down that route. It comes back to the liquidity problem when you’re holding high-risk, high-return assets – active ETFs are open-ended structures, so forced selling of illiquid assets can lead to value destruction while favouring those who are first out of the exit.
Investment trusts – proving their worth for more than 150 years
Andrew Van Sickle: Can you explain the recent furore over cost-disclosure rules and how they have led to “doublecounting” for investment trusts? How much harm did this do to the sector’s reputation? Has the situation been rectified now?
Peter Walls: The cost disclosure issue has been a major headwind for the investment trust sector for nearly five years thanks to the European Union’s packaged retail PRIIPs rules, which made many funds appear expensive by double-counting the costs of investment trusts. Last month, the City regulator confirmed that trusts will be able to present their expenses clearly and fairly under new “consumer composite investments” rules, which will apply in 18 months. There are still issues to be resolved in this long-running saga, particularly concerning the treatment of wealth managers. It is to be hoped that common sense will prevail on all aspects of cost disclosure going forward, but it is unlikely that investors that withdrew from the sector in recent years will return any time soon – or ever.
I’m obviously biased as a long-term believer in the structural advantages of investment trusts, but I believe investors should be embracing the unique characteristics of the sector. After all, investment trusts have proven their worth through thick and thin for more than 150 years and have successfully adapted in the face of every conceivable challenge.
Andrew Van Sickle: One recent challenge has been Saba’s activism against investment trusts. What’s your take on it?
Peter Walls: It’s been a bit chaotic at times, but with the many headwinds faced by the sector in recent years, Saba’s founder and chief investment officer, Boaz Weinstein, was pushing against an open door with plenty of capital to back him up. More recently, he seems to have recognised that there is a lot to commend well-run and governed trusts that use their structural advantages and are really prized by most of their investors.
Andrew Van Sickle: Regardless of errors Saba has made, is there a need for constructive activism to sort out underperforming funds?
Peter Walls: There has always been a place for activism in the sector and it’s obviously more likely to happen when discount ratings are wide. While Saba’s claims that they are acting in the interests of “mom and pop investors” may have held water with their US closed-ended fund activism, I don’t think it applies for all of his targets in the UK.
Herald Investment Trust, for example, was a constituent of my portfolio for over 20 years but Saba’s eagerness to build a 29% stake in the trust ahead of the shareholder vote forced me to sell at close to net asset value. Whatever happens next is unlikely to be value enhancing.
Andrew Van Sickle: In which areas are there the greatest problems around governance and transparency and confidence? Have too many boards been asleep?
Peter Walls: Saba’s recent purchases point to the fact that most conventional, equity-invested trusts have seen their discounts narrow this year. Capital will have been recycled from Saba’s successes and their presence on so many share registers has spurred on more boards to take proactive action. Mergers, tenders and share buybacks have been running at record levels, leading to a favourable improvement in the supply/demand situation.
So, the focus has shifted to the alternatives sectors, real estate and deeply discounted private-asset situations, notwithstanding the ongoing Edinburgh Worldwide/ BG USA battle with Baillie Gifford. Unsurprisingly, these are the areas where governance and transparency are more likely to be considerations – witness the now abandoned HICL/TRIG merger – because many of these alternatives only came into existence in the low-interest rate, post financial-crisis period.
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