Investment trust shares are traded on stock exchanges, like those of other public companies. The share price does not always reflect the underlying value of the portfolio. In such cases, the investment trust is referred to as trading at a discount or premium to net asset value (NAV).
If a trust’s discount narrows, the investor’s return gets an extra kick, which Cade says can be hugely significant in some cases.
"Essentially, you’re getting a double-whammy effect," explains Cade. "If the trust is on a 20 per cent discount and the share price goes up 20 per cent, if the discount falls to 10 per cent at the same time, the investor will make 35 per cent."
"It amplifies your returns, though of course it can move the other way if the discount widens."
The graph below shows the impact that a narrowing discount can have on returns. The Aberdeen New Thai IT’s discount has come in from around 10 per cent to 4.3 per cent so far in 2013, which has given the share price a massive boost.
Performance of trust’s NAV and share price in 2013
Source: FE Analytics
According to FE Analytics, the trust’s share price has delivered 37.01 per cent year to date, while the NAV is up just 14.74 per cent. This is an extra boost that investors simply do not get with open-ended funds.
While it is easy to point to a past example, Cade says timing a discount play is extremely difficult, and that he wouldn’t recommend retail investors buy a trust just because of its discount.
"I wouldn’t buy anything just because it’s on a discount, because you’ve also got to have a view of the underlying assets," he explained.
"You have to understand the volatility of the underlying assets – the discount could well come in, but you’re still going to lose money if the market you’re invested does badly."
"There’s a lot of fund managers and hedge fund managers operating in the market, which distorts discounts, so there’s the risk of that, too."
However, he points to a number of ways that long-term investors can maximise their returns with a well-timed move into a closed-ended vehicle.
"A good place to start is looking at the trading range," he said. "We look at what the average discount/premium has been in the short-term – say three months – and also over one year."
"It’s also worth looking at the long-term average. Discounts tend to revert back to the mean, but over a long period there are shifts in the trading range. If you are buying into a trend, it’s worth having a graph up telling you how the discount has behaved at different periods."
"I’d also look to compare the trust’s discount with its peer group. If you rate two managers equally but one has a trust on a wider discount, then there could be an opportunity there."
He says there are three more specific factors that investors should look out for: "If there’s a distressed institutional seller who sells 20 per cent of the trust, then the discount would go out. This often happens when a trust leaves an index, which could be seen as an opportunity."
"The last event-driven factor is if a star manager joins a trust."
FE Alpha Manager Alex Wright took charge of the Fidelity Special Values trust in September last year. Since then, the trust’s discount has come in from 14 per cent to 9 per cent.
This movement has contributed to Wright’s stellar run over six months; our data shows Fidelity Special Values is up 29.33 per cent over the period, compared with 13.45 per cent from its FTSE All Share benchmark.
Performance of trust vs index over 6months
Source: FE Analytics
FE Trustnet published a story about star managers on a discount in 2012. The list included Angus Tulloch, James Anderson and Alexander Darwall.
Cade (pictured) also points to a number of potential pitfalls that investors should look to avoid.
"You’ve got to make sure that the spread on the trust isn’t too wide. Quite often you don’t actually get the figure quoted on the screen," he explained. "The smaller, less liquid trusts often have a 2 per cent spread on them, which straight away eats into your discount."
"There are also structural factors to look out for. Small cap trusts tend to always be on discount, because they are largely owned by institutional buyers, who tend to trim back their exposure when the discount gets to a certain level."
"There are a few exceptions that have bought out the institutional money, such as Standard Life UK Smaller Companies IT and Dunedin Smaller Companies IT.”
"There’s a similar thing going on in the Asia sectors. The City of London IT is a massive trust of trusts, and tends to buy trusts when they get to 10 per cent and sell them when they get to 6 per cent."
"There are some on a premium in that sector, though."
Cade also brings up the issue of share buy-backs and new issuance as a reason to be wary.
Some trusts will buy back shares or distribute new ones if the discount/premium gets to a certain level, which means some trusts look very cheap, when in fact they are at an average level.
Among the highest-profile investment trusts that are currently on a wide discount include the £2.3bn Templeton Emerging Markets IT, which is on a discount of 9.2 per cent, and the Standard Life UK Smaller Companies IT, which is on a 5.1 per cent discount.
Just a matter of weeks ago, it was on a slight premium.