For an investment trust what investors – both buyers and sellers – are looking for in terms of liquidity is the ability to transact with the minimum amount of price disruption in the maximum volume desired.
According to one institutional investor: “On day one of an investment trust there should be low expectations of liquidity. Maybe even none. Everyone has bought into an idea. The shares are trading at or around net asset value (Nav). Expectations are high.”
What happens next depends on a combination of skill, luck and sentiment. If the timing is good for the asset class, and the manager does a good job, the shares remain popular and in demand. Roughly two years out, however, investors’ objectives may begin to change.
For an institutional investor, the real value of the closed-end fund structure today is in the conversion of illiquid or esoteric strategies into marketable securities. This means investing for cashflows with the prospect of realisation of the investment at some point in the future, as opposed to trading.
For an individual private investor, the value may be stability and lower ongoing costs.
Investment trusts typically weather market volatility better than their open-ended counterparts because they are not forced sellers of assets at exactly the wrong point in the market cycle.
Two years out from launch, normal turnover commences in the trust’s shares. An investor is able to obtain a ‘daily mark’ by reference to the price on the exchange (the share price) and to discover some liquidity when it really matters.
According to a specialist broker in alternative investment companies, the ‘daily mark’ is particularly valuable for an illiquid or esoteric underlying asset class where a regular valuation mechanism does not exist, for example, secondary interests in private equity funds.
Whether the shares trade at a 5 per cent premium or a 20 per cent discount, all investors have the opportunity to trade at that level. That is, assuming that the market price is a fair reflection of the value or prospects for the underlying portfolio. Unfortunately, shareholder communication can get stale and portfolio information and prospects fall out-of-date leading to share price ratings that are worse than reality.
So shares showing a ‘daily mark’ on a 40 per cent discount may not actually trade because no-one is willing to sell, even though there may be buyers. Share price volatility dramatically reduces liquidity, since there are fewer investors willing to deal with an unstable discount rating. This is one of the conundrums of investment trust investing and one of the issues that vexes investors.
Looking at the liquidity of investment companies generally, one adviser said that for a £100m investment trust he expects to see 0.15 per cent to 0.25 per cent daily turnover (£150-250k) whereas for a conventional smaller trust he would expect turnover of five times that amount.
That equates to roughly 3 per cent turnover per month for a £100m investment trust. Here are further statements from the same adviser: “liquidity is always a function of price” and “Liquidity may be obtained at the expense of value”.
