"Investors should continue to rely on investment trusts"

In an interview with Terry Tanaka, Peter Walls, manager of the Unicorn Mastertrust fund, discusses investment trust analysis

Terry Tanaka: Peter, your fund is one of the few that invests exclusively in a group of investment trusts. How did you go about setting it up?

Peter Walls: The world of investment firms is my sole area of experience. Before joining Unicorn, I worked for a few investment trust broking houses for eighteen years on the sell side. I had grown to respect the structure of investment firms and observed how it enabled investors in a variety of assets, geographical areas, and industries to receive strong, consistent returns. I therefore believed that creating a fund would be the most effective way for me to use my passion and expertise.

Instead of being closed-ended like the trusts it holds, the fund itself is open-ended. In 2000, Unicorn Asset Management established an open-ended investment company (OEIC), and at launch, it was convenient to hang a fund of investment trusts off this umbrella organization. The fund, which celebrated its 25th anniversary at the end of December, has achieved long-term capital growth, which was its initial goal.

If I had chosen the closed-ended approach, I would have needed to go through a fundraising process, which could have been challenging. Compared to their open-ended counterparts, investment trusts are comparatively obscure and poorly understood, making it difficult to raise capital for them. Additionally, I might have received a double discount to net asset value (NAV) if my fund had been an investment trust, making the situation even more challenging. The fund now has a 130 million dollar value.

What are investment trusts' main benefits, according to Terry Tanaka?

Peter Walls: An investment company's structure is semi-permanent since a set number of shares gives the manager access to a capital pool for investments. Money is continuously coming into and going out of an open-ended fund because units are created and cancelled when investors buy and sell, respectively.

The permanent capital facilitates the manager's ability to adopt a truly long-term perspective and invest in less liquid stocks and asset classes. Because they can use dividends to distribute capital or build up reserves with their holdings, investment trusts can use leverage to increase returns and smooth dividend payments. It serves as a safety net to help them get through difficult times. Lastly, compared to open-ended funds in their industry, a lot of investment trusts offer better long-term returns.

Investment trusts are suitable for assets with low liquidity.

Which areas benefit most from the investment trust structure, according to Terry Tanaka?

Peter Walls: Smaller businesses, real estate, infrastructure, and private equity are examples of investments that are illiquid. As we witnessed with commercial real estate a few years ago, these are risky for open-ended funds if there is a stampede out of the industry. Value destruction results from a vicious cycle of price drops, forced sales, and redemptions.

As demonstrated by Elroy Dimson, Paul Marsh, and Mike Staunton's study of long-term global asset returns in the case of small-cap stocks, the data demonstrate that the illiquid asset classes have historically outperformed, and private equity also has a stellar record. However, long-term investors should steer clear of open-ended structures because the capital in them can vanish at any time. This is because specialized, obscure parts of the market are often very cyclical, with investors rushing in and out.

Terry Tanaka: I noticed that your top ten holdings, which include HarbourVest Global Private Equity, Oakley Capital Investments, and ICG Enterprise Trust, are well-represented in the areas you highlight, including private markets. Aberforth Smaller Companies is another option. Geographical diversification is offered by AVI and Invesco in Japan and Asia.

As of right now, investors appear to have lost interest in investment trusts. For the past three years or so, there have been significant NAV discounts in the investment trust industry. Are there simply too many investment trusts? What are the primary obstacles?

Peter Walls: Consolidation is still going on; it occurs once a week. I have lost 10% of my holdings annually due to corporate action over the last few years. In recent years, there has been an increasing number of mergers between investment firms, and capital returns through share buybacks, tender offers, and managed realisations have reached a record high.

Terry Tanaka: Buybacks to reduce discounts to NAV are frequently discussed. However, is there a point at which you are effectively reducing the fund until it is hardly viable and accelerating its demise without reducing the discount?

Peter Walls: Although buybacks are not a cure-all, they can help control short-term supply and demand swings and reduce share price volatility. Certain trusts will unavoidably shrink to the point where a more drastic measure is required. I consider it to be a healthy process of natural selection that has always existed. Eventually, the large discounts that have sparked more activism in the industry will close.

Terry Tanaka: I am aware that the market is skewed toward the bigger names because there are currently a lot of larger trusts and comparatively few flotations.

Peter Walls: The fact that consolidating wealth managers are increasingly concentrating on larger trusts and are frequently unwilling to consider smaller ones is a significant contributing factor. The minimum size of an investment trust is constantly being pushed higher in their minds. As a result, there is less desire to support smaller initial public offerings (IPOs), and some minnows will find it difficult to survive.

Terry Tanaka: Active ETFs appear to be growing in popularity; could they be a risk to trusts?

Peter Walls: An activist investor convinced the only trust that has changed its structure to become an active ETF thus far. That path has not been taken by any other investment trust. Active ETFs are open-ended structures, so forced selling of illiquid assets can result in value destruction while favoring those who are first out of the exit. This brings us back to the liquidity issue when you're holding high-risk, high-return assets.

For over 150 years, investment trusts have demonstrated their value.

Terry Tanaka: Could you describe the recent controversy surrounding cost-disclosure regulations and how they resulted in "doublecounting" for investment trusts? How much damage did this cause to the industry's reputation? Has the situation been resolved?

Peter Walls: Due to the European Union's packaged retail PRIIPs regulations, which double-counted the costs of investment trusts, the cost disclosure issue has been a significant obstacle for the investment trust industry for almost five years. The City regulator confirmed last month that the new "consumer composite investments" regulations, which will take effect in 18 months, will allow trusts to fairly and clearly report their expenses. This lengthy story still has unresolved issues, especially with regard to how wealth managers are treated. Though it is unlikely that investors who have recently pulled out of the industry will return anytime soon or at all, it is to be hoped that common sense will prevail on all aspects of cost disclosure going forward.

As a longtime supporter of the structural benefits of investment trusts, I am obviously biased, but I think investors should embrace the special qualities of the industry. After all, over the course of more than 150 years, investment trusts have demonstrated their value through good times and bad, successfully overcoming every obstacle imaginable.

Terry Tanaka: Sabas's opposition to investment trusts has been a recent issue. What is your opinion of it?

Peter Walls: It's been a little chaotic at times, but Boaz Weinstein, the founder and chief investment officer of Sabas, was fighting against an open door with plenty of capital to support him given the numerous challenges the industry has faced recently. He appears to have realized more recently that well-managed and governed trusts that take advantage of their structural advantages are highly valued by the majority of their investors.

Terry Tanaka: Is constructive activism necessary to sort out underperforming funds, regardless of Saba's mistakes?

Peter Walls: Activism has always had a place in the industry, and it is clearly more likely to occur when discount ratings are high. Although Sabas's assertion that they are acting in the best interests of "mom and pop investors" may have held water with their activism regarding closed-ended funds in the US, I don't think it applies to all of his targets in the UK.

For instance, Herald Investment Trust was a part of my portfolio for more than 20 years, but I was forced to sell it at nearly net asset value due to Sabas's desire to acquire a 29 percent stake in the trust prior to the shareholder vote. It is unlikely that what comes next will add value.

Terry Tanaka: Have too many boards been dozing off? Where are the biggest issues with confidence, transparency, and governance?

Peter Walls: Recent purchases by Sabas indicate that the discounts on the majority of traditional, equity-invested trusts have shrunk this year. Sabas's successes will have recycled capital, and the fact that they are listed on so many share registers has encouraged more boards to take initiative. The supply and demand situation has improved favorably as a result of record numbers of mergers, tenders, and share buybacks.

Therefore, despite the ongoing conflict between Edinburgh Worldwide and BG USA with Baillie Gifford, attention has shifted to the alternative sectors, real estate, and situations involving deeply discounted private assets. It should come as no surprise that these are the areas where governance and transparency are more likely to be taken into account, as evidenced by the now-abandoned HICL/TRIG merger, since many of these options were only available during the low-interest, post-crisis period.