The prices of investment trusts' shares do not always reflect the value of their assets, meaning these can trade at discounts or premiums to their net asset value (NAV) – ie cost more or less than their assets. So some trusts’ boards try to limit the amount by which the share price differs from the NAV via what are known as discount control mechanisms.
Around 60 out of the roughly 400 investment trusts listed in the UK have an explicit discount target, according to broker Winterflood. One of the most common ways to try to stick within it is to buy back the trust’s shares when it hits a certain level of discount, and issue shares when it hits a certain level of premium, typically between 0 and 12 per cent. Some of these targets are implemented strictly, and some are only triggered if the discount exceeds the target for a period of time.
Personal Assets Trust (PNL), for example, tries to ensure that its shares always trade close to NAV with share buybacks at a small discount to NAV and issues of shares at a small premium when demand exceeds supply. As a result the trust fairly consistently trades at a slight premium.
Boards also try to control discounts by offering shareholders the opportunity to sell their shares back to the trust at regular intervals or under certain conditions. For example, Diverse Income Trust (DIVI) has an annual redemption facility whereby shareholders can voluntarily tender their shares. Over the past few years this trust has typically traded at only a slight discount or premium.
Some trusts have increased their dividends by paying them out of their capital as well as the income from their investments, and their discount has narrowed because an attractive income has been popular with investors. These include JPMorgan Global Growth & Income, which rerated after introducing an enhanced dividend policy, whereby it pays dividends worth at least 4 per cent of its NAV at the end of its preceding financial year. It now trades at a premium to NAV of around 2.5 per cent.
Controlling discounts to NAV can be beneficial to a trust’s shareholders, as it means they are less likely to buy shares in a trust that then swings out to a wide discount. However, it doesn't mean you should only invest in trusts with a discount control mechanism.
If a trust’s performance is poor or it invests in an asset class that is out of favour, a discount control mechanism may not contain the discount. For example, Baring Emerging Europe (BEE) has conducted many share buybacks and will give shareholders the opportunity to tender up to 25 per cent of their shares at the end of its 2020 fiscal year if the average discount is higher than 12 per cent during the entire period or performance does not exceed 1 per cent of the benchmark annually over that period. However, it is still trading at a discount to NAV of about 15 per cent, and has typically traded at a discount of between 10 and 15 per cent for the past few years.
“[A discount control mechanism] shouldn’t be a primary concern because in effect performance and other factors are more important than controlling the discount, although it may help at the margins,” says David Liddell, chief executive of online investment service IpsoFactor Investor. “If a trust or sector is out of fashion or performance is bad, it will not help. And where it has worked well there have been other factors such as good performance.”
He highlights Finsbury Growth & Income Trust (FGT), which has a policy of buying back shares if it swings to a discount of more than 5 per cent, but hasn’t needed to as it has performed very well. It typically trades at a slight premium to NAV, which it seeks to keep low via share issues.
Some trusts’ policies are to only apply discount controls subject to certain conditions, for example ‘in normal market conditions’. This means boards can implement them only when they want to rather than when you might want them to, for example, when the discount has widened in tanking markets.
Some trusts invest in a fairly popular area or a naturally high income area so generally don’t fall to discounts, and don’t have a policy to contain them. But there is a risk that if the area they invest in goes out of favour there could be a substantial fall in their rating because they don’t have any protection. “You need to consider as to whether they are investing in assets that are in vogue,” says James Carthew, head of research at at QuotedData.
Many trusts don’t have a hard discount target, but in practice their boards work to control discounts to NAV by buying back shares, such as City of London Investment Trust (CTY). Its board aims for the share price to closely reflect the NAV and “intends, subject to the overall pricing of other trusts and overall market conditions, to consider issuance and buybacks within a narrow band relative to NAV”. The trust’s board frequently issues shares to keep its premium down, so it typically trades at a small premium.
Tender offers and share buybacks can result in a trust becoming small, meaning that its shares become harder to buy and sell, which can put larger investors off. This could result in the discount becoming even wider and, for the remaining shareholders, rising costs as these are spread over a smaller investor base.
In extreme cases, if so many shareholders take up the offer of a tender that the trust would become very small, its board may decide to wind the trust up, which is not good for shareholders who want to continue investing in it. A recent example of this is BlackRock Emerging Europe, which gave shareholders the opportunity to tender 100 per cent of their shares at NAV less costs. As 61 per cent of the trust’s shares were tendered its assets would have fallen to £48m, so its board decided to liquidate the trust.
If a trust is successful in keeping its discount tight, investors who like to bargain hunt don’t get the opportunity to buy it at relatively wide discounts. And Mr Liddell argues that if a trust has a stated discount limit, then you should not buy it when it is on a narrower discount than this. “Ideally buy a trust where there is potential for discount narrowing,” he says.
If a trust has an annual redemption facility this makes it more like an open-ended fund, according to Daniel Lockyear, senior fund manager at Hawksmoor Fund Managers. Investment trust managers can take a long-term view because they don’t have to liquidate assets to meet shareholder redemptions. Having to make annual redemptions could compromise this ability, although is unlikely to affect trusts focused on assets that are easy to buy and sell.
For this reason, trusts that invest in illiquid, unlisted assets are less likely to have discount control mechanisms. So only opting for ones that do have one could mean having to forego certain types of asset, for example, property or private equity, adds Mr Lockyear.
If you are very worried about discount volatility a better option might be an open-ended fund, but if it invests in assets such as equities its unit price could also be volatile, albeit in line with the assets it holds.
