Emerging markets may be the one bright spot in investment trusts, a sector that is still under-performing

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The Independent Online
Towards the end of last year, I wrote about the investment trust sector and how it seemed to be facing troubled times. I said consolidation looked inevitable, with the market suffering from oversupply and also a worrying deterioration in the general level of discounts, where the price of shares in the trust is less than the value of its underlying assets. The warning proved timely, since there have been a number of further disappointments since then.

With the exception of overseas specialist trusts, the discount gap has mostly failed to narrow; and in the case of general trusts, the gap between share price and net asset value is, at an average of 14 per cent, about as wide as it has been at any time in the past year. For new investors, this is still an interesting buying opportunity, but for those who are already shareholders, the deterioration in ratings over the past couple of years is a disappointment.

The strength of sterling has knocked the sector back and there have been other worries, including the various tax changes in the Budget. Apart from the ending of ACT tax credits, which will hit higher-yielding trusts but has been priced into the market, the main issue is what the promised review of capital gains tax might throw up.

The great threat which has hung over the general diversified investment trusts for years is that many of the big investment institutions might want to dispose of their big shareholdings. Whereas 20 years ago, it was common for life assurance companies and others to place a portion of their investment funds with general trusts for them to manage on their behalf, most now prefer to make their own investment decisions. If they give money to investment trust managers, it is mainly to those who run specialist sector or country funds which the institutions cannot so easily replicate themselves.

To date, they have been restrained by the large capital gains tax bills they stand to incur if they realise their holdings. But if the review of the taxation system promised by the Chancellor, Gordon Brown, results in some form of tapered CGT system, designed to encourage longer-term investors, it could change the whole ball game. It is too early to guess how things might fall out in such circumstances, but it adds another interesting challenge to a sector already facing threatened competition on the retail front from a new breed, the open-ended investment company (OEIC).

A look at the sector fund flow statistics for the first half of the year shows that concerns about its health are not without foundation. While unit trusts have enjoyed a bumper year for sales, the same is not the case for investment trusts. In fact, during the first half of this year, there was a net outflow of funds from the sector for the first time since 1990.

Of the pounds 980m of new money that came in, roughly half was in the form of debt rather than equity. New issues brought in barely more than pounds 200m - a far cry from the bumper year of 1994, when two investment trusts each raised pounds 500m from the retail public. The biggest outflow of funds was the decision by the British Investment Trust to turn itself into a unit trust. Unitisation is one of the routes by which investment trusts try to overcome the effect of a deteriorating discount.

As the table shows, the average level of discount on investment trusts is still 10-15 per cent. Although Japanese trusts have responded to the recovery in the Tokyo stock market this year (up 19 per cent in sterling terms), only North American trusts are trading anywhere near their lows for the year in terms of discount, and one has to wonder how long that can persist, given the buoyancy of the US stock market.

The worst problems are in the smaller companies section. As has been widely noted, virtually all the strength in the London stock market this year has come from the largest companies. The Footsie index, which broadly represents the performance of the largest 100 companies by market capitalisation, is up 28.5 per cent over the past year. But the FTSE 250 index, which measures the next tier of medium-sized and smaller companies, has risen only 1.5 per cent during the same period.

What we are seeing is a blue chip rally, and it is no surprise that the specialist smaller company trusts are taking a beating. Yet the strength of Footsie is not doing much good even for those general trusts which closely follow the main market indices. The Alliance Trust, for example, has grown in net asset value by 15 per cent over the past year, but is still languishing on a 16 per cent discount. Scottish Mortgage is selling on a discount of just under 14 per cent.

Of course some of the better quality, more specialist trusts are still selling on low discounts, reflecting either exceptional performance or other special factors.

My conclusion is that buying a good name general trust on a 15 per cent discount looks a good bet on a two-to-three-year view. I am not persuaded that the time has yet come to switch back from blue chips to smaller companies.

A combination of low inflation and tough anti-inflationary policies (the combination we now seem to be heading for in the UK) is one that tends to favour larger companies.

One area where I think we could see positive action in the near future is in the emerging market sector. After the euphoria of the early 1990s, the performance of emerging markets generally has been dull over the past two years.

It has become a very selective game, where you need to be invested in the right markets to have much chance of making a decent return.But could that now be about to change?

The analysts at Credit Lyonnais Laing are one team who think there is now good value to be found in some of the general emerging market trusts, and I am inclined to agree with them. Discounts here are mostly over 10 per cent and the outlook for the sector is generally more positive than for some time, with price/earning ratios down from their former stratospheric level to around 14 times on average. They could be one bright spot in an otherwise still unexciting sector outlook.

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