IT geek: avoid making these investment trust mistakes

Buying a trust just because it is trading at a discount to NAV

Everyone loves a bargain, and it can make sense to buy something that seems less than it's worth if there is a strong possibility that it will revert to a more realistic price. But real bargains are few and far between – most of the time things are cheap for a reason – including investment trusts.

What is important is a trust's discount to net asset value (NAV) relative to its history. If the trust usually trades at a wide discount then it is not necessarily a bargain as this is what it usually does, and it is unlikely to come in unless something happens that could change it.

Also see what the trust's discount is relative to the other trusts in its Association of Investment Companies (AIC) peer group, and their histories. Some investment trust sectors often trade at wide discounts, for example, because they invest in illiquid or higher risk assets. Examples include private equity and UK smaller companies investment trusts.

You can check what course a trust's discount or premium to NAV has taken over the past few years at www.theaic.co.uk or morningstar.co.uk.

A common reason for investment trusts trading at wider discounts to NAV than normal is because their performance is not good relative to their benchmark and peers. If the performance doesn't improve the discount is not likely to come in, so it is probably not a good idea to buy a poorly performing trust unless there is a reason why that could change.

Another reason for a discount to NAV can be because the area the trust invests is not doing well. If it does not improve the discount is likely to remain – even if the trust has a really good manager there is only so much they can do if they have to invest in this given area.

A discount to NAV can also be an indication that something is going wrong in which case it is definitely not a bargain. Maybe underlying investments that account for a substantial part of its assets have blown up, it has excessively high levels of debt or expensive debt, or its manager who has been doing a great job has left and is being replaced by someone whose reputation is yet to be proved.

Not buying trusts trading at a discount to NAV

Investment trusts do not always trade at a discount to NAV for a bad reason, so look out for opportunities, bearing in mind that they are rare and some of the issues outlined above are more likely to be the reason for a discount.

For example, if a large institutional investor pulls out of an investment trust this can push it to a discount. An example of this was when insurance company Friends Life decided to divest its investment trust portfolio. These included Witan (WTAN) in which Friends Life had shares worth about £231m, representing around 16 per cent of its share capital. This initially resulted in Witan's discount widening from about 2.4 per cent to 6.7 per cent. 

Investors can be overly pessimistic on the area a trust invests in but its performance could improve when sentiment improves.

The trust's manager might have a strong long-term performance record but be going through a bad patch. If they return to form the discount could narrow.  

If the style in which a trust's manager invests is not in fashion, for example value investing, it could trade at a discount to NAV. But if this changes the trust could re-rate.

If a trust that has been doing badly and is trading at a discount to NAV changes manager, in particular to someone who has a strong performance record, it may re-rate. This may not happen immediately – the new manager might improve performance but investors fail to recognise this so the share price doesn't keep up with the NAV returns.

But in all such cases a re-rating is not guaranteed, or may take some time to come, so be prepared to wait or for the re-rating not to happen.

Buying trusts on a high premium to NAV

It is not a good idea to buy an investment trust at an unjustified or excessive premium to NAV. Trusts trade on premiums for a number of reasons, including that the assets they invest in are fashionable or popular at the time. But this doesn't necessarily translate into long-term growth or a reliable income. And if they do have growth or income potential, maybe there could be a cheaper time to buy them.

Even if a trust seems like a very reliable or solid proposition something could happen to make its share price and premium to NAV come down.

For example, infrastructure investment trusts traded at premiums to NAV for many years, at times double-digit ones, and their safe and steady income stream from government related private finance initiative (PFI) projects seemed low risk and made it hard to see what could go wrong. But last year the shadow chancellor said Labour would nationalise PFI projects if it wins the next election, and this year Carillion (CLLN), which provides services on some of the projects infrastructure trusts invest in, collapsed. This brought down their share prices and premiums to NAV, and HICL Infrastructure Company (HICL) and John Laing Infrastructure Fund (JLIF) have fallen to discounts to NAV.

If you bought one of these trusts on a high premium, arguably the worst thing to do now would be to sell, and make the classic investor mistake of buying high and selling low. And some argue that it could be a good moment to buy shares in infrastructure investment trusts – as long as you can tolerate the higher risks these now entail.

Sometimes there's no need to pay a high premium for an investment trust because you want to invest with the manager if they can also be accessed via another fund. For example, they might run an open-ended fund that follows a similar strategy or another investment trust that is not on such excessive premium.

For example, Lindsell Train Investment Trust (LTI), which highly regarded manager Nick Train runs, is on an excessive premium to NAV of about 43.8 per cent. This has swollen over the past three years and at times been even higher. The higher you buy in the harder it's going to be for you if it falls.

So a much better option could be open-ended Lindsell Train Global Equity Fund (IE00BJSPMJ28), which also has a lower ongoing charge of 0.55 per cent – much lower when you take into account Lindsell Train Investment Trust's performance fee. Or if a UK focus fits your asset allocation better, Mr Train also runs LF Lindsell Train UK Equity (GB00BJFLM156) or Finsbury Growth & Income Trust (FGT) which is on a much more reasonable premium to NAV of about 0.8 per cent.

Trusts that offer an attractive income often trade at a premium to NAV but if interest rates rise this could change.

If a trust cannot keep up its attractive level of income, not only will you face a dividend cut but potentially a fall in the share price and premium, too. Check what a trust's credentials are in terms of its ability to keep paying an attractive income. Is this well covered by what the trust invests in, does it have revenue reserves to plug any shortfall, and does it have a policy of increasing or maintaining its dividend? Also see what its historic record of maintaining or increasing its dividend is.

Totally avoiding trusts just because they are on a premium to NAV

Don't discount an investment trust just because it is trading at a premium to NAV.

For example, if it pretty much always trades on a premium to NAV and it is lower than it has been historically, this could actually be a good entry point.

Or if it consistently trades at about that level and doesn't ever get much higher or lower, because its board carefully controls with this share issues and buybacks, then it probably is not a big problem. Examples include City of London Investment Trust (CTY) which trades on a low single-digit premium most of the time.

This is especially the case if you hold the trust for a very long time as hopefully its returns will make up for the premium. What is important is selling out at a higher price than you bought it for. And over the long term it could be better to opt for a trust at a premium that performs well in the years ahead, rather than one at a discount that loses you money or underperforms alternative options.

Not checking the gearing and its costs

A feature of investment trusts that distinguishes them from open-ended funds is their ability to take on gearing – debt. This can increase their returns because they have more assets to invest in the market.

But debt can go badly wrong: if markets fall this can compound losses, a reason to have a closer look at a trust that appears to have a high level of gearing relative to its peer group.

Also check the trust's annual report to see what level of interest it is paying on its debt, because if it's very expensive this is eating into its returns. If the debt doesn't have long to run then this is a problem that will disappear soon, but if it is long term that doesn't bode well.

Not paying attention to a trust's size

A detail you might not think of looking at is an investment trust's size. But if it is small it can mean that it is less traded and the bid-offer spread on its shares could be wide.

It may also have a relatively high ongoing charge because its fixed costs are spread over a smaller base of investors. Funds with high charges should be avoided because it is likely there is something similar available with a lower charge.

A small size could also mean a trust trades persistently at a discount to NAV because its board does not want to make it even smaller by doing share buybacks.