As an investment trust is effectively a listed stock, the value of its share price often differs from its net asset value. If there is less demand for the trust, then it will usually trade on a discount to NAV, while if there is more demand, it will be on a premium.
This can present a problem because if you were to buy a trust on a premium and then sentiment were to turn and the trust’s NAV fell, you would be hit with a double whammy of losses.
Although discount volatility can be one of the reasons why more adventurous investors favour a closed-ended fund, as this can present buying opportunities, it is also the reason why open-ended funds have been a private investor’s first port of call: they are transparent, easy to understand, and rely solely on the performance of your chosen manager. What you see is what you get.
However, some investment trusts are able to eliminate discount volatility by using a discount control mechanism [DCM] to protect investors’ interests. This allows them to get exposure to all of the advantages of investment trusts – including cheaper costs, gearing and longer manager tenure – without the hassle of worrying about what way the discount is going.
When a DCM is put in place, a trust’s board issues shares if the trust is trading on a premium – therefore increasing supply to meet demand – and buys back shares when it is on a discount – therefore shrinking the amount of shares available to investors.
Usually the board sets a level at which it will take action: for example, a discount or premium of 5 per cent.
Numis Securities’ Ewan Lovett-Turner says that for investors looking for a trust that offers similar characteristics to open-ended funds, there are a number of options available.
"The significant pioneer in discount control mechanisms has been Sebastian Lyon’s Personal Assets Trust, which has had one in place for quite some time," he said.
"It has operated like an open-ended fund and has been very successful as its zero-discount policy has been very consistent. It has also shown a firm commitment from the board, which investors like and so will continue to buy it."
"The board even said that it would happily shrink the trust to just its own money if necessary, but it has reaped the benefits of its decision as the trust has grown," he added.
You only need to look at the performance of Personal Assets Trust’s NAV against its share price over the last three years to see how closely the board has stuck to its guns.
Performance of trust’s NAV & price over 3yrs
Source: FE Analytics
The trust has consistently traded on a slight premium, but as the graph above shows, its share price has performed largely in line with the NAV.
Personal Assets Trust has ongoing charges of 0.95 per cent.
Lovett-Turner also highlights the Troy Income & Growth investment trust as another option for discount-wary investors.
He says that FE Alpha Manager Francis Brooke’s closed-ended fund is one of the very few vehicles of its kind that implements a zero-discount policy, which is particularly pertinent at the moment given that many UK equity income trusts are currently on premiums.
"It is an interesting one as though it has grown slightly, it is still quite a small trust," he said. "However, they have been able to add additional trading liquidity as they can issue more stock to meet demand if they see fit."
"However, if for some reason the hunger for yield diminishes, then there is a chance that a lot of the income-producing trusts may move from their current premiums to discounts. So if the trust maintains a zero-discount policy, then that is a pretty big positive," he added.
That constant premium has contributed to the reason why the trust is in the bottom quartile of the IT UK Growth & Income sector over three years. Although it has beaten its benchmark – the FTSE All Share – over that time, other trusts in the sector have seen their discounts narrow substantially as demand for yield has increased, boosting their performance.
However, if sentiment were to turn, this trust wouldn’t suffer a widening discount – something that is likely to be of great appeal to risk-averse investors.
Performance of trust vs sector and index over 3yrs
Source: FE Analytics
Troy Income & Growth has ongoing charges of 1.22 per cent.
The other notable equity income trust that uses a discount control mechanism is FE Alpha Manager Nick Train’s Finsbury Growth & Income IT.
Data from the AIC shows that the closed-ended fund is on a premium of 1 per cent, and the board has told investors that it will buy back shares if that were to widen to a 5 per cent discount.
Finsbury Growth & Income has ongoing charges of 0.94 per cent.
Lovett-Turner says that although there are a number of trusts that have been very good at keeping on top of widening discounts, others have disappointed investors.
"There have been a few in the past that haven’t been as good in terms of discount control mechanisms," he continued.
"Something like Montanaro European Smaller Companies had firm discount controls at 5 per cent but had to remove them in 2009. Given that demand wasn’t really for European small caps at the time, they had to let the discount widen."
Performance of trust’s NAV & Price in 2009
Source: FE Analytics
Stephen Peters, investment analyst at Charles Stanley, says that in an ideal world all trusts would use discount control mechanisms, but that this is unlikely.
"Yes, I think most trusts should have discount control mechanisms but there are a number of reasons why boards say they are not feasible," he explained.
He says that one of the potential reasons is that a number of investment trusts are too small in size. Discount control mechanisms would be a problem in that scenario because if they kept having to buy back shares to rein in the discount then they would "shrink into obscurity".
Because of that, he says that although there are a number of trusts that could act like open-ended funds, many would struggle to do so.
He also says a trust’s ability to gear could present a problem because if it kept having to buy back shares then the percentage of gearing to NAV would undoubtedly increase, creating more risk.
Other trusts that use DCMs include Martin Currie Global Portfolio IT, Jupiter Green IT, the UK Select IT, Invesco Perpetual Select UK Equity IT and BlackRock Income and Growth IT.