Investment Trusts Trading At Discount
TOPIC # 3
According to Cheng et al. (1994, p.813), ‘an investment trust company (ITC) is a UK public limited company, the business of which consists of investing its funds mainly in securities, with the aim of spreading investment risk and giving members of the company the benefit of the results of the management of its funds.’ In the UK, investment trusts started to form as early as the mid 1800s and helped small investors to diversify their risk through pooled investment (Bengassa, 1999). Not long thereafter, institutional investors also began to participate in investment trusts. The main benefit provided by investment trusts is diversification and the access to managerial skills (Bengassa, 1999). Investment trusts are closed-ended funds that issue a finite number of shares and investors cannot come and go as in open-ended funds (Clarke, 2012). These investment trusts are usually issued at a premium above their Net Asset Value (NAV) but they eventually decline and trade at a discount to the NAV. This trend continues right up until termination when the price converges again towards the NAV (Berk & Stanton, 2004). Investment funds in the UK are invested solely in stocks (Dimson & Minio-Kozerski, 1999) and unlike the situation that obtains in the US, the majority of investors tend to be institutional rather than individual investors (Krintas, 2009). There are varying reasons why the anomaly of investment funds trading at a discount occurs. One view is that discounts result from the fact that ITC shares are often underpriced (Cheng et al., 1994). Other popular views include the effect of taxes, transaction costs, inefficiency of the market, the productivity of fund management and accounting problems (Draper & Paudyal, 1991). This paper will explore the reasons that have been suggested for why investment trusts often trade at a discount. The document will address the areas of management ability, management fees, inefficient markets, how tax liabilities affect discounts, and distribution policy.
One popular view for the divergence of investment trust price from its net asset value is the productivity of fund management. According to Dimson and Minio-Kozerski (2001), ‘the price can be expected to equate to…its NAV only if the market believes that the fund manager would never alter the holdings of the portfolio.’ When an investment trust fund performs badly, this is reflected in a discount to the NAV of the fund (Gemmill & Thomas, 2000). This is the result of the sales of shares which eventually causes the price of the shares to fall (Redhead, 2008). One model suggests that the price of the investment trust is the result of the trade-off between perceived managerial ability and fees (Berk & Stanton, 2007). The explanation for this is that the manager’s ability adds value to the fund and so investors would be willing to pay a premium in the absence of fees. On the other hand, in the absence of managers, investors would only be willing to pay a discounted price. The final price of the investment trust is dependent upon whether the fees or the manager’s ability carries more weight in the eyes of the investors (Berk & Stanton, 2007). The size of the discount varies with time as investors’ perception of the manager’s ability as well as the amount charged for fees changes. In a long-term contractual situation, managers are paid a fixed percentage of the assets under management in the form of fees. Whenever the fund performs badly, investors express their sentiments by trading the shares at a discount (Berk & Stanton, 2007).
The question that is often asked is why would anyone invest in an investment trust being fully aware that the price is very likely to fall to a discount. Managerial ability can explain much of the behaviour that is observed with investment trust funds (Berk & Stanton, 2007). The assumption is that investors behave rationally...
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