- Investment trusts discounts are at their widest since 2008, in the depths of the financial crisis, according to data released this week by the Association of Investment Companies
- Higher interest rates, cost-of-living pressures, and negative sentiment towards the UK stock market all feed into discounts
- …so does the discount drag of illiquid assets
- Z-scores suggest discounts are attractive, but not at bargain basement levels in most sectors
- The discount gap in UK trusts shows investment trusts are still favoured by income-seekers
Laith Khalaf, head of investment analysis at AJ Bell, comments:
“It seems bizarre that investment trust discounts today sit at their highest level since the financial crisis. There are plenty of risks out there in the market, but in 2008 the whole financial system looked like it might collapse. The apparent extreme level of discounts in the investment trust universe can be explained by a perfect storm of factors, some recent, others which have been building up for some time.
“The upshot is investment trust buyers can today gain access to portfolios trading significantly below their net asset value, though care does need to be taken when bargain hunting. Investors need to ensure they don’t lose sight of the wood for the trees. They shouldn’t be tempted into an asset class, sector or trust simply because of a discount, if it doesn’t fit in with the rest of their portfolio, or sits outside their risk tolerance. Ultimately it’s the underlying assets within a trust which should do the heavy lifting in terms of generating long-term returns for investors, and picking up trusts at a healthy discount is just the icing on the cake.”
Weak investor sentiment hits home
“Discounts on investment trusts are a good indicator of UK investor sentiment, and there are numerous reasons why it currently finds itself at such a low ebb. Clearly the cost-of-living crisis has dampened consumers’ ability to save into vehicles like investment trusts. That’s been exacerbated by higher interest rates which have pushed up mortgage costs and made savings rates more attractive. Investment trusts are particularly susceptible to swings in consumer sentiment compared to the wider UK stock market, because their customer base has such a high proportion of private investors. It’s estimated that retail investors account for a third of investment trust assets (source: RD:IR and Warhorse Partners). That compares to around 12% of UK quoted shares more generally which are held directly by individuals, according to the ONS.
“In addition to these substantial recent headwinds, there’s also a long-running antipathy towards UK shares, clearly demonstrated by the fact that investors have withdrawn £44 billion from open-ended UK stock market funds since 2016, according to Investment Association data. Many investment trusts invest outside the UK, but they are structured as UK companies, trade on the London Stock Exchange and sit in the FTSE indices, so a reluctance to invest in the UK stock market does take a toll.”
Passive preference is bad for investment trusts
“Another powerful force which goes some way to explaining weak investor demand for trusts is the continued rise of passive investing. Investment trusts have been exclusively active vehicles since the Aberdeen UK Tracker trust shut its doors in 2016, before abrdn, as it’s now known, divested itself of vowels (still pronounced ‘Aberdeen’ by the way). Meanwhile amongst open-ended funds, passive vehicles have been making all the ground, rising from 9% of total assets 10 years ago to 22% today, again according to Investment Association data. And in the last two years, the selling down of active open-ended funds has been pretty relentless. Being active vehicles, investment trusts aren’t immune to this structural trend.”
The discount drag of illiquid assets
“Some of the widest discounts appear in trust sectors investing in illiquid assets, as the table below shows. Investors need to be particularly cautious about bargain-hunting in the illiquid market, because such wide discounts probably mean the market is expecting write downs in the underlying assets. The proliferation of trusts launched in illiquid sectors over the last decade also partly explains why overall discounts are at their highest level since the financial crisis. For instance, none of the trusts currently in the Renewable Energy Infrastructure had been launched onto the market in 2008. The mix of the investment trust universe has shifted, and very wide discounts in illiquid asset classes are exerting a greater gravitational pull on the average figures for the investment trust market.”
Discounts and Z-scores in selected AIC sectors
Source: Morningstar to 6 November 2023
What Z-scores tell us
“Investment trust discounts do need to be taken in some kind of context, as a trust trading at a discount might actually be priced closer to NAV than it has been historically, and so might not represent good value. Z-scores provide an indication of how far a trust’s discount (or premium) is trading below (or above) its historical average. A negative Z-score tells us the current discount (or premium) is below average levels, a positive score tells us it’s above average levels. Broadly speaking a Z-score of between 0 and -1 suggests a trust is cheap by historical standards, but not hugely so. A score of between -1 and -2 suggests a trust is significantly cheaper than usual, and a score below -2 suggests a trust is trading near the very bottom of its previously observed range.
“The table above shows average Z-scores across selected sectors based on the last five years of pricing data. The average trusts in almost all sectors are trading at discounts below their longer term average. Many have an average Z-score of between -1 and -2, which suggests it’s a decent entry point for these sectors, and when you come to sell, chances are you will do so closer to the net asset value of the trust.
“Some care does need to be taken when interpreting Z-scores, given the sharp change in the interest rate environment. This is especially the case with sectors which are highly sensitive to interest rates such as property and infrastructure. The average trust in both the Renewable Energy Infrastructure and Infrastructure sectors is trading at a 5 year Z-score of below -2, but this partly reflects the high premium put on income streams from this sector when interest rates were near zero. Today’s very pronounced discounts are clearly at the other end of the spectrum, and the contrast here explains the extreme level of Z-scores currently at play in these sectors. Looking at the Z-score over a shorter time frame which excludes the period of ultra-low interest rates would yield more moderate results, but would also incorporate less market data.
“Clearly looking at sector averages only gives us a very generalised view, and when picking trusts investors need to inspect the statistics for individual funds as there can be a wide range of variation within sectors.”
The UK discount gap
“The table above shows that the average UK All Companies trust is currently trading at a discount of 13.6%. Investors buying UK trusts might well consider they are getting a double discount, given the low relative value of the underlying UK stock market, on top of the investment trust sector trading well below its net asset value. Though it must be said the supposedly low value of UK stocks largely derives from comparison against a very expensive yardstick in the form of the US stock market.
“It’s notable the average discount for trusts in the UK All Companies sector is more than double that for the UK Equity Income sector. This is no doubt a reflection of the fact that the UK is seen as more of a destination for income rather than growth, but is also likely due to the fact that investment trusts can smooth their dividends, which makes them attractive for income seekers. When income trusts are trading at a discount, that has a twin benefit for investors. They can buy a pool of assets below their market value, and on top receive a yield above that of the underlying portfolio. Indeed the dividend stream provided by UK income trusts is a major reason why they don’t stray from NAV to the same extent as trusts in the UK All Companies sector. As discounts widen, rising yields tempt investors in, and put a floor under prices.”
