Discount controls have become popular with many trust boards over recent years as a means of keeping the movement in the share prices of their trusts broadly in line with that of the asset values of their portfolios, and avoiding the unwelcome corporate activity of arbitrageurs.

The concept of seeking to control the size of the discount was generally welcomed as a means of ensuring the shareholders were more consistently rewarded for the performance of their trusts. Under broadly positive market conditions, the process seemed to work well. However, general market uncertainty in the past 12 months has led to fears that some trust boards may simply be acting like Canute in a futile gesture that can only result in their trusts reducing to an unsustainable size.

A variety of approaches
Simon Elliott, head of research at WINS Investment Trusts, reports, ‘Around 50 funds now have an explicit discount target, although the nature of these varies widely. The discount level ranges from three per cent to 12 per cent and some are implemented strictly while others are only triggered if the discount exceeds the target for a period of time, such as Glasgow Income.’

He adds, ‘Numerous other funds also use buy-backs to defend discounts, even if the board has not stated an explicit target, such as JPMF Mercantile or Charter European. Then there are some that have adopted a semi-redeemable structure, buying back at small discounts and issuing at small premiums. Examples here include JPM Elect and Personal Assets.’

Elliott feels, ‘The proliferation of discount controls reflects increasing pressure from shareholders to reduce discount volatility. In some cases, this is a defensive measure to stave off the threat of corporate activity, although it is increasingly common for funds seeking to raise new capital to introduce a discount target to reassure investors that the downside to the discount is limited.’

Reducing in size
The mechanism used by most boards to try to control their discounts is the share buy-back. Put simply, a board can seek authorisation from its shareholders to buy back up to 15 per cent of its shares. This process involves going into the market and literally buying back stock from existing shareholders in the trust. The net result is that there are fewer shares in issue linked to the same pool of assets, so the asset value per remaining share will rise and the discount will narrow.

The problem is that the share buy-back is a rather blunt instrument. Peter Walls, managing director of Unicorn Asset Management, says, ‘You get to the stage where the funds become so small that you either have to give the money back to the shareholders or restructure the trust in some way. We saw that with Falcon here at Unicorn, and Advance UK Focus recently went the same way.’

It would seem that, with regard to the effectiveness, or indeed desirability, of a share buy-back policy, size matters. Simon Elliott argues, ‘In our view, it is particularly difficult for smaller funds with a market cap of less than £50 million to maintain an active buy-back policy. Funds such as Witan or Foreign & Colonial IT are able to buy back on a regular basis, but for smaller funds this is not a long-term option, as it is effectively “death by a thousand cuts”. Performance may be hit by having to sell holdings to meet redemptions in weak markets.’

John Moore, head of the collective investments service at Brewin Dolphin, insists, ‘It doesn’t really work for small trusts. It is very difficult to do this when you have a trust that is sub £100 million, but it does work quite well in larger trusts. Foreign & Colonial, Witan and Scottish Investment Trust have all made use of this strategy and you can’t say that any movements in their discount are due to performance.’

He adds, ‘Witan may have had a strong couple of months but basically it has had a poor year. Scottish Investment Trust has had a better year, so it has probably been easier for them to buy in the market, while Foreign & Colonial has a had a very strong 12 months.’

Moore continues, ‘Another variation on this approach is the Martin Currie Portfolio Trust, which has a sort of discount control, whereby it has a continuation vote if the discount is above 7.5 per cent in the last six weeks of the year. That approach seems to work quite well, as it means its discount level is never too far from where it should be.’

Benefits of liquidity
Certainly it is easier for the larger, more liquid investment trusts to conduct a successful discount management policy. Jeremy Tigue, fund manager at Foreign & Colonial Investment Trust, reports, ‘We have been pursuing an active buy-back strategy where we consistently buy back shares whenever the discount hits ten per cent. The discount range has been between eight and 11 per cent over the course of the past year.

‘During that period, we have bought back 8.6 per cent of our shares, which we calculate has added 3.2 per cent to the trust’s net asset value. By comparison, Alliance Trust, which doesn’t buy back its shares, saw its discount move between ten and 17 per cent over the same period.’

Tigue insists, ‘We are very relaxed about buy-backs because of the change in our share register over the past 20 years. Eighty-two per cent of our shares are now held by retail investors, and the largest institutional holder, at four per cent, is Legal & General, which has to hold us for its index funds. We see our buy-back policy as adding value for shareholders, and our approach significantly differentiates us from the market at large.’

Nick Sketch, investment trust analyst at Rensburg Sheppards, adds that ‘We are strong supporters of discount controls, where these are practical. So we are not talking about trusts like 3i or Candover worrying over whether they are at a three per cent discount or a five per cent premium. But where your portfolio is very liquid there is no excuse for not doing it.’

John Moore, however, insists, ‘In smaller trusts, share buy-backs can’t work. You have the evidence of that from Standard Life Smaller Companies and Jupiter Primadona. The Standard Life trust was trying to defend a five per cent discount and they just couldn’t do it, while with Primadona, they also had to admit that they couldn’t sustain the original policy.’

He admits, ‘This is a very sensible attitude to take as the market was moving against them and you don’t want to be in a situation where the potential buyers of the trusts are being put off from holding its shares because of the discount. But then you see what happens when the discount control comes off. In the case of the Standard Life trust, it shot up over 20 per cent, although it is back around 12 per cent now.’

Importance of consistency
Another potential problem is that not all trust boards understand the importance of sticking to a discount control policy once it has been established. Peter Walls comments, ‘Share buy-backs are a sensible idea for those trusts with a good following, good track record and solid share register, and these are the trusts that will also ultimately look to issue new stock, when circumstances permit. Boards should realise what they are getting into. You have got to be consistent or you will have to go back to your shareholders and say that we have to find another way of doing this.’

Simon Elliott adds, ‘More funds are struggling to meet the commitments that they have made to protect a specified discount level through buy-backs. For some time, we have been concerned that boards have made commitments to reduce the discount without considering the long-term consequences. In recent years, the environment for equities has been relatively benign, but we warned that discount targets would be difficult
to enforce when market conditions deteriorated.’

He adds, ‘Some funds are trading at a substantially wider discount than their target, not only measured by the current discount but also using an average over six months. The wording of a discount control mechanism commitment often gives a board the flexibility to let the discount drift. Sometimes the target is referred to as a long-term objective, while a few boards, such as Jupiter Primadona’s, have even stated that the level of the target will be adjusted over time to reflect market conditions.’

Nick Sketch feels, ‘The big offenders are those trusts that say they are putting a discount control in place but then that is all that they do. There are several whose position is that they will buy back their shares if their discount is out of line with that of their peers. But that is a difficult position to defend if all the trusts in their sector are standing at discounts in excess of 20 per cent.’

Read the small print
Simon Elliott says, ‘The most obvious advice that we can give investors is to read the exact wording of a fund’s discount control to see whether the board has made a firm commitment to protecting the discount, as is the case with Foreign & Colonial IT, or whether it has left itself some “wriggle room”, a comment that applies to most of the funds. This is not always easy, and the wording is sometimes revised or redefined at a later date.’

He adds, ‘In our view, shareholders should challenge boards that fail to keep their promises. However, we do believe that there is a creditable argument that a well-managed fund which falls out of favour should be able to adapt its buy-back policy to reflect market conditions. Ultimately, few shareholders are likely to complain if a board introduces a firm discount target, particularly if this is at a tighter level than the current discount.’

But Elliott suggests, ‘We believe that this may not always be in the best interests of the fund over the longer term. A consistent buy-back to defend a discount can give investors comfort without having to publicly state a target level. Discount controls should not be treated in isolation, and the board should consider why the discount exists. It may be that buy-backs will help to support the discount by removing a temporary overhang, but a more fundamental change could be required in order to attract new investors.’

Playing by the same rules
Peter Walls highlights another issue: ‘My view is that the ability to buy back shares  has to be a useful tool for investment trusts to have at their disposal, as has the ability to issue stock at a later date. But the problem is that unless everyone sticks to the same set of rules, you are never going to be able to get around the problem of investors selling the expensive trusts, which are expensive because they have been buying back their own shares, and buying the cheap ones, which are cheap because they haven’t been buying back their shares.’

He adds, ‘You are going to get people arbitraging between the two. There are those arbitrageurs that will do this as a matter of course, but in these circumstances it is not just the usual suspects but ordinary, rational investors who will say to themselves: “If I sell the trust that has bought back already and buy the one that hasn’t, not only do I get the better discount but there is the possibility that corporate activity will also take place in the future.”’

Nick Sketch adds, ‘Having given themselves a hard discount target, boards then have to follow it up. If in a year or two they haven’t maintained it then it becomes a corporate governance issue. If they don’t implement their buy-back policy consistently then their shareholders could argue that their reasonable expectations  have not been met.’
He also feels, ‘Discounts prevent mergers between trusts. There are sectors where there are too many investment trusts. If you try to merge two trusts together that are both on 15 per cent discounts, it doesn’t work, as the shareholders demand a cash alternative, which scuppers the deal as they don’t want to be converting to a new trust at a discount.’

Whither the discount?
The core problem, however, is what gives rise to the discount in the first place. John Moore argues, ‘What you have to remember is that discounts are ultimately all about performance. There may be other factors that affect the level at any point in time, such as investors unloading their portfolios onto the market, but basically it is a reflection of how the market views a trust’s performance.’

And Nick Sketch concludes, ‘People should see discount controls not as a back-stop but as an opportunity to make money. If you buy back stock then up goes the NAV. We are not suggesting that companies make a habit of shrinking themselves out of existence, although that is often the criticism of buy-back policies. But we don’t see that as the problem. Our argument is that trusts should do it aggressively enough so
that there isn’t a discount.’