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Should you swap your shares for an investment trust on a discount?

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During a bear market in shares (like the bear market we’re in as I type), investors flee the scene like lemmings leaping off the Titanic.

One effect of such pessimism is widening discounts on investment trusts. When nobody wants to buy them, big, venerable investment trusts can easily trade at 10% discounts to their underlying assets (known as the trust’s Net Asset Value, or NAV for short).

For adventurous investors, discounts are an opportunity to get more shares for your money. A classic play is to buy the investment trust at a discount when times are bleak and then sell it when everyone has cheered up and the discount has narrowed, or even become a premium.

What if you’re already fully-invested and have no spare cash? Well, how about swapping your existing portfolio of blue chip shares, such as a high yield portfolio (HYP), for a discounted investment trust that holds similar shares already, and then selling and swapping back to a HYP when the discount closes?

Would it be sensible? Is it even financially viable, after trading costs? I’m not sure myself, so let’s explore whether you really can make money by swapping your portfolio of shares for a discounted investment trust.

Recap: Why big discounts can be good for investors

Investment trusts are companies quoted on the stock market, which can be bought and sold just like any other share. If you’re not up-to-speed on them then please read my introduction to investment trusts.

Done that? Great. You’ll know now that when you buy an investment trust when it’s priced at a discount, you’re buying the underlying shares on the cheap. A 10% discount on an investment trust is like a ‘10% off!’ sale at your local department store. Bargain!

Better still, investment trust discounts tend to wax and wane, so if you buy a trust when its discount is wide and sell when it narrows, you can make significant gains, on top of any increase in the underlying holdings.

For example, here’s discount narrowing:

  • You invest £100,000 in Fictitious Funds Investment Trust, which is trading at a 10% discount.
  • Your underlying holdings are thus worth £110,000.
  • The discount narrows to 5%. Let’s assume there’s no change to the underlying NAV.
  • Your shares in the trust are now worth £105,000.

There is another advantage if you’re an income investor. Buy shares in a discounted equity income investment trust, and you get more dividend income then you would if you bought the underlying holdings, simply because you’re getting more shares, and thus more dividends, for the same investment money.

For example, here’s how a discount can boost your income:

  • You invest £100,000 in Fictitious Funds Investment Trust, which is trading at a 10% discount.
  • The trust is invested in five high yield companies, which yield an average of 5%.
  • If you’d spent £100,000 on shares in the five companies, you’d thus be entitled to £5,000 in dividends a year. (5% of £100,000).
  • However the discount means you got an extra 10% worth of shares when you bought in. This means (ignoring charges) that you’ll get 10% more income then if you’d bought the shares yourself, or £5,500 a year in total.

Never ignore charges, and other downsides of investment trusts

In reality, annual management charges of around 0.5% will erode any income advantage that arises from the discount, compared to buying and holding the underlying shares.

For instance in the example above, by buying the shares via the investment trust discount I’ve increased the yield from 5% to 5.5%. Knock off those charges and I’m back to 5% again – the same as if I’d held the shares directly.

There are other potential downsides to investment trusts, too, compared to directly holding shares yourself:

  • The discounts can widen further, rather than narrowing.
  • They may widen at time when for personal reasons you have no choice but to sell.
  • You’re trusting a manager, not your own judgement, and paying for it.
  • Most managers fail to beat the index.
  • Your manager might do really badly, which would reduce the NAV and widen the discount.

Now when you buy and hold shares yourself, you’re relying on your own judgement, and theory says you’ll also likely struggle to beat the index, too. But at least you won’t be paying for the privilege!

Why I am considering trading my HYP for an equity income trust (for a bit)

I own a basket of blue chip, high yield shares, many of which have suffered from the year-long credit crunch. Will they fall further? Possibly. But I believe you need to be invested in the market for the long term.

Sure, take some gains off the table in the good times, practice asset allocation, and make an effort to buy during the bad times. But I agree with Benjamin Graham that the core of your portfolio should be invested according to your age and risk tolerance, not the current state of the markets.

The question here isn’t whether I should sell the shares and put the money into bonds, cash, or under the mattress. It’s whether there’s a case for liquidating the portfolio, and immediately buying back into the market via a big, liquid investment trust on a wide discount that holds similar shares to the ones I’ve already got.

Something like, for instance, the City of London Investment Trust (or CTY, to use its stock symbol for short).

CTY is on a discount of 10%. It currently yields just over 5%. Its holdings include big dividend paying shares very similar to the ones I’ve got in my portfolio.

Its top 10 holdings are: BP, British American Tobacco, Vodafone Group, Royal Dutch Shell, Diageo, GlaxoSmithKline, National Grid, BT Group and Scottish and Southern Energy.

Those aren’t precisely the shares I own in my HYP, but they’re certainly the sort of shares I’d expect to see in a HYP today.

The lack of a big bank is an obvious omission, but a quick check further down the Trustnet page I linked to reveals CTY is nearly 20% invested in financials. I suspect CTY used to be more heavily invested in banks, and that they plunged in value out of the top 10 as the credit crunch unfolded. Sure enough, Lloyds and Barclays make an appearance in the historical holdings data .

In short, CTY looks a good proxy to a HYP.

The pseudo-arbitrage HYP to IT proposal is as follows:

  1. Sell all my separate HYP share holdings.
  2. Buy City of London Investment Trust on a 10% discount.
  3. Twiddle thumbs, go for a walk, watch policeman get older, wait a few months/years.
  4. Sell when the discount has reduced to 5% or less, for profit.
  5. Buy back a new HYP.

I call it pseudo-arbitrage because it’s clearly not real arbitrage; CTY’s managers haven’t been shadowing my portfolio for the past five years. But I do believe the holdings would roughly track each other, or at least that there’s as much of a chance that they’d do better as that they’d do worse to my own HYP would. It’s a reasonable swap.

What’s more, CTY has an excellent record of increasing dividend payments. They went up over 10% last year, and if I recall correctly they’ve an unbroken record of 30 years or so of dividend increases. So I can be hopeful about the income.

If I like CTY so much, why didn’t I just buy it in the first place? Well, that’s a good question and one I’ve been considering myself recently as I’ve focused more on asset allocation.

Partly, it’s because I love holding shares… the thrill of a takeover, the idea that I am a tiny owner in a giant such as BP or Lloyds. Also, I hate paying charges. Equity income investment trusts typically trade on very narrow discounts, at least as far as I recall, so it’s cheaper to hold the shares directly. Finally, I like being in control.

The story here though is about getting something out of nothing from my existing shares.

To recap:

  • I’m already exposed to the equity market.
  • I’m already exposed to the same sort of shares as CTY.
  • I could get greater exposure for the same cost (with some risks as above).
  • I could make a capital gain.

Cost issues of swapping from a HYP to an investment trust

(Nearly there!) Leaving aside the specific risks of investment trusts I looked at several hundred words ago, the main issue as I see it is one of cost.

Cost of selling the portfolio: Let’s say I have 25 holdings, each of £2000, and it’ll cost me £12 to sell each one. My total selling costs are £300.

Cost of buying the investment trust: I now have £49,700 to invest on the City of London IT. The broker will charge me £12. The spread between buying and selling as of today was about 0.5p of the share price of 220p, or roughly 0.2%. The government will charge me 0.5% stamp duty.

My total costs are, roughly £12, plus (0.7%*£49,000) = £348.

I’m left with £49,352 in CTY shares. This buys me underlying assets worth 10% more, or £54,287 (but remember, if I sold today I’d only get what the (discounted) CTY shares are worth, not what the NAV indicates).

So I’ve increased my underlying high yield share exposure by £4,287, although for now I’m showing a slight loss. I need the discount to narrow for it to be profitable.

There’s no guarantee, as I’ve said, that the discount will ever narrow enabling me to see any of that value, but in the meantime I can hold for the decent income, as I’m doing with my HYP anyway.

The pay-off: What does a narrowing discount get me?

Fast-forward a year, and let’s pretend that shares CTY holds are priced roughly at the same level they’re at today, but people are a lot more optimistic about the markets and so the trust’s discount has narrowed to 5%.

In other words, the holding is now worth in ready money 95% of £54,287, or £51,573. I decide to sell and buy my own HYP again.

Cost of disposing of my holding in CTY: £12 brokers fee, leaving me with £51,561.

Cost of buying back a 25-share strong HYP: Let’s assume a 0.25% spread for each share, plus 0.5% stamp duty,  or 0.75% in total, plus £12 per holding in brokers fees. The total cost is £300 in dealing fees, plus £384 in various dealing costs, or £684 in total.

The net result is I end up with a share portfolio worth £50,877. That would be a gain on the initial portfolio of £877, or 1.75%.

Is it worth trading in the HYP?

On these purely hypothetical numbers, you’d have to say yes. Sure, 1.75% is a small uplift, less than I expected before I crunched the numbers, but in this example shares actually went nowhere over the 12 months. 1.75% is more than 0%.

But in reality it looks a lot of fuss for not much gain, plus more risk. There’s the danger of sitting in a trust for years while the discount widens (and may never narrow), and the possible risks and consequences of losing control of your investments due to some unforeseen circumstance with the trust (very small, but real).

The broker fees really add up, too. It costs £612 to complete the trip from HYP to trust and back again, which is a huge sum compared to overall gains on the operation.

The converse of that is if you’re dealing with a portfolio of, say, £100,000, the fees stay fixed with an online broker, so you’ll get a better uplift of around 2%.

It’s also possible that the discount on the trust could close entirely, resulting in a far greater gain – investment trusts do sometimes trade at a premium during heady bull markets. It’s risky to assume this would happen, however.

Finally, in my example the NAV didn’t increase. In reality it very likely would if the discount widened, which would increase your gains. If you’d stayed put in your portfolio of shares you’d also have benefited as shares rose, but you’d benefit more in the trust, since you got more share exposure initially for the same money due to the discount. (Confused? I could use a cup of tea and a lie down myself!)

Final thoughts on swapping a share portfolio for a discounted investment trust

I’ve not considered a few other factors, most particularly Capital Gains Tax. If selling your portfolio incurs a capital gains tax bill of any size, I doubt the swap would be worth it. Check the latest capital gains tax limits to see if you’d be hit.

Another thing I’ve not mentioned is an investment trust can be geared (i.e. take on debt), which can magnify losses in a downturn, and boost gains in rising markets. Overall it makes the trust holding riskier than owning the shares directly.

Finally, I’ve not at all considered what to look for in an investment trust, which would take a whole other article (or five!). For the sort of HYP-to-IT swap I’ve outlined here, you want an old, traditional trust with a lot of assets that keep management costs low, and needless to say it needs to be focused on income from dividends. In particular, realise that discounts may reflect deep worries about management or the sector a trust focuses on. It’s not a one-way bet by any means!


If you’re tired of holding a share portfolio directly, wide discounts might indicate a good time to swap your shares for a similar investment trust. I’m not sure about the financial case, however… I’m going to sleep on it. Alternatively, if you’ve got some spare cash why not simply pick up a discounted investment trust bargain? The discounts we’re seeing could suggest that high yield shares are cheap.

{ 2 comments… add one }
  • 1 ivanopinion June 25, 2013, 12:58 pm

    Did you do this? In retrospect, you would have made a killing, because CTY is now on a premium. In retrospect, this 10% discount in 2008 was crazy. CTY invests in listed shares, so you could be confident that you were getting a real 10% discount. Even in the panic of the crash, why didn’t the market immediately arbitrage the discount away?

  • 2 The Investor June 25, 2013, 3:03 pm

    @ivanopinion — Yes, I did do this, but it was amongst much else so I can’t claim it was a clean swap. I’ve traded far more in and since 2008, so really ditching most of my then extent HYP for discount ITs was the least of it. 😉

    The market didn’t arbitrage the discount away because everyone hated shares and were fearful. (Read this article on discounts for more).

    This is by no means unusual, though it was rare for income ITs to go to such discounts. Right now, for example, you can buy shares in the Hansa Trust and get a nearly 25%+ discount to NAV. There family control makes it harder for any potential arbitrager to come in and out the value. (I hold).

    Alliance Trust is another one that has consisted overwhelmingly of listed shares and traded out a big discount for years. An activist did manage to get in there to mix that one up a bit though. There was a point when a billionaire could have made a 20% or so buy buying Alliance Trust and liquidating it. Presumably the hassle makes it more work than its worth (especially with lots of small shareholders).

    One problem for a potential arb with deep pockets is that the discount can close when they start to move, due to their actions, though it’s not a big problem since they can then exit again at a profit!

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