Should I buy discounted trusts?

We're keen on investment trusts at MoneyWeek. One reason for this is that they can often allow you to buy assets at less than their true value. That's because shares in an investment trust are traded on the stockmarket unlike other types of fund, such as unit trusts and open-ended investment companies and their price is driven by market demand. If more people want to buy, the price rises; if they don't, the price falls. So the trust's shares can be undervalued or overvalued compared to its net asset value (NAV) the total value of its holdings.

Looking at the difference between the trust's share price and its NAV and understanding why it trades at a discount or premium is important when deciding whether to invest. That's because even when a trust is trading at a big discount to NAV, you're not necessarily getting a good deal, while a trust that trades at a premium isn't always a terrible deal.

There are several reasons that a trust may trade at a discount. It could be that investors are concerned and have started selling their shares in the trust, perhaps because they believe a particular sector will soon go out of fashion, or because they have growing doubts about the manager's ability. Investors may also be sceptical as to whether the NAV is accurate some investment trusts have holdings in unlisted companies, where valuations aren't always up to date.

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If an investment trust is trading at a premium to NAV, it's sometimes evidence that investors are overexcited about a sector and that the trust is overpriced. However, a more modest premium can be a sign that investors see it as an exceptionally well-run fund. You're paying more than the assets are currently worth, but you think the manager's decisions will add enough value in future that you are willing to pay up for access to their skill.

So when choosing an investment trust, you shouldn't look at the size of the current discount or premium in isolation. You should compare it to the trust's average over 12 months and ideally over a much longer period. If the current discount is larger than average (or the premium is smaller), it could be a good time to buy in.

However, do research the trust carefully to check that there isn't a compelling reason why the discount has widened perhaps the manager has made serious mistakes, for example. Also look at the sector average for similar funds, to see how the trust stacks up next to its peers: trusts in different sectors often trade at different discounts.

The sector's trade body, the Association of Investment Companies, is a good source of information on individual investment trusts. And MoneyWeek's editor-in-chief, Merryn Somerset Webb, has put together a portfolio of six of our favourite investment trusts.