investment trust discounts attract saba capital

• Persistent discounts have attracted a US activist hedge fund
• Their criticisms are valid, their cure is self-interested
• A wake-up call for Investment Trust boards

​The Investment Trust sector has been under pressure for the last few years.  Investment Trusts that invest in liquid public overseas equities are compared to lower cost index fund and ETFs.  Investment Trusts that invest in liquid public UK equities – likewise, but with the additional challenge of a general deallocation from UK equities impacting flows.  Finally, Investment Trusts that invest in property and other real assets such as wind farms and infrastructure have been pressured by rising borrowing costs that also impact valuations.
Throw into the mix an extensive debate around cost disclosures[1], a public boardroom bust up at Scottish Mortgage[2] and accusations that the industry is too “cosy” with independent boards being independent in name only but in reality very rarely challenging or replacing sponsoring investment managers.
This has created a perfect storm for Investment Trusts where the lack of demand has led to persistent discounts.

Vulnerable to an attack
As the sector has not got its house in order pre-emptively, sharks are now circling in the shape of an activist US hedge fund, Saba Capital, that has built up stakes in 7 investment trusts.  They are now requisitioning shareholder meetings to oust each Trust board and install their own candidates as board members and transfer the investment management contracts to Saba.
If they are successful it’s a neat way of getting hold of almost £4bn of UK retail assets and collecting management fees on the same.  In this respect, their strategy (however presented) is not without self interest.

Who are Saba Capital Management?
Saba Capital Management is a US based hedge fund specialising in arbitrage.  It also manages US-based investment trusts.

We agree with the diagnosis
We agree with Saba’s diagnosis of the failings of some of the Investment Trusts.
We also agree with the key tenets of how boards should act to deliver value to shareholder.  Based on Saba’s own proposal[3], this would be to:

1. Offer liquidity events to address NAV discounts
2. Reviewing Trust’s managers including performance and fees and evaluating the termination of existing management arrangements
3. Refocus the Trusts’ investment mandates to realise scale benefits and synergies (for example consolidation).

In our views, these should be “good housekeeping” points for any trust board.

We disagree with the cure
However we disagree with Saba’s self-interested proposal to take over these Trusts with just two of its own appointees to each board.  From the outside, this looks like an asset grab in a sector that has done too little to address its own problems.
It would be preferable for Investment Trust boards to wake up and force change themselves, rather than wait to have it forced on them by self-interested third party.
Ironically, it may take this abrasive battle to stimulate change in the sector.

What happens next?
In the end it will be up to retail investors to vote their shares.  The risk is that investor apathy and or the technological barrier to exercising a vote via retail platforms (another area of unfinished business that has been neglected too long) means that Saba
If Saba do win, it will vindicate their activist approach and a sorry indictment that the Investment Trust sector didn’t get its house in order earlier.  So either way it’s hopefully it’s catalyst for reform and increased discipline, transparency and true independence in the Investment Trust sector.

Why do investement trusts trade at a discount
The share price of an investment trust can be at a wide premium or wide discount to their NAV, for the following reasons:
1) because there is low or shrinking demand for the shares. As investment trusts are closed-ended funds, the premium or discount reflects the direction of supply and demand of shares.  For an investment trust, the premium or discount to NAV is primarily a function of demand.  When demand is very high, the share price can be at a premium.  When demand is very low, the share price can be at a discount.  
2) because the fund holds some hard-to-value or periodically valued investments.  Assets such as physical property or infrastructure projects, a discount to NAV can reflect a lack of confidence in the NAV attributed to those assets.  For example, when interest rates rose dramatically which would force a reduction in the value of a property portfolio, the market may have applied a greater discount to NAV more quickly, than the NAV would be reviewed. 
3) because there is no catalyst to drive a re-rating.  With no catalyst or a valuation re-rating such as a capital event (capital distribution, share buyback, change in dividend policy), discounts can persist.

Why do investment trust discounts  narrow?
Discounts can narrow for three reasons:
Firstly, if there is high or growing demand for the shares.
Secondly, where there is potential for a capital event.
Finally, assuming markets are efficient, when there is a change in the outlook for net returns over time.
Furthermore, where an investment trust invests entirely in liquid publicly traded securities, this means the NAV can be clearly evaluated, creates scope for “arbitrages” – buying or selling the Investment Trust relative to its underlying holdings.  This helps keeps premiums/discounts narrow. 

Why do investment management fees matter
The investment management fee is typically applied to the NAV (a few trusts are moving to management fee being applied to share price to align interests better with shareholders).
Investment trust fees matter as they consume a portion of the trust's NAV. 
For two investment trusts with an identical basket of underlying assets, an investment trust with high fees as a % of NAV will underperform an investment trust with low fees as % of NAV, other things being equal.

What is the difference between a fund, an ETF and an Investment Trust?

• Funds (OEICs and AUTs) are not listed on an exchange, and their units can be bought or sold each day at their NAV.  The investment management fee is applied to the NAV.
• Exchange Traded Funds (ETFs) are public limited companies (plc) listed on an exchange and their units can be bought or sold anytime during market hours, and their share price can be at a negligible premium or negligible discount to their NAV, 1) because the fund holds easy-to-value publicly listed securities and 2) because the funds are open-ended there is an active primary and market for fund units that can absorb supply and demand.  The investment management fee is applied to the NAV.
• Investment Trusts are public limited companies (plc) listed on an exchange and their units can be bought or sold anytime during market hours

Conclusion
The investment trust sector needs reform.  We would prefer the sector to reform itself.

[1] some want Investment Trusts to be treated as operating companies and have their running costs excluded from fund-of-fund OCFs. Other wanting Investment Trusts to continue to be treated as other publicly listed retail funds (ETFs), and ensure their running costs continue to be included in fund-of-fund OCFs to maintain a level playing field. We are in the latter camp. To bring nuance to the debate, we think there should be differentiated treatment between Investment Trusts that invest predominantly in publicly listed securities, and those that invest predominantly in real assets (property, infrastructure etc).

[2] https://www.ft.com/content/84c6442c-4108-4094-b94d-8585517da00a

[3] https://www.mindthegap-uktrusts.com/