Don't be shy, ask ii...why do some trusts always trade on a discount?

13th January 2022 08:47

No question is a stupid one, so whether you want to find out what you need to do to start investing or how the stock market works, don’t be shy, ask ii. Email yours to: ask@ii.co.uk

Mr Wood asks: why do some investment trusts consistently trade at a price above net asset value (NAV) and others below? Are company share buybacks good or bad for investors? Is there a limit/ratio on share buybacks each year? And why do some trusts with what appear to be outstanding balance sheets receive so little publicity?

Kyle Caldwell (pictured above), Collectives Editor, interactive investor, says: with investment trusts there are two 'layers' of activity: the performance of the underlying investments held in the investment trust (the net asset value, or NAV), and its share price.

Each trust issues a fixed number of shares, which raises a fixed amount of money for the manager of the trust to invest in a portfolio of assets.

As with other shares traded on the stock exchange, an investment trust’s share price fluctuates according to supply and demand. If demand from investors for its shares is sufficiently high that it outstrips supply, an investment trust’s shares might trade at what is called a premium. Conversely, if demand is low, a trust might trade on a discount.

Research: Top Investment Trusts | Sustainable Funds List | Top UK Shares

Investors who buy an investment trust that is trading on a premium are paying more than the underlying investments – the NAV - are worth. The opposite is true when a trust is trading on a discount; here new investors are potentially picking up a bargain.

Discounts

Some trusts do persistently trade on a discount. In many cases this is down to a lack of investor appetite for its shares and a lack of share buybacks being made by its board.

Low demand for an investment trust’s shares could be down to its performance not standing out from the crowd. It could also reflect poor investor sentiment to either the region or sector of the market that the trust invests in. It might be because its investment style is out of favour, or because it has a low dividend yield or doesn’t pay a dividend at all.

Trusts with a low profile can also trade at discounts to NAV. Some trusts are managed by boutique fund management firms, whose pockets are less deep than the larger asset management firms. Such trusts tend to fly under the radar of many investors. With demand low, such trusts tend to persistently trade on a discount.

Share buybacks

On the supply side an investment trust’s board can decide to buy back its own shares. By reducing the number of shares in circulation there is less of an imbalance between supply and demand. In theory, this will reduce the trust’s discount, benefiting its shareholders as the share price will be given a boost as it narrows towards the value of the trust’s underlying investments. Some trusts have so-called discount control mechanisms. This is where boards promise to purchase their own shares if the discount exceeds a certain level, such as 10%, in normal market conditions.

The big downside is that buying back its own shares makes an investment trust’s assets smaller. For trusts with assets of less than £100 million, there is the risk that its assets could shrink to a point where it is no longer economically viable to continue running the portfolio.

At annual general meetings (AGMs), boards often ask shareholders for approval to purchase up to 14.99% of their own shares over a 12-month period. If a board wants to purchase 15% or more of its shares, the purchase must be made by way of a ‘tender offer’.

Premiums

If demand is high enough, an investment trust will trade on a premium. This could reflect an impressive performance by its underlying holdings, as well as strong interest in either the region or sector it invests in. It could also be down to the way the trusts invests being in favour, such as by investing in assets with inflation-linked income streams.

As a way of keeping a premium under control, many boards issue new shares at a premium to satisfy investor demand.

Ultimately, though, the best way for an investment trust to reduce its discount is by catching the attention of self-directed retail investors. In some cases, market-beating performance alone does not increase demand. Instead, a better combination is to have a mixture of a good profile with investors and solid performance.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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