Along with an investment trust’s ability to gear – or borrow – and smooth its dividend by holding back earnings in a good year, closed-ended funds also offer investors the chance to buy a portfolio for less than its actual net asset value (NAV).
Say a trust was on a discount of 10 per cent – the investor would be buying £100 worth of shares for £90. The added benefit is that if the NAV were to rise and demand for the shares were to increase, the price of those shares would go up.
This works the other way, of course.
If you bought into a trust that was already popular and was trading on a premium, then your losses would be magnified if things turned sour.
However, discounts are also one of the biggest draws of investment trusts. Buying a good trust on a wide discount to NAV can make an investor a lot better off if this figure narrows.
The graph below highlights the benefits of a narrowing discount.
Performance of trust’s share price vs NAV over 3yrs
Source: FE Analytics
Our data shows that the Henderson Euro Trust’s net asset value is up 29.52 per cent over three years. However, as the discount has narrowed substantially, investors who bought the trust three years ago would actually be sitting on a return of 59.52 per cent.
Like anything, however, there are two sides to this story.
While it is very profitable to wait for a trust's discount to widen before buying into it, then see this figure subsequently narrow, spare a thought for people who already own shares in it.
They will have been hit by huge capital losses if they had bought at a slight premium or at NAV, even if the trust’s assets have actually performed OK. That is why certain retail investors shy away from trusts.
Because of that threat of a widening discount, many management boards now use a discount control mechanism (DCM) to entice shareholders. These work by designating a certain discount level. If the discount were to reach that level, say 5 per cent, the board would simply buy back shares and shrink the trust’s size to limit the damage and protect their existing shareholders. While it can contain losses, it limits potential returns.
There has also been added pressure on boards to control their discounts on the back of the Retail Distribution Review (RDR), which has caused private investors to look for funds with lower fees.
Therefore, if a board can offer a trust that operates more like an open-ended fund and can mitigate market timing, then the size of the trust could increase.
Peter Spiller (pictured), who has managed the Capital Gearing Trust since the early 1980s, recently told FE Trustnet that more investment trusts should look after their shareholders by keeping a lid on widening discounts.
He pointed out that a lot of private investors do not have the time or expertise to constantly check discounts or premiums, so they should be able to trust boards to keep a check on the share price. However, I also recently spoke to a high-profile investment trust manager who wished to remain anonymous because his board has a discount control mechanism. However, he told me that he had "real sympathy" for people who are opposed to such mechanisms as they can limit returns.
Peter Walls says that because of these DCMs there is a lot less value in the investment trust space than there used to be. Walls manages the five crown-rated Unicorn Mastertrust, which only invests in closed-ended funds.
He says he only likes to buy trusts on a discount, as he aims to deliver high capital growth to his investors, but he says finding bargains has been an uphill task recently.
"This has been the case since the abolition of the advance corporation tax in 1999, which excluded boards from buying back their own shares. Because of that, it is no surprise that discounts have generally narrowed."
Despite that lack of bargains, Walls’ strategy has worked very well in the past.
According to FE Analytics, his £9m Unicorn Mastertrust is the best-performing portfolio in the IMA Flexible Investment sector over five years, with returns of 126.99 per cent; this is over 60 percentage points more than the returns of the average fund.
Performance of fund vs sector over 5yrs
Source: FE Analytics
Nevertheless, even trusts in areas that have been particularly out of favour have not seen their discounts widen massively.
Take closed-ended emerging markets funds: growth in this sector has slowed, currencies have fallen against the dollar and commodity prices have fallen.
However, Oriel Securities’ Tom Tuite-Dalton recently told FE Trustnet that discounts on emerging markets trusts have stayed relatively stable because their boards have been much more willing to buy back shares.
Although this may provide some head-scratching for investors looking for a contrarian bet, Walls certainly sees the merits of DCMs.
"They can be good for both long- and short-term investors," he explained.
"I have been looking at RIT Capital Partners recently. It used to be very well liked and would be trading on a premium more often than not. Now performance is not as good, it is trading on a wide discount."
"That’s good news for me, but someone who bought it on an 8 per cent premium won’t be feeling as happy," he added.
Some trusts are even stricter with their discounts. Closed-ended funds such as Sebastian Lyon’s Personal Assets Trust have a zero-discount policy whereby they buy back shares if the trust moves on to a discount and issue more of them if its premium widens.
Therefore, they operate like an open-ended fund in many respects.
Walls points out that some smaller trusts cannot have a DCM, because if they keep buying back shares then they would shrink into insignificance.
The manager says that investors should not give up on finding bargain investment trusts, although they may have to wait a little while.
"For me, the bottom line is that a lot of these mechanisms don’t work in falling markets," he said. "If you are patient, there are opportunities out there."
"It is fair to say that not a lot of discount value is out there. But, there will always be discount volatility in more specialised area. The debate about whether discounts are good or bad has rumbled on for ages, but right now there aren’t many discounts out there," he added.
