Investment trusts: How to spot a golden goose

With most trusts permanently trading at a discount, how can investors identify a good egg from a bad one?

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Deep and widespread discounts have been touted as a prime buying opportunity, with investors now able to buy trusts at prices well below their net asset value (NAV). However, it is worth bearing in mind that investment companies have always traded at discounts historically, meaning the current opportunity set may not be the golden goose some investors take it for.

While the current average trust discount of 15.6% is deeper than usual, they traded 6.2% below NAV over the past decade and an even steeper 7.9% over the past five years. This might have investors wondering how they can differentiate the trusts that can materially narrow their discounts (potentially even reaching a premium) from the majority that are perpetually stuck below their NAV.

Liquidity matters

The asset class a trust invests in is an indicator of how likely it is to narrow its discount, according to James Carthew, co-founder and head of investment company research at QuotedData. Most trusts invest in equities, which are highly liquid and can be easily sold to raise money. These proceeds can be used to buy back shares in the trust that will in turn shrink its discount. Having this option readily available should stop the discounts on equity funds getting out of hand, says Carthew.

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“Equity funds should trade on relatively narrow discounts and the more liquid their portfolios are, the tighter those discounts be,” he adds.

Yet this is not the case for all equities. Trusts investing in small caps cannot sell out of their holdings with as much ease, so while it is still an option, it is not as accessible. Carthew says trusts investing in small caps that have discounts above 25% are “definitely cheap” as they should be trading below 20%. With large-cap equity funds, anything with a discount in excess of 5% is worth considering as “it should reasonably trade back to 5% again”.

Past discounts

Looking at how a trust has traded in the past is a reliable way to forecast where it could travel in the future. When a trust’s discount or premium moves, it often returns to its average level, according to Carthew. All investors must do is examine the portfolio and assess whether anything has fundamentally changed. If a trust has maintained the same strategy then it is likely to return to normal, but if a shakeup has occurred then past discount data becomes void.

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Carthew says this is the case with Scottish Mortgage. It upped its private equity exposure which has altered the portfolio composition and changed how it will be valued in future. Looking at its past data is therefore less reliable.

“Scottish Mortgage ramped up the amount of private equity, which changed what the fund was doing and could permanently affect the discount,” Carthew says. “But if you’ve got something investing in equities where nothing has really changed, then you should expect a gradual reversion to the norm.”

Read the rest of this article in the May issue of Portfolio Adviser magazine