Investment trusts are experiencing a "existential crisis"—we've heard it all in the 1970s

According to Terry Tanaka, those who are worried about investment trusts' future should keep in mind what transpired fifty years ago

Investors in investment firms were particularly hurt by the 2022 stock market downturn because many trusts also experienced a significant increase in their discount to net asset value (NAV). Discounts began in the low single digits on average, increased to mid-double digits by year's end, and then increased to almost 19 percent by late 2023. Since then, markets have recovered robustly and are still rising. However, the average discount has only decreased to 14%, and in other subsectors, they are still significantly larger.

The industry has suffered grave repercussions as a result. Wealth managers and individual investors who sold in 2022's fall or during the recovery that followed have hardly made a profit. For both new and existing trusts, share issuance has virtually stopped. Trusts have been combined or wound up. Activist investors have entered the market, arguing that the underlying returns had been subpar in certain instances.

There were some trusts that were lost. Others worked in industries that were not popular, like infrastructure, private equity, or healthcare. When small- and mid-cap stocks outperform, many generalist funds that are more exposed to smaller stocks than the index find it difficult to keep up with the market. However, the recent dominance of a limited number of US mega-caps has reversed this effect. Lastly, despite the market's rise, UK investors have persisted in selling UK shares of trading and investment firms.

Talk of an "existential crisis" has replaced the optimism of a few years ago. The compounding effect of growing discounts, low liquidity, and poor performance deters investors. Unquoted property and asset valuations are viewed with extreme caution. With aggressive buybacks failing to lower discounts, trust directors are accused of being inattentive. However, despite the extreme pessimism, it's important to remember that seasoned professionals have heard it all before.

A period of investment trust crisis.

The industry was in severe crisis fifty years ago. The two-year bear market reached its lowest point in January 1975, with UK shares falling 70% nominally and 80% in real terms. Trust discounts reached a peak of over 40%. They shrank as the market recovered, but for the following ten years, they stayed at about 25%. Private investors continued to be the sector's mainstay until the mid-1960s, following the establishment of Foreign and Colonial (now F&C), the first investment trust, in 1868. The sector typically traded at a premium to NAV, and new launches were frequent. However, inflation, bear markets, poor relative performance as discounts increased, and a growing inclination toward unit trusts that traded at NAV and life-insurance products with favorable tax treatment caused them to start pulling out of the market.

For private investors, investment trusts had significant drawbacks. There were no self-invested personal pensions (SIPPs) or individual savings accounts (ISAs) to shield them from higher rates of income and capital gains tax. There was a 2% stamp duty. Unless they were dealing in large quantities, private investors were required to pay a 1.65 percent commission to a stockbroker for both purchases and sales. Only when the broker approached a "jobber" (market maker) on the stock exchange floor and requested a bid and offer could the bid-offer spread be obtained.

Although interest rates were unaffordable, a trust could borrow money to make investments. Section 54 of the 1948 Companies Act prohibited both share buybacks and capital dividend payments. Dividends were restricted to earnings, and all expenses, including interest and management fees, were expensed. However, accumulated revenue reserves could be distributed. Boards were self-electing oligarchies that served indefinite terms and frequently colluded with managers. Only the annual and interim reports and accounts were shared with investors. There were no fact sheets, and only experienced investors could conduct broker research. There were very few opportunities to speak with, see, or meet the managers.

Investment was heavily skewed toward Britain as a result of exchange controls: UK equity exposure was close to 50% in 1975 and increased to over 60% in 1980 as markets, particularly in the UK, recovered. The removal of exchange controls in 1979 encouraged trusts to make more foreign investments, but at the time, the UK was outperforming foreign markets, so this diversification was not adding value.

Investment trusts' pivotal moment.

However, by 1981, recovery was beginning to show. According to Robin Angus of Wood Mackenzie, "the tide for investment trusts has turned and the climate has changed dramatically for the better." "The majority of global markets have advanced significantly; more specialization in the industry has been available, and the reform of the capital gains tax has made trusts more appealing to professional funds. The success of international diversification has not yet been reflected in prices, but average discounts are still close to thirty percent. The "

Six takeovers, eight conversions into unit trusts, and six additional trust removals had occurred in the preceding year. Ten new issues, five rights issues, and thirteen changes to investment policy were raised in opposition to that. Four oil and energy trusts, three investments in Japan, three in technology and biotechnology, and three in smaller UK businesses were the results of the shift to specialization, which was primarily achieved through new issues.

Pension funds and insurance companies, who saw it as an inexpensive way into the equity market, invested in the industry and became its dominant holders as private investment declined. But there was now a fresh danger.

The tactic of persuading their clients to bid on investment trusts at a discount as a covert rights issue was created by corporate financiers. As a result, Robert Maxwell acquired control of the Bishopsgate Investment Trust, and the British Coal Pension Fund successfully launched a hostile bid for the largest investment trust in the industry, the 1.1 billion Globe Investment Trust. "Killing the goose which lays the golden egg" was how Angus described such bids and liquidations. "A once-and-for-all gain is never repeatable, even though it may be desirable and significant. The "

Regarding discounts, he wrote that "a fairer ground for criticism if discounts were something new" would exist. "They offer the astute investor countless chances to profit by trading in and out. If one is fortunate enough to identify a winner early on, they can, at most, gear up their gains. Performance, not excess supply, was the issue. "An attractive trust will sell at a slight discount or even a premium, while an unattractive trust will sell at a larger discount regardless of how significantly the total number of shares is reduced. A "

An improved prospect for investment trusts.

Although Angus passed away in 2022, he would undoubtedly notice many parallels between then and now if he were still with us. Although he would acknowledge it, he would not have much time for the "death list mentality with regard to the future of the industry." He would note that the majority of well-performing trusts were trading at a premium or at a slight discount, and he would draw attention to the fact that four years prior, trusts trading at NAV had made their seemingly poor performance worse. He would undoubtedly acknowledge the progress made in trust governance, commend share buybacks, and support the current dividend flexibility. And he would likely consider the past few years to be a time of creative devastation for the industry and observe once more how the tide had turned.

Investment trusts will have a brighter future. Net issuance will replace mergers, buybacks, and liquidations as premiums increase and discounts decrease. However, split-capital trusts, insurance-underwriting trusts, hedge fund-like trusts, and renewable-energy trusts are the areas where net issuance has historically tended to concentrate. Such crazes, which typically result in tears, should be avoided by investors.

According to Edward Warner, chair of HarbourVest Global Private Equity, "the lesson for trusts over the past few years is that you have to get on the front foot and tell your story." It's true. Investors should not wait for a better investment opportunity, as was the case in 1981. It might never happen.