Investment Trusts: What is a Discount?

Before you deposit your cash into an investment trust, get to know the jargon. Here Morningstar analyst Jackie Beard explains all

Jackie Beard, FCSI 29 August, 2013 | 8:43AM
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'Discount to net asset value' is common term we use when talking about investment trusts , but what exactly does this mean?

In simple terms, the net asset value (NAV) is the per-share worth, or value, of the portfolio of investments. It is calculated by dividing the total value of all the investments in the portfolio, less any liabilities, by the total number of shares in issuance. A unit trust or OEIC trades at its NAV. However, a quirk of the investment trust structure means an investor can often buy assets more cheaply than their value. In other words, they can buy, say, £1 of assets, for 80p.

The converse can also apply, when an investment trust’s shares trade at more than the assets are worth, and this is known as a 'premium to NAV'. In other words, an investor may pay £1.20 for assets that are worth just £1.

There are many reasons cited for the cause of an investment trust’s discount or premium level. Academic studies have been carried out, reasons researched, but ultimately there is no one concrete reason, rather, it’s a collection of factors that can contribute to differing extents dependent on the individual fund.

Some reasons for a trust trading at a discount include:

A spell of poor performance

Sector/country/region out of favour

Illiquidity of underlying assets

Conversely, a premium can occur for a number of reasons:

Reliable income stream

Strong performance

Change in management

But it’s not as simple as just finding a trust that’s trading at a healthy discount to its NAV. That discount could widen further and result in an investor losing money, even if the underlying value were to increase.

We think it’s important to look at the relative discount and relative premium – ie, where is the trust trading now compared with its trading history. Absolute discounts and premiums can persist, so the relative value matters. We measure this using a z-score.

Z=(current discount-average discount)/standard deviation of the discount

A negative z-score shows the current discount is lower than average; a positive z-score shows the current premium is higher than average. We think a z-score of less than -2 signals a fund that is relatively inexpensive and a z-score of more than +2 a fund that is relatively expensive. But neither one is conclusive and shouldn’t be looked at in isolation.

Relative discounts can help investors avoid value traps though.  For example, a trust trading at a 10% discount could be seen as a bargain, offering investors £1 of assets for just 90p. However, that net asset value of £1 could fall to 90p and thus the investor would lose money. So it’s important to try and understand why the discount or premium has deviated from its norm as this could help to indicate whether it’s an attractive investment. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Jackie Beard, FCSI

Jackie Beard, FCSI  is Director of Manager Research Services, Morningstar EMEA