At its heart, value investing is about buying £1 of assets for less than £1 and one area offering plenty of discounted assets is the world of investment trusts and other closed-ended funds. Unlike open-ended funds such as unit trusts and oeics, shares in closed-ended funds hardly ever reflect the true worth of their underlying portfolio of investments – the so-called ‘net asset value’ (nav).
Instead, since closed-ended funds are themselves listed on stock exchanges, their own shares will be subject to the same laws of supply and demand as their underlying investments and, depending on factors such as the skill of their manager or the popularity of the sector in which they operate, they will trade at a premium or a discount to their nav.
More often than not, they trade at a discount to nav, which reflects the fee that the manager charges investors a fee to run the assets, which they would not incur if they owned the assets directly. sometimes these discounts can prove too wide, creating opportunities for activists to wind-up the fund and sell the assets for a profit.
According to data from Bloomberg, there are roughly 5,600 closed-ended funds in total, of which some 3,800 have active data on their premium or discount to nav. Of those, 1,273 are tradable on a liquid secondary market and their premiums and discounts are set out in chart 1 below.
As you can see, the great majority of funds – some 91% – trade at a discount to their nav, with just 104 at a premium. focusing in on those 104, as we have with chart 2 above, you can see that very few closed-ended funds trade at double-digit premiums and only a dozen or so – that is, 1% of our original 1,200 – are on a premium of 20% or more.
One interesting point about this handful of high-flyers is that a lot of them, including the four whose recent premium/discount history is shown in chart 3 below, are high income funds. In this environment of low interest rates, this is perhaps to be expected – indeed, it could even be seen as a physical manifestation of the modern cliché that income-generating investments are these days ‘at a premium’.
Investors do, however, need to tread carefully. Here on The Value Perspective, just as we can grow very excited when we see £1 of assets costing less than a pound, we can grow very nervous when we see £1 of assets costing more than £1. Whether that sets off your own warning bells is up to you but do bear in mind funds on a premium will have to work much harder to pay back their investors after fees.
On a related note, do watch out for funds that engage in returns of capital as opposed to returns on capital. a fund paying an 11% dividend yield may look a hugely attractive proposition but it will not be if a lot of that 11% is made up of your own money being returned to you. This can happen with some funds and will only erode their net asset value over the longer term.
A final caveat is that many funds currently trading at a premium, including those in chart 3 above, invest in high-yield fixed income assets and operate levels of borrowing or ‘leverage’ of 20% or more. thus, should interest rates rise, there is not only the risk of a trust losing its premium as it falls out of favour but also of any drop in performance being magnified as a result of that leverage.
For any investors tempted to pay a premium for a fund because of the apparently high income on offer, a useful checklist of questions would be: is that income for real; is the fund’s dividend sustainable; and what will happen in the event the dividend is cut – would the underlying assets be attractive enough to justify the price of the investment?