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Why do investment trusts trade at a discount or a premium?

Discounts and premiums

See my earlier article on investment trust NAVs, discounts, and premiums if you don’t know what those terms mean.

The stock market isn’t totally efficient, in my view. But it seldom hands out free lunches.

You might then wonder why an investment trust would ever trade at a price below what its assets are worth (that is, at a discount) – let alone why some people would be dumb enough to pay more for it (a premium).

Actually, there can be good reasons for both situations. Discounts are especially common.

In late summer 2008, for instance, I posted about numerous income investment trusts trading on 10% discounts in that deep bear market.

Discount aisle

Reasons for a trust trading on a discount may include:

  • Investors are scared, and so having been dumping their shares in investment trusts. Most trusts are less liquid than their underlying holdings. This can mean the trust’s share price falls faster than its NAV, increasing the discount.
  • Investors may be skeptical that the trust’s NAV is really as much as is claimed. Private equity trusts – where valuations are infrequent and often off-market – are typically discounted for this reason. Commercial property trusts (REITs) may trade at a discount if investors suspect real world prices are falling faster than management is updating the trust’s NAV.
  • A lack of faith. Investors may believe bad management is going to reduce the investment trust’s NAV instead of growing it. This is often seen with trusts with a poor track record.
  • Disinterest. Simply the whims of fashion. Discounts often close and widen from month to month with little apparent rhyme or reason.

Theoretically a very large discount should be arbitraged away by the market before long. In reality sometimes discounts can persist for years before action is taken.

For example, when I first published a version of this article in August 2010 I wrote:

Alliance Trust is one huge old trust that has traded on a discount of nearly 20% for an age.

Arbitragers have looked at releasing the value (by buying the entire trust and then selling all its holdings for a 20% gain, minus costs) but so far nobody has pounced.

Interestingly, the discount finally began to narrow a few weeks later! It’s now around 10%.

What happened? Well, from memory Alliance Trust’s performance improved a tad – or at least investors took a more generous view of it.

But more importantly, an activist investor called Laxey Partners targeted the trust in late 2010, demanding the board take action to limit the size of Alliance’s discount. This interest was enough to close the discount to 15% even before Alliance’s board implemented any explicit measures in response (such a formal share buyback plan).

The Alliance story went through many twists and turns, including the involvement of another activist and much boardroom drama. A Telegraph article from last October provides a recap.

The takeaway for our purposes – apart from wondering whether activist investors read Monevator – is to note that big discounts do not necessarily mean a trust is permanently impaired. They can be and often are reversed.

But sometimes big discounts do portend doom. I’ve seen the value of several specialist property trusts implode over the years. Usually they were overwhelmed with debt. In every case a huge discount preceded their demise.

Finally, discounts may persist when for some reason it’s not possible for an outsider to stir up much of a threat to the status quo.

Typically there’s a large controlling shareholder – perhaps the family that initially set-up the trust. Hansa Trust is a good example.

Premium aisle

As you’d expect, reasons for the rarer situation of a trust trading on a premium are the inverse:

  • Investors are bullish, and have bid up the price of relatively illiquid trusts in their mania.
  • Suspected undervaluation in reported NAVs. As with the equivalent situation with discounts, this will typically involve unquoted investments, such as property or private equity. Investors may guess the NAV of a trust has risen beyond its officially reported value. The Lindsell Train investment trust is a great example, currently trading at a 58% premium! Investors seem to believe the trust’s holding in its own management company is dramatically undervalued, despite said management urging otherwise. A clue that this is the cause of the premium (besides the sheer enormity) is that the Finsbury Growth Trust has the same manager and very similar holdings – except it has no stake in Lindsell Train. Finsbury currently trades around NAV.
  • Strong faith in management. For example, Anthony Bolton’s China trust initially traded on a premium. Investors believed Bolton’s superb record with his UK fund implied he would grow the China trust’s NAV fast enough to make up for the premium and more. But it turned out he couldn’t – at least not in the short-term – and the premium evaporated. The fund now boasts new management and a 15% discount.
  • Fashionable. If an investment trust has been in the news or is one of the only trusts operating in a hot sector, it’s often bid up in price.

As a rule of thumb, it’s best to avoid buying investment trusts trading on a sizeable premium, as you may lose money if it narrows.

However I wouldn’t quibble over just a 1-2% permium if you’re a hardcore investment trust owner. Refusing to pay anything but a discount can keep you out of excellent trusts with strong multi-year records for years.

Equally, a trust trading on a discount may not be the bargain it first appears – or at least the discount may not be set to narrow anytime soon. As always, it’s vital to do your own research.

Want more? Please do peruse our other articles on investment trusts.

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{ 16 comments… add one }
  • 1 jyoti ghosh August 11, 2011, 3:08 pm

    Exactly what I needed – well explained

  • 2 Gary February 4, 2012, 2:35 pm

    One of the things property companies expected upon conversion to REIT status in 2007 was that their shares would swing from trading at a discount to NAV to a premium to NAV.

    Could you outline some of the reasons behind this – what is the benefit to a company if shares trade at a premium? I’m doing a dissertation on REITs, but i don’t fully understand why there is such emphasis placed upon a REITs shares trading at a premium.

    Thanks

  • 3 Amit November 17, 2016, 1:27 pm

    I have never understood why discounts are so common in investment trusts and so uncommon in ETFs. Is it because the etf issuers are contracted to control discount?

  • 4 dlp6666 November 17, 2016, 1:28 pm

    “But sometimes big discounts do portend doom. I’ve seen the value of several specialist property trusts implode over the years. Usually they were overwhelmed with debt. In every case a huge discount preceded their demise.”

    Reminds me of my getting stung with Invesco Property Income IT where I thought I’d bagged a great discounted bargain with a fine yield but breach of its loan to value covenants eventually led to its effectively going bust (I foolishly stayed invested thinking the Invesco ‘brand’ was so reliable and would eventually deliver. Mistake).

  • 5 tom_grlla November 17, 2016, 1:33 pm

    The market cap of an IT can sometimes have somewhat of an effect on discounts.

    e.g. sub-£100m ITs have a limited pool of potential investors as most wealth managers and institutions will give them a swerve, and this can leave them on wider discounts.

    Smaller ITs are also less appealing as the bid-offer spread can be horrific.

    Also, if an IT is of a sufficient size, and the discount widens, the board may buy back shares. But they’re less likely to do so (in my experience) if the market cap is less than £100m as they don’t want the IT to become too small.

    (I appreciate there is a very small pool of people interested in this sort of detail…).

  • 6 The Investor November 17, 2016, 2:17 pm

    @Amit — Re: ETFs, normally what are called “Authorized Participants” are able to close discounts/premiums with ETFs fairly swiftly — usually so swiftly that they’re effectively negligible — by the normal process of creation/redemption that allows money to flow in and out of ETFs.

    However you do sometimes see discounts/premiums with ETFs, particularly in ETFs holding illiquid investments, or when there’s some kind of market shock, such as an unexpected outage or a flash crash, or if the ETF becomes very small and unviable. In all these cases the normal activity of Authorized Participants has been disrupted.

    There’s no implicit promise that an Investment Trust will trade at NAV. And of course investment trusts are ‘closed-ended’, which means they don’t expand or contract their capital base when new money flows in/out. Rather, the price responds to supply and demand. Hence no Authorised Market Participants in the process, and so no sort-of-automatic arbitrages. Instead, market forces are left to sort out the discount/premium over time.

  • 7 arty November 17, 2016, 2:19 pm

    same question as posted on the IT’ for deaccumulating thread (though figures of course changed now):

    What is the easiest way to get reliable figures for current premiums/discounts for some of these trusts? Different sites seem to give different figures, some of which are plainly ridiculous, such as the 12m average Premium/Discount for TMPL shown as -38.65% on HL:
    http://www.hl.co.uk/shares/shares-search-results/t/temple-bar-investment-trust-ord-25p-share

    Would be great if there was one place (like your table on that thread) where one could see all the discounts, yields, etc live (or liveish)

  • 8 Passive Pete November 17, 2016, 3:27 pm

    I think that another reason for the high proportion of discounts for IT’s is their higher ongoing costs when compared with alternative products that have similar investment goals. Take for instance, The Merchants Trust that is currently trading at a discount of around 8%. It’s aim is to invest in higher yielding UK FTSE 100 companies. Then compare that with iShares Core FTSE 100 ETF. Merchants Trust has a Total Expense Ratio of 0.58%, whereas iShares cost is 0.07% pa. In addition, iShares is based in Ireland, so I understand that there is no stamp duty to pay on the purchase of the ETF, whereas the Merchants Trust is UK based, so stamp duty is an additional cost.
    As previously noted, the bid/offer spread for IT’s is often higher. For Merchants Trust it’s currently 0.344% whereas the iShares ETF is 0.045%. Another indicator of the apparent illiquid market for IT’s is the Exchange Market Size – Merchants Trust is 750 shares (approx £3,300) whereas iShares ETF is 12,500 shares (approx £84,000).
    I’ve chosen Merchants Trust because its quite sizeable and, for IT’s, its TER is reasonably low. However, the relative illiquid market and higher ongoing costs are why I don’t hold any IT’s.

  • 9 hosimpson November 17, 2016, 8:59 pm

    What do you think of RCP? It was a bargain in 2012-2013, but no longer; do you have a view as to why?

  • 10 The Investor November 17, 2016, 10:04 pm

    @hosimpson — Just from memory (a) it came out of the financial crisis a bit slow/defensive, and so underperformed the rally (having outperformed through it) and (b) it instigated a formal dividend policy a few years ago, presumably to try to tap into the mania for income then and to close the dividend. Any holders may have more detail! 🙂

  • 11 The Investor November 17, 2016, 10:16 pm

    @dlp6666 — I went through something similar with a Japanese REIT (JREIT!) into the crisis. Not fun. Only a tiny position though.

    @tom_grlla — Yes, can be a factor (and also for premiums in boom times, although it’s been a long time since we had a proper boom! 🙂 )

    I think illiquidity can be worth pushing through if you are going to buy to hold and so garner any excess return for putting up with it. E.g. my mum (via some coughing and prodding from me) invested in the Rights and Issues Trust’s capital shares a few years ago. The spread becomes immaterial if you just keep holding so it’s — um — spread over many years.

    Re: Buybacks, for small trusts sometimes they also can’t keep buying back because of strictures regarding major shareholders and control. From memory Hansa is in this boat.

    @arty — I use http://www.aicstats.co.uk/ a lot. You’ll need to go into each Trust to see the discount, but they’re usually pretty good. (Some trusts update more regularly than others. You can check the LSE website for RNS releases on NAVs to see if you’re missing more regular updates). I think Trustnet has tables showing discounts/premiums at the top level; it certainly used to. In my opinion the discount/premium situation is only a small part of the story, of course.

    @Passive Pete — Perhaps. Someone has probably done some research on costs and discounts. However I think most IT investors are in them because they see a reason for out-performance (…) and/or they want access to a collection of assets (or a manager) that isn’t going to be replicated by passive vehicles. (We can argue about whether they’re right to, but that’s for a different thread really. 🙂 ) I don’t think they’re weighing up a trust versus the most similar tracker and comparing costs.

    That said there was a UK tracker fund that ran as a Trust which was quite often on a discount. Not sure if it still exists. It wasn’t the cheapest tracker, which may add some weight to your theory. Then again people buy expensive trackers (e.g. Virgin) so I have my doubts the market is really that discerning.

  • 12 Jaygti November 17, 2016, 10:32 pm

    The uk tracker is aberdeen uk Tracker trust (AUKT).
    It’s current discount according to HL is 6.7%. Although it was over 10% during May. Its market cap is £312 million, and its ongoing charge is 0.29%.
    Dirt cheap for an IT, but not for a Tracker. I’m not sure if the discount makes up for the slightly higher ongoing charge compared with a fund or ETF though.

  • 13 magneto November 18, 2016, 11:04 am

    The Infrastructure ITs highlight examples of ITs trading at substantial premiums today.
    HICL for example is currently on a premium of circa 15%.

    The reason usually given for substantial premiums in such sectors is that in today’s low yield environment, an effectively index linked (real) yield of 4.43% is hard to beat.
    Seems an eye-watering premium though!!!
    And atypical of the IT sector generally.

  • 14 The Investor November 18, 2016, 11:21 am

    @magneto — Indeed. 🙂 You may recall from our previous discussions of (supposed) bond substitutes that I am sceptical of the high premium put on infrastructure funds currently. (I haven’t got a problem with the trusts per se, but I do with the notion that they are bond substitutes and also with the valuations…)

    It was only 18 months or so ago that the majority of UK income investment trusts were on premiums, in some cases fairly high (though not as high as infrastructure today). That made even less sense, given they just held a bunch of very liquid and listed equities. Sure enough, it didn’t last.

  • 15 Financial Samurai November 20, 2016, 4:50 am

    Oh, and our investment trusts in the UK? I’m not sure they are the common here in America unless we are just calling mutual funds and closed in mutual funds a different thing?

  • 16 The Investor November 20, 2016, 10:06 am

    @FS — Yes, in the US they are called closed-ended mutual funds, as you suggest. The other big difference is ours tend to be very old and trusted, whereas in my experience in the US they are often niche/specialist and sometimes associated with borderline spivvy / risky investing. (We had something like that with what were called “split capital” trusts 20 years ago, but those are a different thing again…)

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