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Bargain basement funds

Created:

12 August 2008

Written by:

David Stevenson

Over the past few years the London stock market has internationalised at an astonishing rate - dozens of global companies, many of them based in emerging markets, have chosen to list their shares on either the main market or its junior sibling, the Alternative Investment Market (Aim). This globalisation has been particularly pronounced in the world of investment funds - just a few years ago this slightly cosy sector was dominated by generalist investment trusts such as Alliance Trust. Not anymore - the closed-end listed fund sector has been utterly transformed with a host of new funds.

Well over 60 funds were launched over the past few years, with a daunting variety of highly specialised investment strategies. Most of the funds cluster around one or two major strategies - property and emerging markets, with more than a few specialising in both.

Fund managers range from local outfits - Vinacapital and JSM Indochina (like many of the growing number of Vietnamese funds it's based locally with Western management) - through to London-based hedge funds (Principle Capital and Charlemagne Capital are particularly active in this sector) and traditional fund management groups (Progressive Fund management runs the Advance Frontier Markets fund). This huge variety plus the very specialised investment mandates in operation have tended to put off smaller private investors. It also doesn’t help that many of the funds price their shares in dollars.

But in recent months it's not just wary private investors who’ve been avoiding the closed-end fund space - institutional investors have taken flight from anything perceived as risky, selling down small caps, emerging markets and property stocks. This flight from risk has had a deadly effect on this still small, but growing, sector of funds - share prices have crashed and nearly every fund in my shortlist of top funds (see table) has seen a substantial price drop in the past 12 months

That aversion to risk has not been without good reason - a number of key issues have emerged that have focused investors' minds on corporate governance and the fund’s investment strategy in particular. It's clear for instance that many funds timed their initial public offerings (IPOs) at a spectacularly bad point and are now struggling to find ways to invest their money. Take the Ottoman Fund as one example. This raised £150m back in December 2005 to invest in big Turkish residential property developments - the manager then was Development Capital Management (Jersey Ltd). It got off to a promising start and seemed to be riding the wave of new developments on Turkey’s western seaboard, and particularly around the Bodrum and Istanbul areas. Fast forward two years and the market has suddenly changed beyond all recognition - Turkish domestic confidence has taken a hit following on from a political squabble between the military and the AKP-led government while foreign property investors have also started to shun many of the big resorts as property prices in the UK have taken a battering. It's little surprise then that its manager has finally thrown in the towel - back in November the fund announced that “the company would realise assets in a managed way over the next 18-24 months, returning proceeds to shareholders". As the fund is wound down, cost are being cut and the fund recently disclosed that it intends to terminate the fund management agreement with effect from the end of the year.

Another slightly less drastic example comes in the guise of London Asia Capital and its private equity offshoot London Asia Chinese Private Equity Fund Ltd. Again, this seemed like a great idea at the time - a specialist fund, advised by London Asia, that would invest in small-to-mid cap companies about to be floated or already on Western markets. To be fair, most of its investee companies seem to have prospered, but the timing was dreadful. Chinese stocks are down at least 50 per cent from recent highs and heading even lower, with small caps particularly badly hit. That huge downward pressure - Indian small-cap investors have suffered similar falls - has made valuing Chinese investments very difficult and the parent company London Asia recently suspended its shares while the management worked out what the company was actually worth.

The Dawnay Day fiasco is yet another interesting twist on the sector’s problems - the once sprawling property-to-investment banking empire set up three specialist property funds that invested in German and East European commercial property. All three have done more than a passable job of growing their assets in difficult markets - real estate is clearly not a great sector to be in at the moment - but the investment companies were caught up in the collapse of the overall group. Although separate legal entities, their shares were forced down as the group’s owners sold shares to cover wider group investment losses. Management of the companies has now been transferred to the fund managers and the shares look like they might be about to move upward again (the Carpathian fund has shot up in price), but this fiasco has reminded investors that the quality and provenance of the fund manager is hugely important in this specialised sector.

But there’s an even bigger, more systemic problem underlying the big share price falls across this varied list of funds: no matter how good the manager is, if the sector is out of favour, the fund will do badly. Take the Prospect Epicure J-Reit (real-estate investment trust) Value Fund. This is widely regarded as a well-run fund that just so happens to be in the wrong sector at the wrong time - its regular investor report (a model for the sector) is full of expert commentary on why the Japanese real-estate investment trust space has been going from bad to worse. Many smart investors reckon this fund could shoot ahead if Japan recovers its poise - but that’s a big if. In recent months, falls of 10 to 15 per cent have not been uncommon as Japanese institutions have sold down their holdings. The managers in the underlying Reits have desperately cut their debt back to very low levels, and stepped up their management of net asset values, but all to no avail. Shares in the Prospect fund have fallen from 96.5p at launch to their current low of 36.5p - this massive fall should act as a warning to investors that huge share price falls can and will happen.

Nevertheless there’s reason to think that the recent share price falls in the closed-end fund sector are overdone. Property prices are falling and emerging markets will undoubtedly have a rough time in the next two years but some of the discounts to net asset value are now positively gargantuan. Many of the big institutional investors, for instance, have been issuing buy notes on Indian township developer Hirco, noting the very wide divergence between its stated net asset value of over 650p a share and its current 261p share price. Panmure Gordon for instance initiated coverage back in February with a 'buy' note and a 679p price target. It lauded Hirco's unique approach to Indian real estate development based around visionary land aggregation, infrastructure investment and tax-efficient sustainable mixed-use development. Panmure Gordon said it forecasts a net asset value (NAV) of 799p for 2008, 927 pence for 2009, and 1,075 pence for 2010. The broker sees 81 per cent upside potential from the current share price. That optimism was backed up recently by another buy note, from HSBC this time, rating the shares 'overweight' with a price target of 575p - it described the group as a premium developer at an attractive price with a 50 per cent potential return despite the weak property price outlook.

Dawnay Day Carpathian is already labouring under a 64 per cent discount to NAV and pays out a huge dividend yield (15 per cent) . Over at Dolphin Capital, the house broker even put out a recent note that claimed that NAV for the Med-based second home developer might actually increase from its current 227p to over 285p by the end of 2008. The share price though has continued to sink south to 91p a share - at these levels over half the share price is accounted for by cash on the balance sheet. Crucially directors in these funds have noticed the huge discrepancy in valuations and have been aggressively buying back in shares - the boss of Dolphin has been on a buying spree in recent months and has bought over £2m-worth since January. This kind of aggressive share buying by senior fund managers is also evident throughout the sector, but especially at Vietnamese and Cambodian property developer JSM Indochina. Here the main fund manager has purchased over £3m in recent months. Managers at South African private equity fund Blackstar have also been aggressively buying back shares.

Managers have also been switching focus, selling off peripheral developments and focusing on a smaller number of investments to realise shareholder returns - Equest in Eastern Europe is a good example - while some funds (Atlas Estates for instance) have decided to stop paying dividends to conserve cashflow and maintain a strong balance sheet. Part of this sector-wide refocus has been prompted by the interest of shareholder activists and arbitrageurs - Carousel is a big shareholder at Bulgarian land Developments and Laxey has been buying shares in Hirco. Private investors should expect these big activists to keep piling on the pressure at these funds, pushing for managers to narrow the discount to net asset value at all costs.

Why funds launch offshore

The young global upstarts frequently avoid a formal investment trust listing and opt instead for an offshore domicile - the Channel Islands, the Isle of Man and Luxembourg are popular - with shares fairly easily traded via any stockbroker. This offshore domicile is partly for tax reasons - many of the funds deliberately operate in international jurisdictions and don’t want to pay UK tax - but mainly because the funds are aimed at more sophisticated wealthy investors and institutional funds who are familiar with buying very specialised funds offshore.

My shortlist of top funds

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