When it's OK to pay

However, discounts across the investment trust sector have tightened this year and broker Winterflood reports that at least 93 investment trusts were trading at a premium to NAV as at 27 September 2013.

Even before this year, the higher yielding investment trust sectors, such as equity income, infrastructure and property, tended to trade at a premium, although some successful trusts in other sectors are also on premiums. But while attractive yields and good performance are desirable, is it acceptable to buy a trust at a premium, paying more for assets than they are worth?

In certain circumstances, yes, say a number of market experts.

For example, if you can't access the assets the investment trust offers via a unit trust or open-ended investment company (Oeic) you may want to consider an investment trust trading at a premium if it is the only way to access the assets. Examples include funds that invest directly in infrastructure.

If the investment trust has a unique strategy or assets you may also want to tolerate a premium.

If an open-ended fund has closed to new investors and it has an investment trust mirror, even if it is at a small premium it might be better than paying a 4 or 5 per cent initial charge to get into the open-ended fund, or not getting in at all if it has hard closed, according to Peter Walls, who runs IC Top 100 Fund Unicorn Mastertrust (GB0031269367), a fund of investment trusts.

An example is Standard Life UK Smaller Companies Investment Trust (SLS), also an IC Top 100 Fund, following the closure of its open-ended equivalent.

Read our update on this trust

An investment trust at a premium will sometimes perform much better than a similar open-ended fund or similar trust that trades at a discount.

If you are going to hold the investment trust for the long term, a premium to NAV is not such a problem as hopefully its good returns will compensate for this over time. If you don't expect the premium on the trust to narrow any time soon, because it has been fairly constant, you should be able to sell it at a premium. Infrastructure investment trusts are an example of this, says Stephen Peters, investment manager at Charles Stanley.

If the premium reflects the quality of the management team or the trust is making progress with its underlying investments, it is another reason to consider a trust trading at that level.

Sometimes the NAV does not adequately reflect the asset value, for example, with non-equity assets such as property or private equity. These are valued maybe only twice a year, but in-between these points the value of the assets could rise. Because this is not assessed and published the share price may not reflect this, so if you know the assets have risen it could be worth buying a trust that seems to be trading at a premium.

If the market is pricing a trust off its attractive yield rather than the NAV and it is likely to continue to trade at a premium for some time to come, for example property funds or some of the recently launched environmental infrastructure funds, it could be worth buying - especially with interest rates expected to remain low for some time.

Read more on property investment trusts

If an investment trust on a premium has much lower charges than an equivalent open-ended fund or another trust with higher charges, it could be one of a number of things to consider, although factors such as performance should take precedence. It also depends on how large the premium is.

Risks

One of the main risks is that the premium on an investment trust moves to a discount. Things that could cause this include:

■ Performance decline, leading to the shares de-rating.

■ The trust's sector going out of favour.

■ Its fund manager leaving.

■ Corporate governance issues.

If interest rates rise, then the income level the trust is offering will not seem so attractive and its shares may become less popular, causing a fall in the premium to NAV.

An overall market decline could cause the trust's share price and premium to reduce, even if the assets the trust invests in are doing well. Or if an investment trust issues too many shares for which there is not enough demand the premium could fall - share issuance is used by many trusts as a way to reduce their premium.

"If you buy something overvalued it is likely you won't make as much money on it," adds Mick Gilligan, head of research at broker Killik. "You haven't got as much margin of safety if things go against you."

Mr Peters argues that if you can buy an equivalent open-ended fund at NAV rather than an investment trust at a premium then you should probably go for this.

Mr Walls says that it is probably better to buy a trust on a high premium if it does a tap issue, as you may get in at a smaller premium. He adds that outside of income sectors you can often buy highly regarded funds at a discount.

Control mechanisms

Investment trusts try to control premiums and discounts by a number of means.

The main way to control premiums is by issuing shares, and sometimes trusts have a trigger whereby if the premium reaches a certain level they issue shares. But this can mean existing investors' holding of the trust is diluted, and issuing shares doesn't always manage to reduce the premium, as demonstrated by persistent premiums in popular sectors such as infrastructure.

For this reason, some market experts argue that you should not target trusts that have these discount and premium control mechanisms. "Over any meaningful period (one year or more) the biggest determinant of your returns is asset allocation," says Mr Peters. "Rather than considering whether a trust has discount or premium control mechanism, you should consider the assets you want to be in, the manager's style and whether you want a passive or active fund and, if the latter, an investment trust or open-ended fund. Only then should you consider the discount/premium. Leverage (debt) can also be far more important to performance than the discount or premium."

Mr Gilligan says that the premium/discount is a secondary consideration, as the main driver of returns is NAV performance.

Trusts where you can tolerate the premium

Many market experts argue that infrastructure investment trusts are a sector where you could consider a premium. As well as providing an attractive yield, and stable, defensive returns which are not correlated to equities, their returns are also partly inflation-linked.

Funds in the sector you could consider include 3i Infrastructure (3IN). "While the problems with the Indian portfolio have been well-flagged this is relatively modest in the context of the £1.1bn of net assets," says Iain Scouller, head of the investment funds team at Oriel Securities. "The European portfolio appears to be continuing to perform well and we would expect to see a relatively robust performance from the European portfolio in both income and capital terms over the next six months. We think that the fund justifies some premium given the non-dated and non-concession nature of 90 per cent of the portfolio."

The trust is on a 12.11 per cent premium to NAV.

Mr Peters also suggests John Laing Infrastructure (JLIF) on 7.74 per cent if you are a long-term investor.

IC Top 100 Fund HICL Infrastructure offers stable cash flows and an attractive yield, and is on a premium of 7.91 per cent. However, the trust does regular share issues which can mean you may be able to get in at a lower premium via these.

Mr Gilligan suggests environmental infrastructure investment trust Greencoat UK Wind (UKW) is worth its 5 per cent premium because of its attractive 5.74 per cent yield and inflation linking, as long as you hold it for the long term.

Outside infrastructure, Mr Peters says IC Top 100 Fund BlackRock Frontiers Investment Trust (BRFI) on 5.23 per cent, which so far has performed strongly, may be worth the premium.

Read our interview with BlackRock Frontiers' manager

Mr Gilligan suggests Law Debenture Corporation (LWDB), an IC Top 100 Fund, which is nominally on a premium of 12.33 per cent. "This has a trustee business that generates additional income but which is not reflected in the premium," he says. "When you add in the net income from this, the trust is trading at around NAV."

Investment trusts at a premium worth considering

Source: Morningstar

Performance data as at 30 September 2013 

Assessing the premium

If you are going to buy at a premium, you need to assess a number of things first.

Mr Peters says ask yourself what might make an investment trust's premium turn to a discount.

"I always ask how large is the premium I'm paying relative to the returns I expect from this fund, ie what am I potentially giving away," adds Monica Tepes, investment companies analyst at Cantor Fitzgerald. "For example: you have two funds in a given sector and are happy with their investment strategy. One of them has annualised 10 per cent over the past 10 years, the other 13 per cent and you think this is a good reflection of future relative performance. You'd obviously want to be in the 13 per cent one, but how much of a relative premium would you be willing to pay? Thinking you could gain 3 per cent a year, you could decide on a premium based on years of outperformance you are prepared to forego. So you might be happy to give away one year of potential outperformance (3 per cent premium), but not two years (6 per cent premium)."

Jane Heyman, chartered financial planner at McCarthy Taylor, says you need to consider what potential there is for growth. She adds that you should see if the premium is at its normal level, by comparing it with its historical levels, and take into account quality and a long track record.

But she says to try to time your purchase - if you see the premium fall then this could be a good moment to get into the trust.