AIC’s Sayers: Investment trust liquidity needs are all relative

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From time to time, the question of the liquidity offered by investment companies is raised. By liquidity, we mean the amount of shares an investor can buy or sell without moving the price significantly. The more shares you can buy, the greater the liquidity.

However, if we are talking about whether there is sufficient liquidity in a particular share, the question that is often overlooked is ‘for whom?’. After all, providing the stock market can provide the liquidity you personally want, it doesn’t really matter how much there is in absolute terms.

For most retail investors, liquidity is unlikely to be an issue and they will rarely have a problem buying and selling in the relatively small sums in which they usually. The one area that investors should be aware of is in relation to venture capital trusts, where the initial income tax breaks are dependent on holding the shares for a minimum of five years. Not surprisingly, then, trading in the shares will be pretty thin in the first few years but, as most investors want to secure this relief and won’t be selling, this is unlikely to be a problem. Other than this, retail investors can buy and sell investment company shares incredibly quickly and cheaply through online trading platforms without liquidity being an issue.

Even for financial advisers investing money for their clients, liquidity is rarely a concern. Most advisers are usually investing for their clients to take advantage of their ISA allowance or pension allowance via SIPPs. As a result, individual trades in excess of £10,000 are quite rare and can be easily accommodated.

Comments about a lack of liquidity generally come from institutional investors, or IFAs outsourcing portfolio management to groups running model portfolios or discretionary managers who have increased in size due to consolidation. In each case, the buyer wants to place a deal that might be valued in the millions. So what is the position for these investors?

Although size and liquidity are not always precisely correlated, they are a pretty good proxy. Fortunately, with recent strong performance, we have seen the number of larger funds increase. At the end of May 2015, according to Winterfloods Securities, there were 216 investment companies with market caps greater than £100m, up from 189 at the end of August 2013.

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But we should still not underestimate the issue. For example, in a recent survey carried out by Winterfloods of 93 wealth managers and private client stockbrokers, about 50 per cent of respondents considered that £100m market cap was the smallest size of investment company in which they would invest, which was down from around 70 per cent just a year earlier. Just under 10 per cent were looking for more than £200m, having barely registered the year before.

So what can the investment company sector do to address these increased demands for liquidity? One option is to issue new shares and, as a result of a number of investment companies’ shares trading at a premium to their net asset value, new share issuance over the past few years has been extremely strong and has helped to create the liquidity some investors are looking for. There are now 40 investment companies which trade more than £1m of shares a day, and a further 41 that trade more than £500,000 a day. Growing the size of the investment company can also have other benefits, for example in terms of reducing the ongoing charges of the company.

So things are improving, but we should not assume that growing the size of the company is always a good thing. For active funds like investment companies, rapid inflows of money could provide less flexibility for managers to pick the very best stocks for their portfolio, and therefore increase the risks of becoming a ‘closet tracker’. The narrower the investment objective is, the greater these risks. Investment companies such as River & Mercantile UK Micro Cap have even gone as far as to say they will return money to shareholders if they grow too quickly to ensure they do not undermine their investment objectives. 

So, as often in life, this is a question of balance, and the independent boards of investment companies will carefully weigh the advantages of increased liquidity and lower costs against the other impacts rapid growth might have on portfolio management. That said, some wealth managers have privately commented to me that, though they may have a preference for investment companies above a certain size, if the investment company offers a sufficiently compelling investment proposition, they will find a way to get the shares they want.

This is the fundamental point, because although liquidity remains an important issue, we should always bear in mind that investment companies do not exist simply to grow, they exist to deliver the best possible returns for their shareholders. 

Key Takeaway: Strong performance has helped the average investment trust increase in size, so improving liquidity, as investors hunt out larger funds. But investors need to view the liquidity of an investment trust in light of their own demands and needs.

Ian Sayers is director general of the Association of Investment Companies.