Discount control mechanisms (DCMs) have been introduced by many investment trusts but worsening market conditions are making it difficult for boards to stick to their stated aims.
Unlike open-ended funds, trusts are stock market-listed so their share prices can diverge from their underlying net asset values (NAVs), reflecting sentiment. In-demand trusts may trade on premiums to NAV, whereas out-of-favour trusts can trade on wide discounts.
Discount volatility can work against investors and dissuades many independent financial advisers from recommending trusts to their clients. A falling NAV could be compounded by a widening discount, creating a double whammy.
Investment trusts can buy back shares to try to control their discounts and around 50 trusts have introduced explicit discount targets (ranging from 3 to 12 per cent). DCMs include simple buy-backs, trigger mechanisms for tender offers and regular opportunities to redeem holdings close to NAV.
Nevertheless, boards have struggled to defend their discount limits as sentiment has deteriorated. The average discount for the sector has widened from 6 per cent at the start of the year to 9 per cent now and, despite substantial buy-backs, over half the trusts with DCMs are currently trading on discounts wider than their targets.
Managers can be reluctant to sell holdings in a falling market in order to repurchase shares. Meanwhile, trusts could suffer death by a thousand cuts, becoming smaller and smaller (so increasing the impact of fixed costs for remaining shareholders).
Some boards may be hoping to ride out short-term market volatility, rather than taking action hastily. Indeed, a few boards have announced relaxations of their discount control policies, which will disappoint investors who thought they had a degree of downside protection.
If discounts remain wide, shares could be bought by arbitrageurs (activist institutions), who may attempt to wind trusts up in order to unlock their true NAVs.
