While most investment trusts still trade at a discount, increasing numbers are trading at premiums. Should we buy something that’s reassuringly expensive or be wary in case the price has been driven too high?
As usual, the most sensible answer is “it’s complicated”.
Let’s start with the basics. Each investment trust has a net asset value, which is the latest valuation of each of its holdings less any debt that it owes.
However, because trusts trade on a stock exchange and are closed-end funds (meaning the number of shares doesn’t change when an individual investor buys or sells), a trust’s net asset value and its share price will often differ. Sometimes by a very significant amount.
An investment trust trading in excess of its net asset value is said to be at a ‘premium’. The reverse is called a ‘discount’. In most situations, investors prefer to buy at a discount. After all, who doesn’t love a bargain?
Of course, if the discount or premium of a particular trust never changed, then this wouldn’t be an issue as it wouldn’t affect your overall return. In practice, discounts and premiums can shift dramatically over time.
In rough terms, if you bought a trust at a 5% premium and then sold it ten years later when it happened to be at a 5% discount, then that’s a 10% swing. That’s the equivalent of paying an extra 1% each year in charges!
What causes premiums and discounts?
It’s a classic example of supply and demand.
Investment trusts that have performed well in the past are often the most popular. They tend to trade on small discounts or even premiums.
Poor performers languish unloved at the back of the cupboard and can trade at very wide discounts.
In recent years, trusts that pay out a high level of income have been snapped up by many investors. Many of these trade at premiums, even those that have short track records or are investing in totally new areas.
Here’s how the investment trust universe (excluding VCTs) looks at the moment:
Right now, more than twice as many investment trusts trade at a discount than a premium. The majority (just over two-thirds of all trusts) trade between a 15% discount and a 5% premium.
There are extremes at both ends. Lindsell Train commands a massive 75% premium while Global Resouces has the dubious honour of the widest discount at 58%.
Either extreme can be a warning sign. A big premium can shrink, perhaps even wiping out a good underlying performance — Lindsell Train deserves credit for repeatedly highlighting to its investors the dangers of that happening.
A large discount can also indicate ingrained structural problems with an investment trust. It might, for example, have a small number of large individual positions that could be hard to sell at the stated net asset value.
To make matters worse, the premium puzzle has arguably become a lot more complicated recently.
A large number of trusts launched in the last decade invest in so-called alternative assets like infrastructure, renewable energy, leases, property, and so on.
These funds are more difficult to value. There’s no quote you can pull off the London Stock Exchange, as you can for a big company like Unilever or Vodafone. Valuing many of these assets is more art than science, with numerous assumptions required for future growth rates and so on.
And because these valuations are more complex, they are not done as frequently. While a straightforward investment trust that holds just publicly listed companies might release an updated net asset value every trading day, many alternative asset funds are only revalued quarterly or every six months.
Therefore not only are you comparing the share price to a much more squidgy net asset value, but it’s also a value that might be somewhat out of date.
Looking at the raw numbers, though, it’s clear that investment trusts have become ever more expensive in the past few decades.
This chart also illustrates that investment trusts don’t tend to hold up well in time of crisis. When the value of their underlying investments drops sharply, discounts often widen as well, magnifying the pain.
Discounts tend to bounce back relatively quickly, but this phenomenon can alarm the unprepared.
The sharp declines in the chart above correspond to the Asian Crisis (1998), the death rattle of the dot-com bubble (2003), and the financial crisis (2008). The dip right at the end (the EU Referendum) has largely been reversed with the average discount now back to 3%.
Exactly why discounts have narrowed over time is not entirely clear. Investment trusts have become more popular with wealth advisers, increasing the demand for their shares. The long run-up in share prices since 2009, making investors more and more confident, probably hasn’t hurt either.
The rise of alternative asset funds is a factor, too. There are around 100 available right now, of which just under half trade at a premium.
With an ordinary investment trust that invests in publicly traded companies, it’s possible to replicate its holdings yourself, so there’s little rationale for it to trade at a big premium.
Alternative assets often buy things private investors can’t access directly, so there’s more of a case for a premium due to scarcity.
Premium trusts can snowball
Trusts that trade a premium can issue new shares without diluting the value of those held by their existing shareholders. Sometimes they do so gradually to ensure their premiums don’t get too large. Or sometimes they raise lots of new cash in one go, as we have seen with many renewable infrastructure trusts in recent months.
This means funds trading at premiums are much more likely to grow in size, and therefore narrow the average discount for all trusts.
At the opposite end, trusts at wide discounts tend to wither and die, either liquidating themselves or prompting another fund to come along and put it out of its misery.
Here’s a table showing the average discount per sector. In short, it’s all over the place.
|Average (excluding 3i)||(2.9)|
|Global Equity Income||1.9|
|Global Smaller Companies||(1.6)|
|UK All Companies||(9.3)|
|UK Equity Income||(4.0)|
|UK Smaller Companies||(8.3)|
|UK Equity & Bond Income||(3.1)|
|North American Smaller Companies||(16.6)|
|Asia Pacific – Excl. Japan||(5.2)|
|Japanese Smaller Companies||0.9|
|European Smaller Companies||(12.2)|
|Global Emerging Markets||(7.9)|
|Private Equity (ex 3i)||(13.2)|
|Property Direct – UK||(2.9)|
|Biotechnology & Healthcare||13.0|
|Tech, Media & Telecom||(3.2)|
Some sectors, like private equity, have a big variation in the discount between individual funds, while other sectors are much more homogeneous.
Global funds certainly seem popular right now, while most of those that specialise in countries and regions seem to have high single-digit or even low double-digit discounts. There are oddities, of course, with low-growth Japan trading at a much smaller discount than the high-growth Asia Pacific region as a whole.
Sector specialists seem to be in demand, with biotech and healthcare commanding one of the highest premiums. I think this is somewhat logical, though, as splitting your investments by region seems to be much more arbitrary than specialising by industry.
Buy, Marry, Avoid?
I’d say that a trust’s premium or discount has to be judged on its own merits.
If you want to invest in some sectors, a small premium seems to be the price of admission. You could hang around waiting for it to disappear, but sector-wide premiums often seem to persist for many years.
Likewise, large discounts tend to linger for ages, only to narrow dramatically in the brief time you weren’t paying attention.
However, the longer you hold for, the more important the underlying performance of the fund is and the less the initial discount or premium should matter.
Arguably, a premium or discount becomes more important when looking at lower growth/high-income investment trusts, as any change is likely to be a much more material element of your overall returns.
Personally, while I tend to keep an eye on premiums and discounts of the trusts I own, I try not to do so excessively. Just as the tax tail shouldn’t wag the investment dog, the same goes for investment trust premiums.
Please note that I may own some of the investments mentioned above. You can see my current holdings on my portfolio page and the index page summarises my posts by category. Nothing in this article or on this website should be regarded as a buy or sell recommendation as this site is not authorised to give financial advice. I'm just a random person writing a blog in his spare time. Always do your own research and seek financial advice if necessary!
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