Hedge Funds Targeting Investment Trusts
A small but hardy band of hedge-fund activists focus their attention on specialist funds that have listed on the stock market – called investment trusts in the UK. Investment trust shares are listed on the stock exchange and trade like any other stock.
But because they’re closed ended (that is, the amount of money in the fund doesn’t change; investors can’t add to it or withdraw from it), the shares usually trade at a discount. The activists who target investment trusts are sometimes called arbs, but in reality they use a mix of activism and arbitrage to make money for their investors.
The big opportunity for investors is the discrepancy between the fund’s public share price and its net asset value.
The net asset value (NAV) of a listed investment trust is the total value of all assets minus any liabilities, divided by the number of shares in issue. If a fund has total net assets of £100 million (after any debts) and 100 million shares in issue, the NAV of the shares is £1 per share. The NAV is also sometimes called the net book value per share.
In many cases this discrepancy between values (the discount to net asset value) can be substantial; that is, the stock market share price can be well below the NAV. This discount can be as much as 20 per cent; for example, if the NAV per share of a fund is £1.00, its current stock market share price is only £0.80.
But sometimes this discount can be as much as 40–60 per cent, which means that a fund with NAV of, say, £1.00 per share may in fact be trading at just £0.40 a share on the markets.
Relatively low levels of discount (5–20 per cent) attract so-called arbitrage activity, where hedge funds encourage the fund managers to use any spare cash to buy back the shares at the NAV, thus closing the gap.
But very large discounts (over 40 per cent) attract activist campaigns, which usually consist of the hedge-fund manager demanding that the fund be wound up eventually and all assets sold off. In theory, if those assets within the fund reach their NAV, a hefty profit is realised over time.
Investors, especially in closed-end funds such as investment trusts, need to be especially careful about supposed NAVs stated in the reports and accounts. If a fund is forced to wind down and sell its assets in a fire sale, those assets can frequently end up being close to worthless! Sometimes the market is telling the private investor something in a massive discount to NAV!
As an activist, a discount of more than 40 per cent within a listed fund is likely to draw your interest, especially if the discount is in an asset class based in the developed world (the underlying assets are liquid and easy to sell).
Although an activist campaign rarely realises a 40 per cent discount, as a rough-and-ready guide you can make around half of that discount (if everything goes to plan!). Sometimes activists merely force the fund manager to do the selling and then buy the shares back from investors.