What investment trusts are doing about inflation

As the market turmoil builds it is getting harder and harder to call short-term market moves – witness the rally in markets on the Wednesday after the Jubilee weekend, when many commentators were predicting sharp falls.

Anecdotally brokers tell me that volumes are very depressed. The average investment company discount seems to have narrowed which might suggest that investors are still optimistic or it might be the consequence of inaction in response to falls in net asset values (NAVs).

By the time this article is published we could have had definitive action on Greece and the other troubled eurozone countries, but my best guess is that the politicians will have found another way of keeping the plates spinning for a little while longer.

With China, the main engine of world growth, now stuttering, central banks may be forced to print money to recapitalise the banks. The spectre of inflation seems to be growing.

A few investment managers have been concerned about the threat of inflation for some time and their portfolios are positioned accordingly. For instance, Capital Gearing and Ruffer both have high weightings to index-linked bonds. I have struggled to recommend these funds in the past because have both traded at a high premium to asset value. In recent times their ratings have moderated a little.

Capital Gearing’s recent results (published on 29 May and covering the year to 5 April) showed a 3.2% fall in the share price against a 9.3% rise in the asset value over the year. This still left the fund trading on a 4% premium. That is a pretty impressive NAV performance, however (the UK market fell about 4.5% over the same period).

In his report accompanying the results, Capital Gearing investment manager Peter Spiller said inflation now looked much more likely than a deflationary slump. He has increased the weighting to index-linked government bonds at the expense of conventional government bonds.

I thought it was interesting that he has even been selling his German bonds as he worries Germany’s long-standing record of fiscal responsibility could be compromised by last-ditch efforts to save the euro. If he is right, and I think he may be, there are going to be an awful lot of fingers burnt as one safe haven turns out to be not quite so safe after all. Spiller is also looking to make money from discount narrowing in the investment company sector.

The fund’s largest investment trust holding is a stake in North Atlantic Smaller Companies fund, currently trading on a 32% discount. This is not a fund that can easily be persuaded to tackle its discount however, as 23% of it is held by its investment manager, Chris Mills. The rest of the investment trust portfolio is quite diverse. It includes funds such as Private Equity Investor (which I also hold), which is slowly returning capital to shareholders through tender offers.

While the average discount may have narrowed, there are quite a few discount narrowing opportunities out there. We are still seeing shrinkage of the hedge fund sector.

In recent weeks, Cazenove Absolute Equity has thrown in the towel. It has struggled to control its discount for some time.

Last year it changed the investment policy and introduced regular tender offers but this did not solve the problem. Now it is recommending shareholders vote against continuation at the forthcoming AGM and says at least 60% of shareholders are behind this plan.