The closed end structure of investment trusts means they can trade at a premium or discount to the value of their underlying investments or net asset value (NAV). This is typically dependent on investor demand for the shares.

Some trusts look to counteract this situation by employing ‘discount control mechanisms’ (DCMs) which will trigger a response to close that valuation gap if the discount gets too wide. This article will look in more detail at how these mechanisms work.

When valuing investment trusts the market will typically focus on net asset value, or total assets minus debt, because trusts can invest with borrowed cash.

Essentially it shows you what you would get back if the trust was wound up, its assets sold off and the proceeds returned to shareholders minus any liabilities.

How do trusts address discounts and premiums?

An investment trust may issue new stock when shares start to trade at a premium. As for discounts, there are two main ways an investment trust will look to reduce the discount to its NAV, with the threshold anywhere between zero and 10% or sometimes higher.

Probably the most common approach is to buy back shares in the market. Reducing the number of shares in issue should boost the NAV attributable to the remaining shares.

Tender offers or redemptions, whereby the trust will allow shareholders to sell a proportion of their shares back to the company at either a fixed discount to NAV or a price close to the NAV itself, are also employed.

Peel Hunt investment trust analyst Anthony Leatham expands on the options available to trusts: ‘Certain trusts have either a fixed life or a continuation vote in place which can act as a catalyst for a discount narrowing.’

These arrangements mean either a trust will only exist for a fixed period or it will allow shareholders to regularly vote for it to be wound up after which shareholders will be paid their share of the company’s assets at or close to NAV.

‘A final, indirect mechanism has been to offer an enhanced or manufactured dividend and thereby make a trust more appealing to a wider audience and increase demand for the shares.’

‘Death by a thousand cuts’

There is no guarantee that buying back shares will be effective in narrowing the discount as the trust is still at the mercy of market volatility and investor sentiment.

For this reason, Leatham reckons the ‘hard deadlines’ of fixed life, annual redemption facility or continuation vote policies offer a great degree of certainty absent from the buyback approach, noting comments from the chairman of Baring Emerging Europe (BEE) that buying back shares to defend a discount can be equivalent to ‘death by a thousand cuts’.

Winterflood investment trust expert Kieran Drake says it can be damaging for smaller trusts to buy back shares. By reducing the size of the fund it potentially undermines liquidity, making it harder to buy and sell the shares in the future.

Also for trusts which invest in illiquid underlying assets it could be challenging to raise the cash necessary to buy back shares.

Leatham adds: ‘The drawbacks are simple; pursuing a policy which involves spending a material amount of capital to defend a discount that is unavoidably volatile is counterproductive.

‘Instead, taking a holistic approach and letting the NAV returns do the talking, amplified by a concerted marketing effort should lead to more sustained buying demand.’

Opportunities for arbitrage?

Some investors like the closed end structure of investment trusts specifically because they can capitalise on the difference between the NAV and the share price.

Leatham says: ‘Personally, I consider discount volatility to be an opportunity. To see a great manager trading on a wider-than-average discount due to some unforeseen exogenous event can present an opportunity to buy £1 of quality assets for 80p, for example.’

Winterflood’s Drake says there is also ‘potentially’ an arbitrage opportunity on a trust which trades at a wider discount to NAV than targeted by a trust’s discount control mechanism. However, he adds that investors must take a closer look ‘to see how strongly the board has enforced the target in the past’.

He also points out that trusts may only respond to a widened discount if it persists for a certain amount of time rather than acting immediately to address any short-term gap between the shares and NAV.

In some cases, the trust could be using a specific measure of NAV when determining the discount level. Winterflood bases its numbers on an ex-income NAV with debt at par value. Essentially this means any debt is valued as if the rate of interest on it is unchanged by market conditions.

For example, Aberdeen Diversified Income & Growth (ADIG) trades at an 8.6% discount to NAV by Winterflood’s reckoning. However, the discount based on its own calculation of NAV, which includes debt at fair value (or in other words takes account of current rates of interest), is 4.6% and therefore within the targeted level of 5%. (TS)

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