Investment Funds. Figure 1: Discount trends Morningstar All funds ex VCT, ex 3i

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1 3 March 2014 Discounts tighten - ahead of fundamentals? Investment Funds A discount opportunity amid a broader lack of value A key trend in the closed end fund market in recent years has been the erosion of relative value. Even the most highly discounted funds have seen a notable closure of this asset price gap as global equity markets have risen and risk appetite has firmed. Discounts provide attractive entry points to key asset pools, but they also need to reflect a variety of fund and market risks. In order to maximise returns and minimise discount risk (and potential underperformance), we believe that investors need to increasingly focus on valuations as a means of sustaining and enhancing returns. Investment trust bargains in short supply As Westhouse highlighted in our forward review for 2014 (Rising expectations, but are recent returns sustainable?), the average weighted discount across the entire investment trust sector had narrowed to multi-year lows of just 2.7%. This has even occurred in asset classes where there has been a relative absence of (absolute or relative) NAV growth and at a time when underlying company earnings growth has fallen below expectations. Yield has also been an ongoing determinant of this higher pricing, perhaps understandably given still low interest rates. While discount compression on strong performing funds and previously distressed asset classes (private equity, UK smaller companies) has been ongoing for some time, recent months have also seen a narrowing on discounts of historically weaker performing funds as the market seeks out remaining value plays. This implies risks that investors may be overpaying for often weak performing or even higher risk assets. Investment Funds United Kingdom This is an extract from The View From The Tower published on 3 March 2014 Figure 1: Discount trends Morningstar All funds ex VCT, ex 3i Analyst Paul Locke paul.locke@westhousesecurities.com Priced at close 25 February 2014 *Westhouse acts as broker and/or advisor to this company /13 10/13 08/13 06/13 04/13 02/13 12/12 10/12 08/12 06/12 04/12 02/12 12/11 10/11 08/11 06/11 04/11 02/11 12/10 10/10 08/10 06/10 04/10 02/10 12/09 10/09 08/09 06/09 04/09 02/09 Sector ave Source: Morningstar, Westhouse Securities. Market cap weighted average Of course, in many cases, the discount compression we have seen has provided a huge fillip to investors, allowing them to generate positive returns at both the NAV and price levels and, for many funds, significantly exceed the returns provided by the market alone. Particular beneficiaries in recent years include funds exposed to UK smaller companies, Japanese equities and the biotech space. Ave Westhouse Securities is authorised and regulated by The Financial Conduct Authority and is a member of The London Stock Exchange. Registered Office: Heron Tower, 110 Bishopsgate, London, EC2N 4AY. Registered in England Number: Bloomberg WSTH<GO>

2 For example, the average weighted rate of NAV growth in the UK smaller companies trust sector over the last five years has been 300%, comfortably beating the FTSE Smaller Companies (ex ICs) Index with a return of 250%. Yet on a total return basis for the same sector, investors have enjoyed weighted pricing returns of 389% as discounts narrowed from multi-year highs following the global financial crisis. But discount slippage could augment underperformance This raises significant questions for investors currently exposed to, or those seeking access to, the sector. It certainly creates a counter balancing risk if markets do not sustain their gains, if earnings growth continues to disappoint, or simply if investors choose to take profits on relatively tight discount levels on selected funds. Any significant re-emergence of discounts from current levels could mean that holders risk underperforming the market. This is particularly appropriate on asset classes where strong premium ratings have taken hold, underpinned by an attractive yield, but where levels of NAV growth have often disappointed. With discounts narrow, however, there are alternative opportunities for investors to explore. One of these is The World Trust Fund* (WTR.L, -10.1, Buy) managed by Lazard Asset Management. WTR, capitalised at 88m, forms part of the group s discounted asset strategy, a strategy where it currently operates some US$5bn in capital. These assets include closed end funds and investment trusts, as well as other holdings companies whose shares are listed and trade on various international exchanges, and broadly trade at a discount to their asset value. Such discounts can provide protection in weaker markets (as long as they do not widen further) and generate excess returns in both negative and positive market environments if they narrow. Such narrowing could occur naturally if, for example, the fund is underresearched and comes to the wider attention of investors, or through active engagement that provides a specific catalyst to narrow or eradicate the discount. The latter can include share buy-backs or tenders (at a discount narrower than the market), or other factors such as a change in management or management group. Figure 2: Key holding discounts, December 2013 Figure 3: Key holdings, December WTR (portfolio) WTR (key holdings) WTR Morningstar ave Eurazeo JPM Japanese JPM Euro SMC JPM Emerging Citic Securities Swiss Helvetia Tri Continental Gen American BB Biotech First Pacific Source: Morningstar, Lazard Asset Management, Datastream. All funds ex VCTs, ex-3i; Ave weighted discount of top 10 holdings (% of NAV) Citic Securities 7.1 First Pacific Co Ltd 6.8 JPMorgan European Smaller Cos 6.1 General American Investors 6.0 Eurazeo 6.0 BB Biotech 4.3 Tri Continental 4.2 JPMorgan Japanese 4.2 JPMorgan Emerging 4.0 Swiss Helvetia 4.0 Total 52.7 Alpha delivery and a tightening discount Readers of Westhouse's funds research may already be familiar with one of WTR s key holdings, that of BB Biotech (BION SW). This Swiss-listed fund is exposed to the biotech space, an area of significant pricing growth in recent years. Yet while one UK-listed fund with strong portfolio and sector similarities (Biotech Growth Trust, BIOG.L) has enjoyed 10 Westhouse Securities

3 significant discount re-rating in recent years, even moving to trade at a premium, BION has attracted a sustained, double-digit discount to its asset value, which reached over 30% in late Yet for WTR, holding the higher discounted asset has its advantages from a number of perspectives, particularly if the management of the underlying assets is credible, if the fund is simply lacking wider publicity, or if pressure can be applied for the discount to be narrowed. In the case of BION, in 2013, the company, in a bid to address its discount, announced that it would both pay a dividend and conduct a share buy-back, each adding to the attractions of the fund. More work to be done This may represent just the start and further corporate governance steps may still be needed for the BION discount to come down to comparable levels with other biotech funds in both the UK and the US. Yet reflecting the maximising impact that can be made through purchasing discounted assets, investors holding BION over the last year would have comfortably outperformed the often premium-rated BIOG (on a full, Sterling-adjusted basis) both at the NAV level and particularly at the price level as discount compression took hold; the BION discount narrowed from over 30% in September 2013 to under 20% in February This discount narrowing and strong NAV growth proved particularly beneficial to the WTR NAV, providing the fund with strong market outperformance on this stock. Figure 4: Relative price and NAV performance BION vs. BION (12M) BION SW Price NAV BIOG LN Source: Bloomberg, Westhouse Securities WTR does not solely invest in closed end funds, with significant stakes in a broad variety of holding companies where the asset value of the sum of its constituent parts effectively exceeds the price on the stock itself. One of these is the Hong Kong-listed China Merchants China Direct Investments or CMCDI (133 HK). At the end of January 2014, the company stood at a 59% discount to its consolidated NAV of US$ The company invests predominantly in Chinese companies ahead of their potential IPO, which would suggest elevated risk. Yet it also has sizeable stakes in well-known listed companies, such as China Merchants Bank (3968 HK). Crucially here, the value of the listed CMCDI portfolio broadly matches that of its own share price. This means that the CMCDI share price does not take into account either the group s significant cash holdings (some 14% of total assets), or any value to be derived from the unlisted portfolio. So, the unlisted 11 Westhouse Securities

4 holdings provide the investor with an effective warrant on future growth and any upside gain not being priced into the holding company s share price. Crucially, with representation on the board, Lazard AM would appear to be in a potentially strong position to extract further value from the stock moving forward. Strong, discounted exposure to China Discount initiatives boost NAV Companies such as CMCDI also underpin the fund s strong overweight position to the Chinese market, where the fund has 11.3% of its assets vs. just 2.1% for the MSCI AC World Index. This forms part of a broader overweight exposure to Asian markets in general, with strong allocations to Japan (10.3%) and the Philippines (4.8%). The Chinese exposure is designed to take advantage of key trends in urbanisation and growing private participation in the economy, as well as social and political reform. It is also actively targeted at small to mid-cap private companies and those in the financial services space, where Lazard see twin benefits from both strong current discounts and downstream growth benefits of this reform programme. WTR comprises around of the highest conviction ideas drawn from the group s discounted assets team and provides significant diversification at both the top and bottom line levels. With a headline discount of 10.1%, far wider than the trust sector average of just 2.7%, the fund also provides a further see-through discount on its underlying investments of some 20%. The objective of the trust is to achieve long-term capital appreciation and it can do so through both enhancements to the asset value of underlying holdings, and/or discount compression. The fund can also use hedging with the Board s approval, with ETFs used as the prime source of any hedge and, if applied accurately, this can maximise gains derived from discount compression. Key to the success of the fund remains a combination of the performance of a given asset class, any excess returns delivered by a particular fund vs. its benchmark and the gains utilised from any discount capture. Discount capture is not necessarily a rare or sporadic event and reliant solely on the liquidation of one large holding, but spread relatively evenly across the portfolio and could be derived from a number of situations. These can take many forms, although historically they have been dominated by tender offers, share buy-backs and restructurings, rather than outright liquidations. This keeps the underlying asset going, providing potential ongoing discount opportunities and NAV growth delivery. Recent examples have included participation in tenders for funds such as Advance Developing Markets* (ADMF.L) and Swiss Helvetia (SWZ.N), while WTR has also benefitted materially over an extended period from a combination of both repeat tenders and a strengthening NAV on its investment in JPMorgan European Smaller Companies (JESC.L). But NAV and discount enhancements can also be derived from more passive means including changes in management or management that potentially provides a spark to discount compression, with Lazard having exposure to recent examples where this has occurred including Edinburgh Worldwide Investment Trust (EWI.L) and Japan Equity Fund (JEQ.N). As well as potential discount management at the underlying portfolio level, WTR also provides investors with an attractive discount in its own right, as well as a second layer of discount (the so called see-through discount) in its underlying portfolio. In terms of its own shares, strong downside protection is provided through the fund s discount control mechanism (DCM). Once more, we feel that this is particularly relevant to investors when broader discounts in the trust universe are trading so tightly with, in many cases, little or no downside protection should sentiment turn and discounts widen. 12 Westhouse Securities

5 Figure 5: WTR Price, NAV, discount (5Y) Source: Company data, Westhouse estimates Discount protection on WTR The Board of WTR has been active in managing the fund s discount through a recent tender and via share buy-backs. Following recent changes, WTR now provides a DCM based on both the absolute level of the WTR discount and the NAV performance of the fund. Moving from a system where the fund conducted a share tender if the average discount exceeded 10% in a pre-set period ahead of the financial year end (31 March), the Board will now, subject to shareholder approval, conduct a tender for up to 15% of the issued share capital at a 2% discount to NAV if: The shares trade at a discount of more than 10% over the financial year; and The company s NAV (total return) performance over the preceding two financial years has underperformed the benchmark (MSCI AC World Index) by more than 1% pa. With the global economic picture remaining somewhat mixed, it arguably remains something of a paradox that many trust discounts have narrowed so significantly and, in some cases, now arguably fail to reflect forward risks. In terms of conventional investment trusts with a London listing, over 30% of these funds attract a premium to their asset value. Almost two thirds of these trusts attract either a premium or a single-digit discount. And unlike WTR, many of these funds are simply exposed to plain equities or debt and provide no second level of discount that can be managed and extracted. At a time in the Trust sector s history of increasingly rare value opportunities, we believe that investors should be increasingly cautious in terms of overpaying for closed end funds this on a risk and performance-adjusted basis. While we are still arguably at the start of a more positive economic cycle, trust discounts taken as a whole appear somewhat fully priced and ahead of the economic curve, which can add to forward risks of underperformance. This is where a fund such as WTR can play a pivotal role. As well as providing the investor with market exposure and potential Alpha delivery through management and fund selection, it goes one step further. This involves providing access to a broader pool of often heavily discounted assets, a feasible and proven process of engagement with boards and companies to realise the inherent value in these discounts and, through its own DCM, a backstop to excessive discount widening on its own shares. 13 Westhouse Securities

6 Investment Funds Contacts at Westhouse Securities Matthew Kinkead IF Research +44 (0) Paul Locke +44 (0) Darren Papper +44 (0) IF Corporate Finance Alastair Moreton Calum Summers +44 (0) (0) Hannah Young Chris Young +44 (0) (0) Darren Vickers Pauline Tribe +44 (0) (0) Westhouse Securities

7 Chief executive Explanation of recommendations Westhouse Securities Limited uses a three-tier system for its investment funds recommendations. Investors should carefully read the definitions of all ratings used in each research report. In addition, since the research report contains more complete information concerning the analyst s views, investors should carefully read the entire research report and not infer its contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor s decision to buy or sell a stock or investment fund should depend on individual circumstances (such as the investor s existing holdings) and other considerations. Investment funds ratings are explained as follows: BUY: Total returns expected to be in excess of those from the fund s benchmark HOLD: Total returns expected to be in line with those from the fund s benchmark SELL: Total returns expected to be lower than those from the fund s benchmark Total return is defined as the movement in the share price over the medium- to long-term, and includes any dividends paid. Distribution of Westhouse Securities Limited s investment funds recommendations: Westhouse Securities Limited must disclose in each research report the percentage of all investment funds rated by the member to which the member would assign a BUY, HOLD or SELL rating, and also the proportion of relevant investments in each category issued by the issuers to which the firm supplied investment banking services during the previous 12 months. The said ratings are updated on a quarterly basis. This recommendation system differs from the recommendation system used on non-investment Fund research. Investment Funds recommendation breakdown: June 2013 BUY HOLD SELL Overall Investment Funds coverage excluding AIM 100.0% 0.0% 0.0% Funds to which Westhouse has supplied investment banking services excluding AIM 100.0% 0.0% 0.0% Source: Westhouse Westhouse acts as broker or advisor to ADVANCE DEVELOPING MARKETS FUND, ALTERNATIVE ASSET OPPORTUNITIES PCC, BLACKROCK SMALLER COMPANIES TRUST, BLACKROCK THROGMORTON TRUST, CQS RIG FINANCE FUND, INVESCO ASIA TRUST, INVESTMENT COMPANY (THE), MAJEDIE INVESTMENTS, RIGHTS & ISSUES INVESTMENT TRUST, TALIESIN PROPERTY FUND, TR EUROPEAN GROWTH TRUST, UNITECH CORPORATE PARKS, UTILICO EMERGING MARKETS, UTILICO INVESTMENTS, THE PROSPECT JAPAN FUND, THE WORLD TRUST FUND. Westhouse acts as a market maker or liquidity provider for ADVANCE DEVELOPING MARKET LT, ADVANCE FRONTIER MARKETS FUND, ATLANTIS JAPAN GROWTH FUND, ABERFORTH SMALLER COS-ORD, ALLIANCE TRUST PLC, BAILLIE GIFFORD JAPAN TRUST, BLACKROCK COMMODITIES INCOME, BLACKROCK LATIN AMERICAN INV, BLACKROCK NEW ENERGY INVESTM, BLACKROCK SMALLER COMPANIES, BLACKROCK THROGMORTON TRUST, BLACKROCK WORLD MINING TRUST, BRITISH ASSETS TRUST PLC-ORD, BRITISH EMP SEC AND GEN-ORD, CALEDONIA INVESTMENTS PLC, CITY NATURAL RESOURCES HI Y, EDINBURGH DRAGON TRUST PLC, EUROPEAN INVESTMENT TRUST PL, FIDELITY ASIAN VALUES PLC, FIDELITY EUROPEAN VALUES PLC, FIDELITY JAPANESE VALUES PLC, F&C PRIVATE EQUITY TRUST-O, F&C PRIVATE EQUITY TRUST-PRF, FOREIGN & COLONIAL INVEST TR, FIDELITY SPECIAL VALUES PLC, GLOBAL FIXED INCOME REALISAT, GENESIS EMERGING MARKETS, HENDERSON EUROPEAN FOCUS TRU, HENDERSON EUROTRUST PLC-ORD, HERALD INVESTMENT TRUST PLC, HENDERSON SMALLER COMPANIES, HENDERSON VALUE TRUST PLC, INVESCO ASIA TRUST PLC-ORD, IMPAX ENVIRONMENTAL MARKETS, INDIA CAPITAL GROWTH FND LTD, INFRASTRUCTURE INDIA PLC, INVESCO PERPETUAL ENHANCED INCOME, INVESTMENT COMPANY PLC, INVESCO PERP UK SMALLER COS, INVESCO INCOME GROWTH TR-ORD, JPMORGAN ASIAN INVESTMENT TR, JUPITER EUROPEAN OPPORTUN TR, JPMORGAN EUR SMALLER COMPANI, JPMORGAN EUROPEAN INV-GROWTH, JPMORGAN EUROPEAN INVEST-INC, JPMORGAN JAPANESE INV. TRUST, JUPITER GREEN INVESTMENT TR, JPMORGAN INDIAN INV TRUST, JPMORGAN EMERGING MKTS TRST, JPMORGAN JAPAN SMALLER CO TR, JAPAN RESIDENTIAL INVESTMENT, LAW DEBENTURE CORP PLC- ORD, MONKS INVESTMENT TRUST PLC, MERCANTILE INVESTMENT TRUST, MITON WORLDWIDE GROW TRU PLC, MURRAY INTERNATIONAL TR-O, NORTH ATLANTIC SMALLER COMP, NEW INDIA INVESTMENT TRUST, PACIFIC ASSETS TRUST PLC, POLAR CAPITAL TECHNOLOGY TR, POLAR CAPITAL TECHNOLO-SUB S, PACIFIC HORIZON INV TR PLC, RENEWABLE ENERGY HLDGS PLC, CQS RIG FINANCE FUND LTD, RIGHTS & ISSUES INV TR-CAP, RIGHTS & ISSUES INV TR-INC, RENN UNIVERSAL GROWTH-ORD, SCOTTISH AMERICAN INV COMP, SCOTTISH INVESTMENT TRUST, SCHRODER UK MID CAP FUND PLC, SCHRODER ASIA PACIFIC-ORD, SCHRODER JAPAN GROWTH FUND, SCOTTISH MORTGAGE INV TR PLC, TEMPLETON EMERGING MARKETS-O, ALTERNATIVE ASSET OPPS PCC, TALIESIN PROPERTY FUND LTD, TALIESIN PROPERTY FUND LTD ZERO PREFERENCE SHARE, THE PROSPECT JAPAN FUND, TR EUROPEAN GROWTH TRUST PLC, UNITECH CORPORATE PARKS, UTILICO EMERGING MARKETS LTD, UTILICO INVESTMENTS, UTILICO INVESTMENTS-ZDP 2014, UTILICO INVESTMENTS-ZDP 2016, UTILICO INVESTMENTS-ZDP 2018, RENEWABLE ENERGY GENERATION, WORLD TRUST FUND, WORLD TRUST FUND SICAF-CW14. 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