Disclaimer
This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.
In our inaugural jargon buster, we covered the basics of investment trusts. This week we’re going to dive under the bonnet to find out why investment trusts trade on a discount (or indeed a premium).
Open-ended funds (which most of us lazily call ‘funds’) have one price, and that’s the value of the net assets of the fund divided by the number of units in the fund. Easy, right? Well, unfortunately it’s a bit more involved for investment trusts which have both a share price and a net asset value per share.
The share price is pretty easy to understand: as with shares in any individual company, the share price is the quoted price you’d pay to buy or sell shares in the investment trust on the London Stock Exchange.
The second number is the net asset value (NAV for short), which is the total value of the underlying assets held by the investment trust (less any debt or loans it holds) divided by the number of shares in issue to give a NAV per share.
So why does it matter? Well, if the share price is lower than the NAV per share, the trust is said to be trading on a discount and if the share price is higher than the NAV per share, it’s trading on a premium. If the share price is the same as the NAV per share, it’s trading ‘at par’ (although this is rare in reality).
Let’s look at an example: if a trust’s share price is £80 and its NAV per share is £100, it’s trading at a discount of 20%. Whereas if the share price is £110 (and the same NAV per share of £100), it’s trading on a premium of 10%.
You might be wondering why an investor would be willing to pay more than the value of assets in the trust? Usually, it’s due to the trust being in high demand due to its strong track record of outperformance, an in-vogue investment style or a booming sector. Whatever the reason, you’d have to be confident that the trust can continue to outperform and justify its premium.
Does that mean that bargain-seeking investors should find the trusts trading on the largest discounts? Well, not necessarily because the discount could widen further if investor sentiment towards the trust, sector or wider market deteriorates.
That said, there is potential upside for investors if a trust or sector comes back into favour and the discount starts to narrow. Currently, more than 90% of investment trusts are trading at a discount, with a fifth trading on a discount of more than 30%, which could boost returns if investor sentiment towards investment trusts improves.
It’s also worth noting that boards will seek to manage discounts by buying back shares. This reduces the number of shares which increases the NAV per share (of the remaining shares). By the same token, boards may issue new shares to dampen premiums.
In the next jargon buster, we’ll be looking at how revenue reserves work. If there’s anything you’d like us to cover in future jargon busters, drop us an email at [email protected] or [email protected].
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