Look for discount bargains in less liquid assets

Just over a year ago, bargain-hunting among investment trusts was apparently easy – as long as one didn’t believe it was ‘different this time’ or that the financial world was ending – though few people were saying it was easy at the time. Many good ITs with easily valued, liquid assets stood at unusually wide discounts.

Now that a more normal market environment has resumed (albeit with a grim outlook), bargains are harder to find.

So where can we now accept discount risk and expect to earn an enhanced return in payment? Probably not in UK income and growth ITs (which typically trade at no discount), and probably not in the big international generalists (which mostly trade at real discounts of less than 10%). Instead, the discount bargains lie, as usual, in areas that are not the obvious first thing to buy when easing back into buying mode.

Given the horrendous events of 2008, that points towards higher volatility ‘niche’ areas, geared funds and, in particular, less liquid underlying assets.

Just as investors ‘learn’ that risk and leverage are good things after a few years of a bull market and bad things after a crash, so investors ‘learned’ that less liquid asset classes offered the next best thing to a free lunch in 2004-2007, and that liquidity was the only thing that mattered in 2008.

The other half of this argument applies to the mainstream sectors, of course. So an investor who doesn’t want too much discount risk in a portfolio may also want to make changes.

It would be a strange decision to give up on (say) Bruce Stout or Neil Woodford or Philip Gibbs but all of those managers have ITs that trade at a material premium – and comparable open-ended funds that do not. A few switches may be in order.

On the buying side, we should expect to find underpriced ITs in sectors like property, private equity and funds of hedge funds. These are areas where IT discounts will swing around widely over time, as changes in investor sentiment cannot be reflected quickly in funds getting bigger or smaller. Thus, open-ended funds turn out not to be so open after all if everyone wants to redeem, while the ITs stay liquid (in principle) and let their discounts take the strain of a mismatch between buyers and sellers.

In private equity, for example, Conversus Capital, Electra and even the riskier Candover all look too cheap at discounts of 22% to 38%. In commercial property, the ING and Invista ITs trade at discounts of 15% to more than 40%, and all look too cheap. In funds of hedge funds, the ITs from BlackRock, Thames River and Altin trade at discounts close to 20% – that sector will contract further in the next two years, and those discounts will probably narrow.

This does not mean that today is the day to increase portfolio exposure to all these areas – most are intrinsically volatile, and many investors will have decided after 2008 that they want 0% in these asset classes. However, for those who have not, 2010 looks an unusually good time to be a buyer, and ITs like these (though necessarily very far from low risk) look an unusually good way in.

There are still bargains in mainstream areas, too. Fidelity has a good team in Europe, yet its IT trades on about a 16% discount. So do Schroder Japan, Herald, BlackRock World Mining and Ecofin. For investors who want to add in any of these areas, cheap ITs like these look appealing.