Investment trusts: a 150-year-old industry under siege

It is perhaps no surprise that an industry that has been around for more than 150 years is going to have to battle to remain relevant. Investment trusts were under siege last year and a year on there are few signs of the troubles ending. 

Demand from retail investors is in retreat. Passive funds, which have become hugely popular in recent years, have raised the competitive temperature, while fixed income is offering yields that offer a credible alternative for income-seekers. But there are other challenges too.

The FT spoke to some in the industry who described “a difficult environment”, “a highly challenging period” or simply noted that “it’s a funny old time”. But some go further. Ben Conway, chief investment officer at Hawksmoor Investment Management, believes the sector is “in clear cyclical decline”. 

“Cyclicality is a natural feature of most industries, and there is a risk of confusing a cyclical downturn with a structural decline,” he says. “That being said, the strength of the headwinds the sector is facing is strong enough that the cyclical decline is at risk of becoming deep and long-lasting.”

As governments struggle with geopolitical turmoil and the lingering threat of recession, investors are keen to protect their portfolios. Investment trusts, the oldest type of investment fund, also known as “investment companies”, have traditionally claimed to shield investors from risks. They offer a variety of options, from income-focused trusts, which pay dividends, to specialised growth-focused trusts that look for opportunities even in difficult economic times.

“Investment trusts have powered the portfolios of savvy self-directing retail investors, wealth managers and institutions for generations, while also driving investment into growth sectors like infrastructure and private markets,” says Christian Pittard, head of investment trusts at asset manager Abrdn.

His view is borne out by analysis from the Association of Investment Companies (AIC), which found that, at the end of 1999, 88 per cent of investment trust assets were invested in equities. Today, that figure is 55 per cent. The rest is in alternative investments, including significant allocations to private equity (17 per cent), infrastructure (14 per cent) and property (8 per cent).

There are 346 investment trusts, of which 91 are included in the FTSE 250 — more than a third of the mid-cap benchmark index vs one-sixth in 1999. 

Katya Gorbatiouk, head of investment funds at the London Stock Exchange, says the impact of the sector stretches well beyond the confines of the Square Mile, delivering capital into areas where long-term capital is required. Investment trusts serve the LSE’s ambitions to promote energy independence, boost regional growth and upgrade critical infrastructure, among others, she adds. 

Investment trusts have structural advantages. They are closed-ended, allowing fund managers to take a long-term position; they have the ability to gear — to borrow to invest — and their boards are independent.

Nevertheless, even the most positive analysts admit that share price volatility is an ongoing risk. Trusts can trade at a discount or premium to the underlying net asset value of the investments their portfolio holds. This is a mechanism that allows active buying and selling, and discounts can sometimes present attractive opportunities to bargain hunters. But wide discounts have prevailed for so long, across so much of the sector, that some investors are beginning to fear they may never recover.

Last October, the average discount across the sector (excluding 3i and venture capital trusts) was 19.24 per cent, according to the AIC. At the end of this October, it had narrowed slightly, to 16.40 per cent. The hoped-for triggers for recovery, such as the UK election or the Bank of England’s first interest rate cut, passed with no significant re-rating.

Investment trust boards can control discounts by buying back shares and they have been doing this at record-breaking levels. But there are risks. Jason Hollands, managing director at Bestinvest, says: “Boards cannot bury their heads in the sand or they might find they become prey to activists or other more predatorial investors who spy the opportunity to pick up a book of assets on the cheap.”

Winterflood found £6.4bn of shares were repurchased over the first 10 months of 2024, dwarfing the £3.9bn bought back in 2023, itself the highest amount since its records began in 1996. 

Peter Walls, manager of the Unicorn Mastertrust Fund, which primarily invests in investment trusts, says: “We are seeing the introduction of more radical discount control measures such as unconditional or unrestricted redemptions and tender offers.” But not everyone is impressed. Conway says: “Arguably boards have been slow to react to wide persistent discounts and many are questioning the quality of governance in the sector.”

Overall, there’s a feeling that discounts could have narrowed further were it not for several headwinds. The incoming Labour government had a part to play as fears of capital gains tax rises encouraged pre-Budget selling, particularly among some of the long-established trusts. If this were not enough, interest rate expectations point to a higher-for-longer scenario, which reduces the draw of dividend-paying investment trusts.

The strength of the headwinds the sector is facing is strong enough that the cyclical decline is at risk of becoming deep and long-lasting

Another is the growth of active ETFs. While the more common index ETFs seek to track the performance of an index, active ETFs involve professional management aiming to outperform the market, deliver specific strategies or access unusual markets. With high levels of liquidity and transparency alongside a competitive pricing structure, Samir Shah, senior fund analyst at Quilter Cheviot, sees them as “a material threat” to investment trusts. Hollands says: “Let’s not forget that so much attention has been focused on US equities, in a market dominated by big tech, in recent years — yet there are actually relatively few US equity-focused investment trusts.”

Analysts also speak of the “lost years” when European regulation that affected how investment trust charges are reported made them appear more expensive. This led some investors to sell and deterred others from investing. 

In September, the government gave a boost to the sector by announcing it would exempt investment trusts from these onerous cost disclosures. But there is yet to be agreement on what could and should replace these rules, and clarity could be months away.

Many believe cost disclosure is not a panacea — it will only help slow the decline of demand. Pittard says: “The industry needs fresh thinking and innovation — and transformation won’t happen without effort.”

A new constituency of buyers needs to be found. Conway points to the defined contribution pension market as a deep potential demand source for investment trusts that hold illiquid assets. “The industry should be courting these investors with vigour,” he says.

But a positive development is a new wave of investment trust consolidation which commentators describe as healthy and essential. Hollands says: “There are too many small, subscale trusts . . . Their size is a deterrent for larger investors such as wealth managers and multi-managers.”

In 2024 alone, 10 mergers of two investment trusts have been announced so far, an annual record and double the five seen in 2023. The blockbuster deal of this year is the creation of the £5bn vehicle Alliance Witan, a merger between the two big multi-manager global investment trusts, Alliance Trust and Witan. This is expected to join the four investment trusts in the FTSE 100 next time the index’s constituents are reviewed.

Emma Bird, head of investment trust research at Winterflood, sees “no obvious catalyst for discounts to narrow from current levels” but she does think that the increased level of corporate action — buybacks, wind-downs and mergers — limits the likelihood that discounts get any wider.

She is not alone in highlighting that the sector has survived for over 150 years and has overcome numerous challenging periods in the past.

So, what have investors been buying? Deutsche Numis analysts track which investment companies (ICs) have consistently featured on the “most bought” lists of the major UK retail platforms: AJ Bell, Fidelity, Hargreaves Lansdown and Interactive Investor. Typically, long-established companies with equity-oriented strategies dominate the “most bought” lists, but increasingly some alternative assets are featuring, particularly renewable energy. In the past 12 months, 42 per cent of appearances in most-bought lists were global ICs, 16 per cent UK-oriented strategies, 11 per cent tech and 11 per cent renewable energy.

The figures for October underscored the continued dominance of Scottish Mortgage* and JPMorgan Global Growth & Income, closely followed by City of London. New entries to Hargreaves Lansdown’s list were Supermarket Income Reit and Renewables Infrastructure Group, while Interactive Investor’s list included NextEnergy Solar, with Greencoat UK Wind taking top spot.

The question is what should investors buy today?

“Logically, as interest rates come down, those sectors hardest hit on the way up ought to be best placed for a recovery,” says Alex Watts, fund analyst at Interactive Investor. “This means trusts with exposure across unlisted assets, such as private businesses, property or infrastructure.” These areas are more reliant on borrowing so are sensitive to changes in cost of capital. 

Renewable infrastructure trusts have been greatly impacted by rate rises. On average across the sector trusts have fallen from trading at a premium in 2020-21, to a substantial discount in Q3 2024. But the new government intends to “make Britain a clean energy superpower”, and there is an acceptance that development of the UK’s clean infrastructure, such as renewable energy generation and transmission, requires continued investment.

“Technology trusts on a double-discount feels like an obvious anomaly,” says Thomas McMahon, head of investment companies research at Kepler. He singles out Allianz Technology and Polar Capital.

“Biotechnology is interesting,” he adds. “Over the longer run a lot of large-cap pharma companies will see their drugs patents expire and need to find replacements for that.” He chooses International Biotechnology on a 12 per cent discount.

For investors who do not have such a high appetite for risk there are still options. Mick Gilligan, head of managed portfolio services at Killik, highlights the social infrastructure trusts such as BBGI Global Infrastructure and HICL Infrastructure that are “offering attractive [high single-digit] returns into the future and are among the lowest risk vehicles around”.

Most experts urge caution on chasing the widest discounts. Investors must have faith in the underlying asset class and management team first and foremost, with the extent of the discount very much a secondary consideration. They also point out that for a trust to succeed in realising value it needs a co-operative board, and where the board is not co-operative, adequate shareholder engagement.

Overall, commentators agree there are opportunities but are measured in the language that they use. Walls will only predict there is “considerable scope for average discounts to narrow back to single figures” while Bird says “the balance of risks and opportunities at present certainly skews towards the latter”. Hollands is perhaps the boldest: “In a few years’ time, with the benefit of hindsight, I suspect some investors will be looking back at the returns they could have made and kicking themselves for not taking advantage.” Let’s hope they are not kicking themselves for other reasons. 

The author holds shares in City of London and Scottish Mortgage investment trusts.