Be careful what you wish for, as you might not want to live with the consequences.

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This timeless piece of advice seems to apply to many of the UK investment trusts which bravely (as they thought) adopted discount control policies in the bullish market conditions of 2003-2007, but now seem to be regretting having done so.

When shares prices generally are rising, discounts on closed end vehicles such as investment trusts naturally tend to narrow.  In a competitive environment for fundraising, and with activist shareholders pressing for change at trusts that performed poorly, it became flavour of the month for both new and existing trusts to promise active discount control policies.

Mostly these took the form of commitments to buy back shares if the discount widened beyond a certain limit, typically 5%, but the range of targets adopted was wide (from 3% to 12%), as was the strength of the commitment. By the end of last year the boards of more than 50 UK investment trusts had adopted explicit discount control mechanisms of this kind. Several of the biggest trusts have bought in significant numbers of shares as a result.

Since the credit crunch broke last summer, however, markets have become more difficult and a number of boards are becoming reluctant to enforce their commitments. This is not, in reality, that much of a surprise. While buying back shares is a useful way to enhance shareholder value, its inevitable short term effect is to reduce the size of the fund, which has adverse consequences for both the annual fee paid to the investment manager and (potentially) the viability of the whole trust.

Standards of governance at investment trusts have greatly improved in recent years, and the days when boards were effectively in the pockets of their investment managers have to a large extent gone. The threat of having to engage in a public skirmish with an activist shareholder group has galvanised a number of formerly sleepy and docile boards into a more robust stewardship of their shareholders’ interests.

Nobody would suggest that the gradual narrowing of discounts that has been evident over the past few years is entirely down to this renewed boardroom vigour, though it has clearly not done any harm. Supply and demand, coupled with investor sentiment, continue to play an important role in the discount cycle. Whole sectors, such as property and private equity, have swung from trading at a premium to trading at a discount in the past two years.

Smaller companies have also taken a beating. The weighted average discount in the sector, taking debt at fair value, has widened to 15.7%, having been more than 20% at one point in the last 12 months. Standard Life Smaller Companies Trust is one of the trusts that has so far failed to enforce its target discount of 5%. It argues that its commitment to limit its discount to 5% is “over the long term and subject to normal market conditions, and conditions have not been normal”.

The reality may be that the trust is so small (assets of under £50m) that taking vigorous action to reduce the discount would make it unviable in the board and manager’s eyes. But the obvious question that then arises is: why make the discount control commitment if you are not going to enforce it? Instead of appearing robust, failing to act on the commitment announces nothing but weakness.

Robin Angus, a director of Personal Assets, the Edinburgh investment trust, takes to task the boards of trusts that have failed to act on their commitments in his latest quarterly report. “When promises have been made and firm commitments have been given” he thunders, “boards should not then treat shareholders as if they were schoolchildren, or a herd of mute, cowed passengers penned miserably in Terminal Five”.  Shareholders, he goes on, “have every reason to be angry if promises are not kept. The trust sector as a whole is harmed when promises seem not to be worth the paper on which they are written and Boards give the impression that their word is not to be trusted”.

If that sounds a bit righteous, it does not mean it isn’t right. Mr Angus can at least point to the track record of his own trust, which has successfully managed to trade at or very close to Net Asset Value continuously since 1995, thanks to a clear and unambiguous commitment, scrupulously enforced, to buy in (no questions asked) any number of shares from shareholders at NAV. By simultaneously committing to issue new shares to new potential investors at a fraction over NAV, Personal Assets has managed to expand its share capital fivefold over the same period.

It is now taking the highly unusual step of having its commitment to eliminate the discount written in to its Articles of Association. It shows that it can be done; but how many other trusts will follow its example? It would be unwise to bank on there being many. Just as Vanguard’s no-commission, mutually owned business model in the United States has had no imitators, when it comes to a genuine alignment between the interests of shareholders and fund managers, it is easier to talk the talk than walk the walk.



 



Jonathan Davis
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