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My first job was in asset management, despite having no prior knowledge of finance. I more or less understood that most of my new colleagues were managing money for institutions like pension funds in the US and charities in the UK. But there was also a guy (literally, a guy named Guy) who managed mutual funds.
I had no idea what that was. He talked about the greatness of closed-end funds, then rushed off to make a presentation to the board of directors. And then lunch. As I recall, a big lunch.
Mutual funds remain a mystery to me to this day. No matter how much I read about them, I just can’t understand the basics. Or maybe I’m just stupid. As I get older, it’s becoming my default conclusion.
This is troubling because over the past six months or so, investment trusts have excited me in a way that I haven’t felt since I got excited about Japanese stocks 10 years ago, and more recently about UK stocks.
That’s their main selling point.
But I understand the market for them, and at the very least, I can justify owning them. On the other hand, it’s frustrating to be drawn to things that baffle me. I see value in them, I just don’t know why.
First, what exactly is a mutual fund? Mutual funds are publicly traded products that trade on an exchange like a public company and are in the business of investing in public and private assets. Mutual funds have boards of directors, pay dividends, and employ leverage. And just as equity capital remains with a company forever, mutual funds issue shares and use their cash as they please.
Hence the term “closed-end” in contrast to the “open-end” funds that I have in my portfolio. Open-end funds grow or shrink in size depending on the flows of capital. The fact that funds cannot be withdrawn in times of panic means that the trust can invest for the long term.
That’s their main selling point, and rightly so: opportunistically buying stocks when everyone else is going nuts. Or owning private assets with decades of return characteristics. Add in a bit of leverage and those characteristics certainly become attractive.
This is a problem I covered in this column three weeks ago, especially for individuals who don’t have access to private trading otherwise. Many institutional portfolios also can’t be leveraged. Mutual funds are an easy way to get around this restriction.
These characteristics alone make them superior to open-ended products such as investment trusts and ETFs in my opinion. But investment trusts are struggling; purchases via UK advisor platforms fell by almost a third last year. Shares are trading at a significant discount to the value of their underlying assets.
The latter doesn’t make sense, especially for a trust that only invests in liquid government securities whose prices are known. I’ve read many explanations for the 9 percent average discount rate in the UK, but none of them are convincing.
Experts say there are more sellers of shares than buyers. First, that’s impossible, and second, they overlook the point that when they do make trades, they do so at a price lower than the value of the trust assets. Why would they do that?
Lack of trust in the manager? This is another common excuse, but it is illogical. Even if a monkey were managing a mutual fund, you could train it to press the “sell” button, at which point the true value of the assets would be recognized and the discount would disappear.
Some people believe that the gap between NAV and share price will narrow or widen as an investment theme becomes more or less popular. Is this true? Sentiments should affect NAV and share price in the same way, as they both refer to the same underlying asset.
Some trusts hold private assets, most of which do not have daily pricing or are valuated independently by managers, so a conservative discount may be justified (unless a surprising record suggests daily pricing). Underestimating).
So while this is one plausible explanation, it does not explain why the discount continues for trusts that only hold listed stocks. Rather, it is a warning to private wealth holders that perhaps their NAVs are incorrect and mutual fund share prices are fair.
Finally, some in the industry blame UK regulation for forcing them to inflate fees (as Moira O’Neill explained nicely in her column last month), but even if this reduces demand, that’s the same misplaced “there are fewer buyers than sellers” argument mentioned above.
No, there are only two explanations for these discounts, and the correct course of action (buy all mutual funds trading below NAV or don’t buy any) depends on which one is correct.
The first is that the discount is abnormal and will eventually be arbitraged away. This is my view after some thought and is also why I own Japanese stocks. Nearly half of the companies in the TOPIX index trade below book value.
The second explanation suggests that the discount rate is permanent, as with bank stocks with price-to-book ratios below 1. The idea here is that while the Japanese economy is large and diverse, it is unlikely that banks will sell all the assets on their balance sheets at the same time.
Prices will crash. So arbitrage between investment trust shares and NAV is only theoretical. You might be able to buy one trust at a discount and get it to sell its assets, but you can’t do that with all 359 trusts. This is a £275bn bargain sale.
But as activist investor Elliott’s take on a 5% stake in Scottish Mortgage Investment Trust this year showed, discounts can be narrowed by simply attracting attention (share buybacks also boost share prices but reduce net asset values).
It worked well with Japanese stocks, so why not with investment trusts?
The author is a former portfolio manager. Email: contact address; twitter: @StuartKirk__
