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Investment Trust Discounts and Premiums

09 Jan, 2024 | Return|

As Square Mile now includes a number of investment trusts in its Academy of Funds, with more to follow, it’s essential that our research approach considers the nuances of an investment trust’s structure in comparison to an open-ended vehicle. One of the most notable differences is the discount or premium that can apply to investment trusts’ share prices relative to their underlying Net Asset Values (NAV).

These discounts or premia can potentially act as a deterrent to investors. However, they can also act as an incentive. So that advisers can make informed investment decisions on behalf of their clients, in this article, we explore investment trust discounts and premia in depth to see what they mean, how they are managed and how they reflect market sentiment.

WHAT ARE INVESTMENT TRUST DISCOUNTS AND PREMIUMS?

The share price of an investment trust can fluctuate independently of its NAV - resulting in a discount or premium. The discount or premium occurs because, instead of the price being determined by the NAV as open-ended funds are, the price is determined by supply and demand dynamics generated by market participants.

HOW DISCOUNTS AND PREMIUMS ARE MANAGED

To ensure the smooth running of the fund, an investment trust’s independent board of investors can help regulate its current discount or premium. They may wish to do so if the price has dislocated from its NAV to such a degree that action is warranted. For example, in times of market stress, there can be a substantial and sustained dislocation between the investment trust’s share price and its NAV. As a result, this may mean the share price does not reflect the performance of the underlying NAV.

To prevent this, a board can put in place appropriate measures or limits, to dampen the amount, and the volatility, of any discount or premium of an investment trust’s shares.

There are a number of tools a board has at its disposal to manage the level of discount and premium of a fund. They are:

● Share buybacks or issuance: The board can buy back up to 14.99% of investor shares to reduce any imbalance by decreasing the number of shares, if the shareholders have given them the authority to do so. Conversely, if the trust is trading at a premium, the board may choose to issue new shares too.

● Tender offers: Similar to a one-off buyback, a tender offer allows shareholders to sell their shares back to the trust at a specific price on a specific date.

● Implementing a different sales and marketing strategy: Using different tactics to market an investment trust can drum up new interest from buyers, or decrease the number of sellers, thus changing the supply and demand dynamics which affect the trust’s share price.

● Adjusting the dividend policy: As with a different sales and marketing strategy, an adjusted dividend policy can decrease or increase interest from either buyers or sellers, again, influencing its share price.

The most common tool used by boards are share buybacks. Before choosing the best course of action, the board first needs to consider current market sentiment. To do so, they will investigate what is causing an imbalance between supply and demand of the investment’s trust shares, resulting in the discounted or raised share price.

WHAT DRIVES MARKET SENTIMENT?

Market sentiment is influenced by issues such as concerns in a specific sector or a lack of confidence in the manager of the trust. Outside of a trust, wider markets are often impacted by geopolitical events or monetary policy action taken by central banks. Changes to the regulatory framework can also impact varying levels of interest in certain investment vehicles.

Current investment trends can also be a factor. For instance, investment trusts are arguably better structured to buy more illiquid and private assets. Increasingly, the market is likely to demand easier access to such assets and, as such, an increase in demand for investment trusts might be expected.

For Square Mile’s purposes, our analysts evaluate the board’s abilities to conclude what’s driving market sentiment to control any discount or premium and then the subsequent efficacy of their chosen course of action. When taken together with the rest of an analyst’s in-depth research, it is possible to determine whether the investment trust ultimately merits a rating.

Take a look at Square Mile’s rated Investment Trusts.

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