Buying Investment Trusts – Premium & Discount to NAV

The problem with buying Investment Trusts is that they are quite a specialised sector/ or asset class and as they are traded openly on stock market exchanges they trade at a discount or premium to their Net Asset Value or NAV.

Trusts trading on a premium might indicate strong performance or a high income, but they come with a major risk: if the premium falls, investors will lose money. Just as with any other share, if you pay 120p and its price falls to 100p, you have lost 20% of your capital. Investors may make the judgment that the higher income they receive is enough to offset the capital loss, but there is also the risk that the pay out falls.

“Although there are more trusts at a premium today, it isn’t that different in percentage terms,” says Canaccord Genuity investment analyst Kamal Warraich. “The key difference is that the sectors trading at premiums have changed over time and the level of the premiums are higher in some areas.”

Many recent investment trust launches have focused on alternative assets and the provision of a strong and reliable income stream. Their popularity among hard-pressed income-seekers means they have consistently traded at premiums.

Most of the 39 trusts that have traded at an average premium of 5% or more over the past year have specialist or alternative mandates.

How much is too much?

Paying more for something than it is technically worth is not a great investment strategy. Equally, just because something is trading at a discount does not make it a bargain.

When it comes to premiums, how much is too much? The answer is subjective. “You really have to look sector by sector and consider each trust in the context of history,” says David Liddell, a director of IpsoFacto Investor. For equity investment trusts, he would be wary of a premium of more than 3%.

William Heathcoat Amory, a founding partner of Kepler Partners, agrees. “A premium of up to 3% is acceptable, but anything over that is getting dangerous. A 5% premium seems excessive for a listed equity strategy.

“For unlisted or alternative assets, it’s a bit more nuanced and could be more to do with the way the net asset value (NAV) is calculated.”

In broad terms, trusts trade at premiums because there is excess demand for the shares – more buyers than sellers. While this should help to continue to support the share price, many investment trusts have discount control mechanisms which sees them issue shares to limit premiums or buy them back to narrow discounts.

Buy, Marry, Avoid?

I’d say that a trust’s premium or discount has to be judged on its own merits.

If you want to invest in some sectors, a small premium seems to be the price of admission. You could hang around waiting for it to disappear, but sector-wide premiums often seem to persist for many years.

Likewise, large discounts tend to linger for ages, only to narrow dramatically in the brief time you weren’t paying attention.

However, the longer you hold for, the more important the underlying performance of the fund is and the less the initial discount or premium should matter.

Arguably, a premium or discount becomes more important when looking at lower growth/high-income investment trusts, as any change is likely to be a much more material element of your overall returns.