Whilst dramatic swings in investment trust discounts are largely a thing of the past, it still remains a key issue for investment trust boards and management groups alike. The adoption of discount control mechanisms has proved increasingly popular over the course of the last couple of years, with many trusts adopting "semi open-ended" structures as a way of preventing discounts becoming too wide.
By buying back their own shares and introducing quarterly redemptions, the boards of trusts can control their discount to net asset value widening too far. This has proved popular as such mechanisms can be used to prevent trusts becoming subjects to attacks from arbitrageurs.
From a retail perspective, discount volatility can be a problem for investors who prefer the transparency of a unit trust’s single price. However are their any advantages to discount volatility and can it be used to an investor’s advantage?
Andrew Watkins, distribution director of specialist funds at Invesco Perpetual, says that for investors shrewd enough to spot an opportunity, buying a well managed trust that just happens to be out of favour on a wide discount and subsequently selling it a much narrower discount is a rewarding game to play.
However, he adds: "Whilst most investors can spot an opportunity to buy cheaply, the discipline required to sell ‘high’ is a much more difficult skill to acquire. Many is the time an inexperienced investor falls in love with their stock and misses the high, only to sell at a lower share price and a wider discount on the way down. This phenomenon can happen to experienced investors too."
As a fund manager however, Daniel Lockyer at iimia, says there are plenty of examples of trusts he has bought at wide discounts, anticipating that the shares look good value. The key he says is being positive on the underlying asset class of the trust.
"For example we bought the Polar Cap Technology trust at a 10% discount to NAV and sold it at a wide premium about six months later. The same was the case with TR Property. We bought it on a 12% discount at the start of 2005 and sold it at 3% discount four months later," says Lockyer.
However Lockyer adds that he has to be mindful when playing discount volatility. This, he says, is because there is every chance that the price could drift back to a discount. "If the share price falls faster than the NAV it can have a very negative impact as it drifts back to its long-term average discount level. We tend to be more long-term investors, but if the discount of a trust we hold changes and narrows significantly we will trade it out of our portfolios and bring it back in when it gets back to a more attractive level."
However while Lockyer as a fund manager believes he is in a good position to take advantage of discount volatility, he does not think that IFAs and retail investors are in good position to follow suit. He argues: "Discount volatility is one reason many retail investors don’t like investment trusts and while managers look at trusts everyday, retail investors don’t."
For example Lockyer notes that some investment trusts are more volatile than others, so while there are some you can buy and hold, there are other more specialist portfolios where sentiment towards them can quickly change. Trusts which are more volatile include Japanese smaller companies, technology and property portfolios, while those with the lowest volatility are the global generalists, where Lockyer says the discount typically stays around the 10% level.
At present the average discount for global generalist trusts is 9.4%, compared with the global specialist sector where the average trust trades at only a 1% discount to NAV.
With retail investors preferring trusts with lower discount volatility, the benefits of controlling discounts becomes more apparent. Watkins notes that if a board has a stated policy of buying-in shares at for example a 10% discount, and sticks to that policy, the discount will not widen beyond that point. "This gives investors confidence that the discount will not be volatile," he says.
Watkins adds: "It is the volatility of discounts that is key rather than the absolute level of the discount itself. That is why all boards should adopt discount control mechanisms and seek approval from shareholders to use them as appropriate. Many will never have to do so and sometimes it is the mere fact that such mechanisms are in place that keeps volatility in check."
Trusts which have adopted such discount controls are the Invesco English & International Trust, Gartmore Growth Opportunities, Falcon and JP Morgan Fleming Overseas. Elsewhere the £1.45bn Witan investment trust and £2.48bn F&C investment trust have both committed to buyback their own shares if their discounts hit the 10% level.
Charles Cade, head of research at Wins Investment Trusts, says that for trusts such as F&C and Witan, this is a useful tool. "At present both trusts are trading around that level, so having the buyback policy means you can by the fund and be sure it won’t widen beyond that point, indeed it could even narrow," he says.
However Cade does note that the small cap trusts which have adopted quarterly redemptions (Invesco English & International, Gartmore Growth Opportunities and Falcon) have been less successful. This he says is because he says the trusts have seen ongoing large redemptions meaning they have been shrinking in size.
"There are lots of other small cap trusts which are trading on wide discounts which makes it harder for the trusts to retain their assets," he adds.