Starter’s orders

Investment trusts have not had an easy ride; hurt by an oversupply in the early 1990s and the split-capital trusts debacle. But with Schroders about to launch a new trust into the market, Adam Lewis ask whether this marks a return to the sector\'s heyday or is it a one-off?

After a week-long placing and offer period, Schroders this week launches its Oriental Income investment trust. Managed by Matthew Dobbs, the conventionally structured trust aims to take advantage of dividend growth in the Asia Pacific region, and the group is planning to raise a minimum of 50m.

With just one other income-focused trust placed in the Far East excluding Japan sector, the rationale for creating such a vehicle seems clear. However, what is extraordinary is a group launching a new mainstream investment trust.

Owing to discount problems created by an oversupply of trusts launched in the early 1990s, over the last few years the flow of newly created investment trusts has dried up. In the last two years, according to the Association of Investment Trust Companies, just 17 conventional trusts have been issued, most of which are confined to investing in property and hedge funds. This compares with 94 funds from 1993-95 across all sectors of the market.

As a result, many in the investment trust industry are closely monitoring the success of the Schroders launch. Could it be that if the group is successful the sector will return to the heyday of the early 1990s, or is this launch just a one-off?

Because of the large number of new investment trust issues between 1993 and 1995, Nick Greenwood, chief investment officer at the iimia investment group, says that there was an oversupply of funds in most sectors of the market. This led to a situation where there were more sellers of trusts than buyers, and by 1997 most were trading at discounts.

In addition to wide discounts, Amany retail investors have been put off conventional investment trusts because of what happened to split-capital structured trusts. David Harris, chief executive of the InvaTrust consultancy, says even though it should not have done, the collapse of splits tarnished the investment trust sector as a whole.

As a result, most of the activity within the conventional investment trust sector over the past few years has been confined to the rollovers of existing trusts and the swapping of investment managers from one group to another.

Robin Stoakley, UK retail managing director of Schroders, notes that client concerns over discounts have proved the biggest obstacle to launching a new trust in the past few years. Indeed, why would investors pay a premium for a new trust and face the risk of immediately seeing about 10% wiped off the value off their investment, when they can invest in a similar vehicle trading at a discount?

At July 18, 2005, the weighted average discount to net asset value for trusts in the Global Growth sector stood at 14.4%, while the average discount in the UK Smaller Companies sector was 13.8%. This compared with a weighted average discount of just 0.6% for trusts in the Specialist sector.

Greenwood says: “The bulk of the large discounts in the investment trust sector are in the global generalists and UK smaller companies. This reflects the oversupply of trusts in those sectors. For example, the average discount for UK Growth trusts is 5.6% and for UK Income Growth trusts the average discount is 3.2%.”

Because of the lack of income-mandated Far Eastern investment trusts, Schroders does not face a discount problem. Tom Tuite-Dalton, an investment trust analyst at Arbuthnot Securities, notes that the only other trust of this nature is Henderson Far East Income, which is currently trading at a 4.4% premium.

He says: “There is an obvious gap to fill in the Far East income space and I am surprised a trust of this nature has not been launched sooner.”

The Schroder Oriental Income trust has the objective of delivering a gross yield of between 4.25% and 4.5%. Focused on achieving an absolute return, manager Dobbs will invest in a diversified portfolio of 40 equities in the Asia Pacific region, including India and Australia. Dobbs also has the ability to invest in Japan.

According to Stoakley, dividend yields in Asian markets are at the same level as in Britain, and several markets in the region, including South Korea and Taiwan, are offering yields of more than 2%.

He adds: “Over the last five or 10 years, dividend growth in Asian markets has grown at a respectable rate. We believe this trend is likely to continue, but not at the expense of dividend cover. Since the Asian crisis in the late 1990s, companies in the region have been repairing their balance sheets and refocusing on profit maximisation. This has helped lay the foundation for increased sustainability of dividend payments going forward.”

As a result Stoakley says Schroders was approached by several large discretionary clients who felt there was a need for more Asian equity income trusts to take advantage of the dividend growth story. “There are still several investors in the private client world who prefer the structure of investment trusts over unit trusts. With the Henderson Far East Income fund consistently trading at a premium for the past four years there is a definite demand for this trust, and there is also a strong investment rationale for it.”

Indeed, Greenwood expects more groups to launch Far East income trusts as he says yields in that region will be one of the major themes in 2005. He argues: “Japan cannot rise until the locals start buying their own market. Bigger dividend payments will be one of the main catalysts for them to start doing so. As such the Schroders trust is a good idea and I will definitely be buying some at launch in my iimia investment trust”

However, if Schroders is successful with the launch of Oriental Income, it may not necessarily be the trigger for a new trend of groups launching mainstream equity investment trusts.

Harris says the only way to get a new trust away is to invest in a niche area where a gap in demand has been identified. He says: “Everyone is always looking for the next area to invest in. Over the past few years we have seen the creation of a number of property investment trusts as performance from that asset class has been strong recently. Indeed, I think we will see a few more of these launches.

“However, it would be harder to launch a trust in the more conventional sectors as there are too many funds, many of which do the same job. While the management groups argue their vehicles have slightly different remits to their competitors, from the average investor’s point-of-view they all look similar, and tend to perform in a similar way.”

Andrew Watkins, distribution director for investment trusts at Invesco Perpetual, agrees. He says for a group to launch a new trust it must have a unique selling point – for example it invests in Russia – otherwise there is no point in creating it.

He says: “Property trusts have proved popular because they offer diversification away from equities, and in addition pay a yield of between 6% and 6.5%. Income is flavour of the month; investors don’t care if they get this from British equities or from Far Eastern equities and Schroders has identified this. However, it would be much harder for them or any other group to launch a trust in a more mainstream sector because the demand is not there.”

So it would appear that in order to launch an investment trust you have to find a niche. JPMorgan Cazenove is currently in the process of brokering a new Guernsey-listed exempt investment company called the T2 Income fund.

Managed by America-based T2 Advisers, the aim of the trust is to provide a high level of income by investing in the debt securities of small to medium-sized companies, primarily located in Britain and Europe. The focus is on technology-related companies such as software, hardware, internet, media, telecoms and semiconductors.

In America T2 manages a Nasdaq-quoted investment company called the Technology Investment Capital Corporation (Ticc). However, owing to US regulations the company is required to invest its assets almost entirely in America-based companies. The decision to launch the trust here was based on the opportunities it was seeing for investments in Britain and continental Europe.

JPMorgan Cazenove is seeking to raise 48.2m for the trust and its expected annual dividend yield, in respect of the four quarters to June 2006, is 7.2%.

Elsewhere, last week trading began on a new 75m emerging markets utilities investment trust. The Utilico Emerging Markets Utilities trust, which will trade on both Aim and the Bermuda Stock Exchange, will be managed by the Australian investment adviser Ingot Capital Management.

Tuite-Dalton says the trust only invests in certain emerging market sectors such as water, oil, gas, ports and transport. This, he says, is a play on the China growth story, and the demand for infrastructure it will create.

The portfolio of the trust is predominantly focused on Asian, Latin American, emerging European and African markets. However, Ingot will have the flexibility to invest in markets worldwide. The trust can invest in shares, bonds, convertibles and other types of security, including non-investment-grade bonds. It will also be able to invest in unlisted securities.

Ingot also manages the split-capital structured Utilico investment trust. Formed out of the reconstruction of the Special Utilities investment trust in August 2003, it invests in more international utility-related sectors in the UK, Europe, North America and Australasia. Only 10% is held in emerging markets.

The launches of Schroder Oriental Income, T2 Income and Utilico Emerging Markets Utilities prove there is demand for niche investment trusts. However, Stoakley does not believe these launches will mark a return to the early 1990s when groups were launching new trusts for fun.

On the other hand, he adds: “If the Schroder Oriental Income trust gets off the ground successfully it proves that if you have an investment case, a sound structure and a manager with a strong reputation, investment trusts are still in demand.”

Indeed, it is expected that the new Schroders trust will have taken in excess of 100m of shareholder money by the time it starts trading this week. If you add to this the money raised by Utilico and T2 it means that in the past few weeks of fundraising more than 220m of new money has been raised.

Several groups are watching the Schroders launch with interest. Stephen Westwood, head of investment trusts at Fidelity, says: “It will be fascinating to see how the launch of the Schroder product goes. It is positive for the sector when things like this come along and a strong flow of money into it could encourage others to do the same if they too can identify market demand.”

Greenwood notes: “There is no point any more buying an investment trust that is almost exactly the same as an equivalent unit trust. Groups are recognising this and the capital structure of investment trusts is now evolving to create mandates that suit the more sophisticated investors. So the sector is changing, and we will see more launches going forward, but it won’t be to the same degree we witnessed between 1993 and 1995.”

In investment circles people always seem to be looking out for the next theme or trend. As a result, owing to the dearth of new conventional equity trusts launched over the past few years, the launch of an Oriental Income trust was always going to spark interest. However, it would be appear investors are not about to be flooded with new investment trust paper.

Compared with the early 1990s when they launched all manner of trusts – many of which did the same thing – groups now have to be more clever. They have to spot the gaps in the market others have missed; they have to use more imagination; and most importantly they have to be first in. As such, the overriding theme for investment trust launches going forward is that it is hip to be niche.

Attack and defence: arbitrageurs and discount control mechanisms

In recent years the number of investment trusts to have come under attack from arbitrageurs has increased dramatically. As opposed to several years ago when it was seen as “ungentlemanly” to attack a trust sitting on a discount, more and more hedge funds are now building positions in trusts trading on large discounts, with the aim of forcing them to reconstruct.
This means the boards of investment trusts are having to be more proactive to keep their discounts to a minimum. As a result, says Nick Greenwood, chief investment officer at iimia investment management: “The investment trust sector is going through a period of accelerated evolution. More and more trusts, including my own iimia investment trust, are using control mechanisms to avoid their discounts widening.”

The discount control mechanisms Greenwood refers to include the ability of trusts to buy back their own shares when there is too much supply, putting shares into treasury and the introduction of redemption facilities for investors.

Just last week the board of the 275m Invesco English & International trust, a UK smaller company specialist, announced proposals to offer shareholders the ability to redeem shares on a quarterly basis at net asset value less costs and an exit charge. This followed the building of a 16% stake in the trust by hedge fund group Laxey.

The first exit charge for the scheme, which needs shareholder approval at an extraordinary general meeting, will be set at 4%. However, this will fall to 3% after six months and 2% after 12 months. Allowing for debt repayments and portfolio realisation costs, the first redemption is expected to be at a discount to net asset value (debt at fair value) of about 9.2%.

Charles Cade, head of research at Close Wins, says that rather than waiting for a hostile requisition, the board of Invesco English & International has proposed this adoption of a semi-open-ended structure. He explains: “Unlike a one-off tender offer, the regular redemption facility means shareholders can be confident the discount will not widen significantly from its current level once the threat of corporate action has gone.”

The action taken by the board of the Invesco trust is similar to that taken by the Gartmore Growth Opportunities trust last month. It too added a quarterly redemption facility; however, unlike Invesco, it also made a number of changes to its investment mandate and introduced the use of treasury shares

Cade says: “It is too early to judge this type of semi-open-ended structure. However, we believe it retains many of the benefits of a closed-ended fund – that is, the ability to gear and an independent board – without suffering the potential disadvantage of a persistent and/or volatile discount. This should make the vehicle more attractive to new investors, particularly private client groups and funds of funds.”

It was not until December 2003 that investment trusts buying back their shares were first allowed to hold 10% of the share capital in treasury to sell in the future, instead of having to cancel the shares. In this way boards increased their control over the capital structure of their trusts and have greater influence over the supply and demand of shares.

Tom Tuite-Dalton, analyst at Arbuthnot Securities, says the arbitrageurs have forced boards to think more carefully about how they can best represent the interests of their shareholders. “I expect all new investment trusts launched will have annual tender facilities where investors can sell their shares at a fixed discount. This, in addition to the buyback facilities trusts can already use, will help boards keep discounts under control.”

The new Schroder

Oriental Income trust, which begins trading this week, will employ only one discount control mechanism. Robin Stoakley, UK retail managing director of Schroders, says: “As the fund is Guernsey-domiciled it can’t hold shares in treasury, which is a shame as it is a tool that would have lent itself well to this trust. Instead, if the trust trades at more than a 5% discount the board has laid down a firm commitment to buy back its own shares. This should give people comfort that there will always be a buyer of shares.”

Cade says: “It will undoubtedly be tempting for other boards to follow the same route as Gartmore and Invesco by restructuring their shareholder base. However, in order to maintain a narrower discount than their peers, we believe that funds need to be differentiated by investment mandate, management resources or performance record.”

Indeed, David Harris, chief executive of the InvaTrust consultancy, is not convinced the buying back of shares, or issuing shares into treasury, has a material effect on narrowing discounts. He says these measures have to be backed up by good performance, which in itself will create demand for the shares.

He says: “For as long as there are too many investment trusts, there will always be a discount problem.”