The closed-end nature of investment trusts is why there is often a difference between the share price and the value of the underlying assets (the net asset value – NAV). Most investment trusts trade at a discount to net asset value, although some trade at a premium.
Since 1999, investment trusts have been permitted to buy back their own shares in order to manage the gap between the trust’s share price and the value of the underlying assets held by the trust – its NAV per share. Where the share price is less than the NAV per share, the shares are said to be trading at a discount. This means buyers of the shares are gaining the benefit of the underlying assets for less than their face value.
However, the benefit of buying at a discount can only be crystallised if the discount is smaller – or has diminished entirely – at the time of sale. If the share price is higher than the NAV per share, the shares are trading at a premium.
Shares tend to trade at a discount when the supply of them is greater than the demand. By buying back shares, the board can mop up the oversupply.
The knowledge that a trust board is willing to buy back the shares if the discount widens helps instil confidence among investors, who may be less happy to buy shares that could see a significant future widening in their discount.
There are broadly two types of discount control mechanism (DCM), known as ‘hard’ and ‘soft’. A ‘hard’ DCM will state that the board must buy in shares if the discount to net asset value exceeds a certain amount.
Foreign & Colonial, for example, has a ‘hard’ DCM, which states that the board shall ‘vigorously defend’ its target of a maximum discount of 10 per cent by buying back shares.
F&C Global Smaller Companies is “committed to keeping the discount close to 5 per cent in more stable market conditions”, though this target takes into account the possibility of discounts widening in volatile conditions, where it may not be possible to meet this target.
A ‘soft’ DCM generally means the trust has the authority to buy back shares and may use this to manage the discount, but is not compelled to do so. This can be useful for those investing in less liquid asset classes, such as commercial property and smaller companies.