Investment trusts’ unique features – such as gearing and trading at a discount or premium – make them great vehicles for generating income and set them apart from open-ended funds.
But compared to their open-ended counterparts, investment trusts can appear more complex, especially once concepts like discount volatility and gearing enter the picture.
Indeed, in practice, their complexity still leads to some confusion among many advisers, and could even be discouraging some from recommending them to clients.
Yet, by taking advantage of investment trusts’ unique features, advisers gain the potential to invest in “a brilliant investment brain”, according to Claire Dwyer, associate director for investment trusts at Fidelity International.
Advisers also gain access to the best up-and-coming unlisted investment ideas and the ability to access illiquid asset classes in a structure, allowing the underlying portfolio to remain intact regardless of the vagaries of the market, she adds.
But such features pose their own challenges and risks, and understanding how they operate is the first important step towards being able to take advantage of their benefits.
First, it is important to recognise the role of investor demand as a key driver of whether a company is at a discount or premium.
To understand this, advisers must understand the role of the net asset value: the value of all the investments the trust holds minus any debts, liabilities or loans, explains Annabel Brodie-Smith, communications director at the Association of Investment Companies.
On the other hand, the share price of the investment trust tells you what investors think the trust is worth, compared to what it is actually worth, continues Ms Brodie-Smith.
Discounts and premiums arise when there is a difference in price between the market value of the underlying holdings – the NAV per share – and the price per share of the investment trust, she explains.
So if the share price is higher than the NAV, it is said to trade at a premium, indicating investors like the trust and that there is demand for the shares. But if the share price is lower than the underlying assets, it is said to trade at a discount, suggesting a lack of demand, she says.
What discounts/premiums say about trusts
If you have more sellers than buyers you will see the discount widen, and vice versa, reiterates Ms Dwyer.
She explains: “Weak investor sentiment and general risk aversion will also see discounts become more pronounced.
“Sometimes another reason for a widening discount is a concern that the NAV of the trust may fall sharply, or it may simply be that the sector or asset class is out of fashion.”
Ms Dwyer continues: “A hefty premium or discount may be sending a signal about the perceived quality of the investment manager.”
Harry Stein, sales and marketing manager at Mobius Capital Partners, says some advisers are cautious about recommending investment trusts that trade at a large discount to NAV when the strategy or asset class is out of favour.