Unpacking investment trust jargon

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Unpacking investment trust jargon

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.

Understanding NAV

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.

He explains: “Consequently, a transparent and robust discount management policy is increasingly seen as an important feature to any new investment trust initial public offering.

“Many new listings, including Mobius Investment Trust, not only offer a recurring redemption facility at NAV (after an agreed number of years) but also actively re-purchase shares once a certain discount threshold is breached.

“Combined, these mechanisms have proven successful at discouraging short-term investors from sitting on the share register and entrenching a discount."

While David Cornell, chief investment officer at Ocean Dial Asset Management, which runs the India Capital Growth fund, says when the stock trades at a discount, investors get an opportunity to make much more than in an open-ended fund.

The hope is that, in the long run, the result produces better returns for investors in investment trusts versus those in open-ended funds.Matthew Burrows

He suggests: “There are advantages to playing the discount in the investment trust world, because if you get discount narrowing and the asset value rising then you get a much better return.

“Clearly, that works in reverse when the discount widens and then asset value falls.”

Investment trusts also have the ability to issue new shares at close to NAV to ensure the premium does not rise too far, points out Matthew Burrows, chartered financial analyst and director of distribution at Frostrow Capital.

While gearing is not the sole driver of, but can affect, discount volatility, Mr Burrows suggests good investment performance, active marketing and measures in place to control the discount and premium, should all result in demand for shares and lower discount volatility.

However, he admits “these are attributes of surprisingly few investment companies”.

Nevertheless, he says that instead of being considered negative, discounts caused by factors beyond the control of portfolio managers could be viewed as a window of opportunity.

He adds: “This favours those beady-eyed investors who are canny enough to spot a temporary anomaly that can be exploited.

“So, don’t fear it, exploit it.”

Gearing in practice

Another unique feature of investments trusts is their ability to borrow money in order to finance further portfolio investments, explains Mike Wilson, head of sales at Janus Henderson Investors.

He explains: “The process is known as 'gearing up' and essentially affords portfolio managers the luxury of taking a longer-term view; [to] enhance income and capital returns in rising markets and to act quickly on attractive valuations without needing to sell any existing positions to raise funds.”

“The hope is that, in the long run, the result produces better returns for investors in investment trusts versus those in open-ended funds,” adds Mr Burrows.

He explains: “But markets are volatile and, while gearing can amplify returns in positive markets, so they also amplify losses in down markets.

“However, we all hope that markets will go up over the long-term and our investment managers can exploit those periods of volatility to their advantage, so the effect of gearing should be positive.”

Because some sectors and portfolios are more volatile than others, it is important for advisers to consider the gearing in that context too, and to remember that it is not as easy as saying that gearing is ‘good’ or ‘bad’; it must be taken on a case-by-case basis, he continues.

Gearing often takes the form of a short-term overdraft or a longer-term fixed rate loan called a debenture, explains Melissa Gallagher, co-head of investment trusts at BlackRock.

She continues: “If an investment trust has £100m and borrows £10m, the fund manager can invest £110m on behalf of its investors, which means the investment trust is 10 per cent geared."

Ms Gallagher notes: “Fund managers gear up or gear down depending on whether they are positive or negative about stock markets; they will look to reduce gearing when markets look expensive and increase it when markets look cheap.”

So effectively, gearing, usually expressed as a percentage, is calculated by dividing the company’s debt by its equity, and each trust will have a gearing limit, agreed by its board, which is expressed as a percentage of net assets, adds Mr Burrows.

Mr Burrows points out: “Gearing equivalent to 10 per cent of the portfolio in a ‘slow and steady’ sector with a diversified portfolio of 100 stocks may be acceptable, but in a highly volatile sector with a concentrated portfolio, it could be considered too racy.”

He continues: “[Gearing] enables investment trusts to be more nimble and take full advantage of buying opportunities without having to sell down current holdings to fund those purchases.

“This is vital when you consider the importance of a long-term time horizon when investing in the markets.”

 

Source: Fidelity International

victoria.ticha@ft.com