The No.1 rule when buying investment trusts

Unlike ETFs, investment trusts often trade at a discount to their net asset values. That means you can lose a lot of money. But it doesn't have to be this way.

Investment trusts can trade at a discount to the sum of their parts. In other words, you can buy them for less than their net asset value (NAV).

Contrast this with exchange-traded funds (ETFs). Whether the assets it holds are rising or falling, that ETF will always trade at its NAV. The profit opportunity here is linear. If the fund's holdings rise, the fund's value rises in lockstep.

But with investment trusts, you can also profit if the fund's popularity picks up and the discount narrows. Of course, that can work against you too: discounts can widen as well as narrow. And when that happens, the loss you take on the portfolio is made worse.

There are funds that today trade at less than half of their NAV. Take the APEN AG Trust. This trades at a 59.9% discount. That means a CHF 43.30 fund trades on the market for CHF 17.40. Over the last three years, the fund's price has drooped 84.1%. It's little wonder the discount is so wide.

But it doesn't have to be this way.

Investment trusts have a panic button that can stem a widening discount. It's called a discount control mechanism (DCM).

DCMs help to keep discounts under control. When the discount level falls below a certain threshold, the fund manager has the option to use the company's cash to buy back shares in the market. This demand should see the discount tighten.

Sounds like a good idea, eh? Yet as much as a quarter of the industry's funds - that's more than 100 listed investment companies - don't operate any DCM.

One prominent wealth manager with "skin in the game" is not impressed. "For an investment trust to have no discount control mechanism is archaic," according to James Burns of Smith & Williamson. Smith & Williamson has £1bn in trusts.

And Simon Westlake of City of London Investment Group agrees that "Boards should not shy away from shrinking funds. They should set levels for what discount they are willing to buy shares at."

My view is that a cautious investor should never buy a trust that doesn't have a DCM. In fact, by actively targeting those funds that do have discount targets, you might be able to get in and profit before the board takes action to close the discount. In a recent article for MoneyWeek, I recommend a few funds that might be worth looking at as the discount looks set to narrow. (If you're not already a subscriber to MoneyWeek, subscribe to MoneyWeek magazine.)

Recommended

When investors get over-excited, it’s time to worry – but we’re not there yet
Sponsored

When investors get over-excited, it’s time to worry – but we’re not there yet

When investors are pouring money into markets, it can be a warning sign of impending disaster, writes Max King. So how are fund flows looking right no…
26 Oct 2021
Larry Fink: the undisputed king of Wall Street
People

Larry Fink: the undisputed king of Wall Street

Larry Fink survived two big financial crises and went on to build a massive asset manager, doing for investing what Henry Ford did for cars. He has hi…
23 Oct 2021
Green finance is set to be the most powerful financial repression tool yet
Bonds

Green finance is set to be the most powerful financial repression tool yet

The government has launched its “green savings bond” that offers investors just 0.65%. But that pitiful return is in many ways the point of “green” fi…
22 Oct 2021
Andrew Hunt: why it's a great time to be a deep value investor
Value investing

Andrew Hunt: why it's a great time to be a deep value investor

Merryn talks to Andrew Hunt, author of Better Value Investing, about his adventures in the market's dark underbelly, looking for the hated and neglec…
22 Oct 2021

Most Popular

Properties for sale for around £1m
Houses for sale

Properties for sale for around £1m

From a stone-built farmhouse in the Snowdonia National Park, to a Victorian terraced house close to London’s Regent’s Canal, eight of the best propert…
15 Oct 2021
How to invest as we move to a hydrogen economy
Energy

How to invest as we move to a hydrogen economy

The government has started to roll out its plans for switching us over from fossil fuels to hydrogen and renewable energy. Should investors buy in? St…
8 Oct 2021
Emerging markets: the Brics never lived up to their promise – but is now the time to buy?
Emerging markets

Emerging markets: the Brics never lived up to their promise – but is now the time to buy?

Twenty years ago hopes were high for Brazil, Russia, India and China – the “Brics” emerging-market economies. But only China has beaten expectations. …
18 Oct 2021