Are investment trusts the new Japanese equities?

Despite having no clue about finance, my first job was in asset management. I more or less understood that most of my new colleagues ran money for institutions: a US pension fund here, a UK charity over there. But we also had a guy (literally, his name was Guy) who managed an investment trust.

I had no idea what that was. He would talk about the beauty of closed-end funds before rushing off to yet another presentation to his trustees. And then lunch. Lots of lunches, if I recall.

Investment trusts remain a mystery to me now. No matter how much I read about them, basic things don’t make sense. Or I’m just an idiot — which as I grow older is becoming a default conclusion.

This is annoying because over the past six months or so, investment trusts have been making me vibrate in a way I haven’t felt since becoming excited about Japanese equities a decade ago. Or UK stocks more recently.

The fact that money cannot be yanked out in a panic means trusts can invest for the long run. It’s their main selling point

But those markets I understand — or at least I can justify owning them. Whereas being attracted to something that baffles me is frustrating. I sense there is value on the table. I just can’t tell you why.

First though, what exactly are investment trusts? They are listed vehicles that trade on exchange — like a public company — whose business is investing in public and private assets. They have boards, pay dividends, employ gearing. And just as equity capital is permanent for companies, investment trusts issue shares and then use this cash as they wish.

Hence the term “closed ended”, as opposed to the “open ended” funds in my portfolio which grow or shrink in size depending on flows. The fact that money cannot be yanked out in a panic means trusts can invest for the long run.

It’s their main selling point — and rightly so. Opportunistically buying stocks when everyone is losing their heads, for example. Or owning private assets with decades-long return profiles. Add some gearing and these features are attractive indeed.

Especially for individuals who do not otherwise have access to private deals — a problem I discussed in this column three weeks ago. Many institutional portfolios cannot be leveraged either. Investment trusts are a simple way around this restriction.

For these attributes alone, they are superior to open-ended vehicles such as mutual funds and ETFs, in my view. But investment trusts are struggling. Purchases via UK adviser platforms were down almost a third last year. Share prices are trading at deep discounts to underlying asset values.

The latter doesn’t make sense, especially for trusts only invested in liquid public securities, the prices of which are known. I read many explanations for these discounts, which average 9 per cent in the UK, but none of them wash.

More sellers than buyers of the shares, say experts. Well, that’s impossible for starters, and misses the point that when they do trade, they do so at a price that’s below the value of the assets in the trust. Why on earth would they do that?

A lack of faith in the manager? Again that’s a popular but illogical excuse. Even if a monkey was running your investment trust, it could be trained to press “sell”, at which point the true value of the assets would be realised and the discount closed.

Others reckon the gaps between net asset values and share prices narrow or widen as investment themes move in and out of favour. Really? Sentiment should act on NAVs and share prices alike. They both reference the same underlying assets.

I get that some trusts own private assets, most of which have no daily pricing or rely on managers doing their own valuations. Hence to be conservative a discount may be warranted (unless an amazing record suggests routine undervaluing).

So this is one plausible reason — but it doesn’t explain why discounts endure in trusts that only hold listed shares. And it is more a warning to the owners of private assets. Perhaps their NAVs are incorrect and investment trust share prices are fair!

Finally, some in the industry blame the way UK regulations force them to overstate their fees (nicely explained by Moira O’Neil in her column last month). But even if this lowers demand, it is the same as the misplaced “fewer buyers than sellers” argument above.

No, there are only two explanations for these discounts which hold up. And the correct course of action — either purchase every investment trust you find trading below its NAV or don’t — depends on whichever one is correct.

The first is that the discounts are an anomaly and will eventually be arbitraged away. This is my view, after pondering this for a while. It’s also why I own Japanese equities — where almost a half of companies in the Topix index trade below their book values.

A second explanation suggests the discount is permanent, akin to bank shares with price-to-book ratios languishing below one. The idea here is that whereas the Japanese economy is huge and diverse, banks could never sell everything on their balance sheets all at the same time.

Prices would plummet. Therefore, the arbitrage between investment trust shares and NAVs is theoretical only. Maybe you could buy one trust at a discount and force it to sell its assets — but you couldn’t do it across all 359 of them. That’s a £275bn fire sale!

But as activist investor Elliot’s 5 per cent stake in Scottish Mortgage Investment Trust this year showed, discounts can be narrowed merely by drawing attention to them (buybacks also help share prices but reduce the NAV).

It worked with Japanese stocks — why not investment trusts?

The author is a former portfolio manager. Email: stuart.kirk@ft.com; Twitter: @stuartkirk__