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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.

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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.

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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.

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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.)

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