Is it time to buy investment trusts at a big discount?

It’s been quite the horror show for markets lately.

As sterling plunged to a 40-year low and government bonds rose to make government loans even more expensive, the Bank of England was forced to step in to calm investor nerves.

While the market has recovered, stocks are somewhat not immune to volatility – the FTSE 100 is down 3.7 percent in the past month, while the FTSE 250 has dragged 8 percent lower.

There has been a broader collapse in buying interest among UK investors – recent figures from Calastone show there has been a flight of shares since the summer.

But where there is uncertainty, there can be opportunities. Investors looking for a bargain may want to look to the UK mutual fund sector, where discounts have stretched to the highest level in years.

Investment trusts are publicly traded and collect money from shareholders to invest whether in UK or US equities, infrastructure, real estate, commodities or other assets.

Because it is limited by the number of shares, the structure of a trust means that the share price does not always match the value of the underlying portfolio it holds.

Unlike open-end funds, which grow and contract as investors buy in or buy out — creating new units if one wants to invest — a mutual fund has a limited number of shares, and someone who wants to buy back must buy shares from an existing shareholder.

It means that mutual fund shares can trade below the value of their investments, also known as a discount. They can also trade above the portfolio’s value, known as a premium.

The more a trust falls out of favor and the less demand there is for its shares, the lower the price the selling parties have to accept to get out.

Current market uncertainty has pushed investment trusts to their biggest discount in years, and investors may be able to grab a bargain.

Which investment companies trade at a discount?

Following Kwasi Kwarteng’s mini-budget, shares of investment companies trade at an average discount of nearly 13 percent below the value of their assets, according to the Association of Investment Companies (AIC).

Nick Britton, head of intermediary communications at the AIC, said: “Investor confidence is at a low ebb as they worry about rising interest rates, high inflation and a global economic slowdown.”

It means that investors looking for long-term opportunities may be able to pick up some trusts that trade at an unexpected discount.

Jason Hollands, Managing Director of Bestinvest says: ‘It’s definitely a buyer’s market now, with discounts for investment companies at the highest level in a decade. Discounts can now be found even in industries where companies have long traded at premiums for NAV – infrastructure, for example.

Of course, much of this simply reflects weak investor sentiment and more sellers than buyers, as investors worry about aggressive rate hikes and the prospect of recessions.

But higher bond yields have also impacted alternative revenue-generating asset classes, including infrastructure, renewables and real estate, which in many ways filled the gap left by bonds during more than a decade of very low interest rates.

“With government and corporate bonds offering nominal yields not seen in over a decade, there is arguably less need to dabble in more esoteric matters.”

Some of the biggest discounts to be found are in equity funds, which are invested in company stocks, especially those with exposure to midcaps and smaller companies.

This is because they tend to be exposed to the more domestically oriented parts of the market where volatility has had more of an impact.

From investment companies in equity sectors, Marwyn Value Investors trades with the largest discount.

As of Oct. 5, it trades at a discount of -40.10 percent to net asset value, but an average discount of -1.78 percent over five years. (The 5-year average discount is taken as an average of all month-ends over the period.)

The company targets mid-caps in the UK, US and Europe and the discount can be explained by the highly concentrated nature of its holdings.

likewise, Desiderius smaller companies trades at a discount of -15.23 percent, but with a 5-year average of 6 percent and a dividend yield of 3.15 percent, the portfolio could offer both growth and income.

likewise JP Morgan UK Smaller Companies is trading at -15.24 percent to its NAV, compared to a 5-year average and yielding 2.33 percent.

Elsewhere Augmentum Fintechwhich invests in high-growth and often privately owned fintech companies, trades at a 37.24 percent discount.

Hollands suggests that trusts with privately held companies may have suffered because “there may also be an element of skepticism about valuations, given the equity market downgrades of growth stocks.”

He adds: ‘I would not recommend that people generally buy from any trusts or sectors with the highest discounts, as some of this could be justified by a tougher outlook. For example, real estate can face a tough time as real incomes come under pressure and higher borrowing costs increase.

Contrarians can be tempted by well-managed trusts such as JP Morgan Mid Cap IT (-9.8%) and Mercantile IT (-13.8%) as a lot of negativity is reflected in mid and small cap valuations, but I think it may be a little too early given the challenges of rising borrowing costs and falling real incomes. Low Country at -8.6% is worth considering for dividend seekers, such as: temple bar (-5.2%).’

It’s worth noting that there’s no guarantee that mutual fund discounts will decline and they could increase further if sentiment doesn’t improve.

Where are the opportunities?

Many of the mutual funds that are traded at a big discount have been running at a discount for some time. However, there are plenty of portfolios that have run at significant premiums in the past, meaning there could be a chance to grab a bargain.

Britton: ‘Buying investment companies at a discount can be an opportunity, because you benefit if the discount gets smaller. Often the diminishing discount will occur at the same time as the asset is increasing in value, leading to a positive double whammy.’

AIC data shows that trusts with high exposure to smaller companies have been rocked by recent volatility, so a better place to look would be trusts that invest in larger, global companies.

Dutch suggests Finsbury Growth & Incomecurrently at a -6 percent discount to net asset value and a return of 2.22 percent.

“While not a basement bargain, historically it has often traded at a premium. The portfolio is focused on international earners such as RELX, Diageo, Unilever and Sage and has little exposure to more cyclical sectors.”

There are also high discounts in emerging markets trusts, including: Templeton Emerging Markets – at a discount of -11.6 percent – and JP Morgan Indian calling Hollands a ‘bargain’ at -19 percent.

But defensive trusts are expensive

There are some trusts that have managed to generate positive returns despite uncertainty.

They use strategies that aim to preserve capital during difficult market conditions and then grow it when the opportunity arises. They don’t use gearing — when trusts borrow money to buy stock or other assets — and have a zero-discount control policy that helps reduce stock price volatility.

Among them is Capital Gearing Trustwhich has been managed by Peter Spiller since 1982 and whose main objective is to preserve the shareholders’ equity.

The company has delivered positive returns in 39 of the past 40 years using stocks, bonds, cash and commodities. Capital Gearing’s board of directors issues and repurchases the trust’s shares to keep the share price close to NAV.

It currently trades at a premium of 2.09 percent and yields a dividend yield of 0.94 percent.

Source: Morningstar/Killick & Co

Trust Personal Assetswhich is run by Sebastian Lyon at Troy Asset Management, has a similar objective and invests in equities, bonds, preferred stocks and commodities.

Like Capital Gearing, Personal Assets Trust ensures that it trades close to NAV through share buybacks and issuance of shares.

It currently trades at a premium of 0.69 percent to net asset value with a dividend yield of 1.17 percent.

Mick Gilligan, Partner at Killick & Co said: “CGT and PNL represent the most attractive mutual funds today for preserving capital, while retaining the potential to invest more fully when stock valuations are valued more attractively. They have a distinct purpose of preserving or protecting capital.

‘They have an asset allocation process that matches that objective. They do not use leverage. They also have a zero-discount control policy that helps reduce stock price volatility.”

He also points to BH Macro, RIT Capital Partners and Ruffer Investment Company as trusts worth considering for those looking to preserve and grow capital.