What I learnt from your open-ended wisdom on closed-ended funds

In an age obsessed with reach, eyeballs and engagement, one of the most important things a quality newspaper can do is ensure that readership tails don’t wag the educational dog.

Columnists and editors know how to zoom up the most-read charts: write about Elon Musk, gold, bitcoin or Apple. Even better, invent a spurious story to have the words “office romp” in a headline.

But no one wants to read hundreds of articles about Tesla and the death of fiat currencies every day. And even if our appetite for Saucy C-suite Secrets is higher, the opportunity cost is learning something new.

Hence a home run (see how I slipped in an American sports reference to boost readership?) is when a niche topic is popular when expectations were that only three investors and a dog, and perhaps my mum, were interested.

Investment trusts, for example. I have received more emails since last week’s column than for anything I have written on crypto or jewellery. The breadth of financial and emotional attachment to closed-ended funds has astounded me.

And most readers are as baffled as I am as to why they trade at such deep discounts to net asset values. Frustrated too (not all though — some said we should embrace the discount and enjoy the concomitant higher dividend yields).

Yet more emails offered explanations for the gap between the prices of these securities and the value of their underlying assets. Many of these were from experts such as multi-asset portfolio managers, trust researchers and academics.

It is clear we have not yet solved the mystery of closed-end funds, so please forgive me another column on the subject. We won’t understand everything. But thanks to your helpful feedback, I reckon we’re getting closer.

What follows, therefore, is a summary of the most common points raised by readers and my £499,847-worth on each of them — since I’m thinking about adding investment trusts to my portfolio.

Let’s begin with some widely held views I still struggle with. That discounts to NAVs are a reflection on underperforming managers, say. The argument goes that if your trust constantly lags behind the market (or is expected to) then a discount is warranted.

But why? Returns have nothing to do with whether the price of your fund should be higher or lower than the value of the assets inside it. At any point in time, these should be equal — in theory at least.

Especially in secondary markets such as equities, managers can never pay less than the market rate for a security, nor can they overpay. Sure, the stock may then out- or underperform an index, but that is not what we’re talking about here.

I agree this is not true in private markets. If a manager spends more on office buildings, say, than they end up being worth, a discount makes sense — but it should eventually be arbitraged away as true NAVs are revealed and prices move into line.

Yet more readers blamed higher interest rates for widening discounts — especially when trusts hold longer-dated assets such as utilities or private assets. This is illogical too. Any change in underlying asset values should move fund prices concurrently.

Meanwhile, scores of practitioners wrote in to say I underplayed the role of investment flows in my previous column. Discounts are a function of soggy demand — especially in the UK due to its ridiculous labelling of fees, which double-counts the costs.

Technical factors are short-term though — by definition. They shouldn’t affect fundamental mispricing. What is more, the discounts observed across US closed-end funds and UK investment trusts are decades’ long phenomena.         

No, the most-likely culprit for these permanent discounts is fees — as many of you were keen to point out. Academics devoted to solving this so-called “closed-end fund puzzle” don’t agree on much from what I have read — but fees always loom large.

It makes intuitive sense. If I’m considering an investment trust with a yield of 5 per cent and annual fee of half a per cent, then I would in theory demand a one-tenth discount to compensate. This is roughly in line with long run averages, as it happens.

Much wider discounts than this, as we are seeing at the moment, are therefore either a massive buying opportunity (once short-term flow effects dissipate) or suggest that the valuations on private assets held in these funds are bollocks.  

Investors should analyse each trust on its merits. What they shouldn’t necessarily do, however, is demand share buybacks willy-nilly of every fund trading at a discount. I want to finish on this because there remains a huge amount of confusion here.

The Five Minute Investor from Money Clinic: Are share buybacks good news for investors?

Listen here

I received loads of emails saying my claim last week that “buybacks help share prices but reduce NAVs” is wrong. It isn’t though — for the same reason buybacks don’t automatically boost the value of a company, as I’ve discussed on Claer Barrett’s new podcast.

Yes, investors end up with a bigger slice of the pie. But its radius is smaller because cash is spent buying the shares. If discounts narrow, that’s only because the NAV has fallen versus the market cap, not the other way around (even if the NAV per share has risen).

Far better for shareholders to apply pressure on the hundreds of subscale trusts to get them to merge or close so costs are lowered and fees reduced. Only this can narrow discounts permanently. But who in the industry — from managers to gravy-train non-execs and accountants — wants this?

But all that is future upside. For now, I’m taking a Warren Buffett (more clicks!) view. Just as he loves a crash so he can buy stocks cheap, what’s not to love about a discount?

The author is a former portfolio manager. Email: stuart.kirk@ft.com; Twitter: @stuartkirk__