Note: This article assumes knowledge of the fundamental differences between open-ended and closed ended funds. To the uninitiated, this article should be useful background reading. I also assume everyone has some knowledge of the Woodford fiasco.
The vast majority of my portfolio is currently split between individual small/microcaps, FTSE 250 and FTSE 100 trackers, as well as some legacy mid/largecap holdings. However I do have also hold some funds and in the past they have been a significant part of my portfolio.
While there are arguments that active fund management should be able to outperform an index tracker, historically this has not generally proven to be the case, and especially not after charges. Whether this poor track record is likely to continue in the future is potential topic for another article, but, for the moment, it is difficult to justify potential out-performance as a reason for holding funds. So why do I hold them?
Exposure to unquoted assets
I hold HarbourVest Global Private Equity (HVPE) because there is currently no other viable way for most private investors to access private equity, and I wish to have exposure to private equity because a) it has outperformed quoted equities in the long term and b) there is a relatively limited correlation between quoted equities and private equity.
I hold Downing Strategic Micro-Cap Investment Trust (DSM) because part of their portfolio is in unquoted loan notes that I cannot access directly.
I have been considering Hipgnosis Songs Fund (SONG) because that provides access to musical intellectual property rights which may be uncorrelated to quoted equities.
There are arguments for buying various other funds that hold unquoted assets for similar reasons.
Discount to fair asset value
One way a discount to fair asset value can occur is where you are confident that the asset value stated by the company is below the “true” value. This could be the case where some assets are unquoted, are illiquid to the extent that price discovery is non-functional, or where NAV can vary significantly between official calculation date/times.
The other way such a discount can occur is with a closed-ended fund. Investment Trusts in particular usually trade at a discount to stated NAV. The HVPE and DSM funds referred to above are currently trading at significant discounts to stated NAV, although especially since they hold unquoted assets you would need to form your opinion of fair asset value and also consider the effect of total fund costs.
In the past I held what is now called F&C Investment Trust (FCIT). When I bought the discount was in its recent historical range of -10 to -12%. For many years I benefited from an amplification of the dividend yield and value creation from discounted share buybacks. During 2018 the discount rapidly contracted due to demand created mainly by a good run of performance which was in turn caused by a high US equity weighting. At the end of 2018 the discount approached zero and so I switched the investment into index trackers, pocketing an additional 10-12% gain. The discount has since increased to 5%. Most of the assets were liquid and quoted, minimising the scope for differing judgements over the fair NAV.
Between approximately 2012 and 2017 I held shares in what was latterly called Aberdeen UK Tracker Trust (AUKT), an Investment Trust tracking the FTSE All-Share index. I bought at a discount of around 5% and benefited from this in the same way as FCIT both while the discount held steady and when the fund liquidated returning close to NAV. Due to the nature of the investments there was never any doubt about the accuracy of the NAV calculation and fees were low.
As a counter example, I have for many years held what is current known as Hansa Investment Company (HAN / HANA). It trades at around a 30% discount and includes a 25% holding in Ocean Wilsons (OCN) which in turn trades an a 30% discount to its Brazilian assets which include a high quality port operation and quoted investments. Investment performance on the remaining 75% has been poor for a number of years and as an effective fund-of-funds suffers look-through management fees alone of 1.3%. It is controlled by the Salomon family and they are unwilling to let the company buy back shares. It recently re-domiciled to Bermuda presumably for family reasons, which raises concerns over shareholder rights and led to a further increase in the discount.
Shorting is an option for Investment Trusts / companies where you are confident they trade above fair NAV and/or where you can see the supply / demand dynamic leading to a decreasing premium / increasing discount. A fund might trade above fair NAV either because the stated NAV is higher than the fair NAV and/or they are trading at a premium to stated NAV. OEICs / unit trusts cannot be shorted and are regularly gated under such circumstances.
Woodford Patient Capital (WPCT)
I’ve commented on this investment trust a couple of times on twitter, but not before on my blog. I sold a small amount short at after seeing in their annual report that they would be forced sellers of illiquid and probably overvalued assets in order to reduce / eliminate their gearing and also due to the likely demand / supply dynamics.
After looking at their holdings in more detail I saw that: a) some of their investments are identifiably worthless and/or would have great difficulty obtaining the required further funding b) some were clearly valuable c) others had potential that would take several years to manifest itself (or otherwise). Attempting to quantify this I estimated fair NAV to be around 33p, albeit with a high range of uncertainty. This compared to a stated NAV at the time of around 63p. This gave me the confidence to maintain my short until around a week ago.
It had long seemed certain that the unquoted and illiquid portion of the investments held in the sister Equity Income Fund would be sold prior any re-opening of that fund, and that the fire-sale prices of these transactions would be used to mark to market the valuations of investments common with WPCT. While the decision to entirely close Woodford’s Equity Income Fund would have brought this fact into sharper relief, I believe it was the resignation as Woodford as manager of WPCT focused minds on the possibility that WPCT’s unquoted assets could also be liquidated. A forced sale of unquoted assets from two funds at the same time would surely only be possible at a large discount and WPCT holders would be left with no way to benefit from any subsequent valuation bounce-back.
Added to the large proportion of the shares held by unsophisticated private investors and recommendations to sell e.g. from the Questor column it was hardly surprising that selling pressure forced WPCT down to around 30p per share yesterday on an unchanged stated NAV.
This morning it was announced that Schroders would be taking over management of WPCT and that they would continue with the same investment policy, i.e. no full liquidation of unquoted assets. Although they are introducing a management fee of 1%, this is reasonable for this kind of trust and the relatively high hurdle for performance fees suggests some confidence by Schroders in the portfolio.
This was clearly very good news and I identified it as such before the market open, however I completely failed to act or grasp the magnitude of the frenzy that was to follow. In the event there was a good opportunity with the first buy at 32p and around half a million shares traded below 33.5p in the first few minutes. High for the day was 40p and the close was around 38p.
The situation remains that several of WPCT’s holdings will be marked to market at fire-sale prices as the Equity Income fund liquidates, that several of the investee companies are likely to collapse when Schroders refuses to provide further funding, and that some of the better investments will need to be sold at a discount to pay down debt. Furthermore, fair NAV on a particular day will only ever be known years afterwards and Schroder’s peformance fee structure continues to provide motivation to flatter stated NAV.
It will be very interesting to see what happens to the share price tomorrow. Much will depend on press comment – there was a clear pattern of small punters selling and larger players buying throughout much of yesterday.
There is money to be made investing in funds over and above the underlying investment returns, despite fees and generally mediocre performance. As per my examples, excess returns can be made across various time-scales (years, months, days and even intraday), taking both long and short positions.
I monitor a number of closed-ended funds and will be writing again on the subject in future.