Discount Trading of Investment Trust Shares - Essay Example

?Why do Investment Trusts trade at a Discount? This article is aimed at focusing the reasons behind the trading of investment trust shares at a discount. At the beginning of this article, investment trusts are explained along with their differences with the investment companies. Later on, the pricing of the shares or units issued by the investment trusts are discussed especially focusing on the concept of Net Asset Value (NAV). After that, the major emphasis of this article would be on finding out the causes that drive those investment trust shares to trade at a discount. Last part of this article would highlight some of the tactics devised in order to control discount trading of investment trust. Summary at the end of this article would conclude this article. Investment Trusts Investment trusts are those types of companies, which are provided the domicile of United Kingdom such that they are listed in the London Stock Exchange. They mainly invest in the equities and securities of the companies across the world, which are listed in different stock exchanges (Redhead, 2008). These investment trusts are run by the panel of the independent directors who take care of the affairs of the investment trusts. Investment trusts are somehow different with the investment companies such that investment companies are domiciled outside the jurisdiction of UK such as Jersey or Guernsey (Redhead, 2008). Pricing of Investment Trusts The pricing of investment trusts are made based on a conceptual term named as Net Asset Value or NAV. Net asset value is the market value of all the investments held by the investment companies. Therefore, the market value of any investment trust is actually the NAV of the investments (Levy and Post, 2005). In case if the market value of the shares issued by the investment trust exceeds NAV, then this concept refers as the shares of the investment trusts are trading at a premium. Conversely, if the market value of the shares issued by the investment trust falls below NAV, then this concept refers that the shares of the investment trusts are trading at a discount. On theoretical grounds, the market value of the investment trust equals to NAV, however, practically this phenomenon is applied very rarely. It has been observed in most of the stances where the market value of investment trust falls below the NAV. This means that the shares of the investment trust are trading at discount. Very occasionally, it appears that the investment trust share is trading at a premium. The following discussion entails the factors that cause the investment trust shares trading at a discount. Investment shares trading at a discount can be regarded as one of the integral aspects that operate behind the performance of the investment trust. The measurement of the shares of the investment trusts can be made in two ways. Firstly, the share price of the investment trusts quoted at the stock exchange. Secondly, market value per share of the assets of those companies, which are held by the investment trusts. In this way, discount can be calculated by simply taking the difference between the price per share of investment trusts and net assets value divided by the net assets value. Principally, the discount is regarded as the function of demand and supply mechanism for the shares of the investment trust. However, the discounts, and specifically the fluctuations in discounts are more important and follow some basis rules, which help understand the problem of investment trust shares trading at a discount more consistently. In case if the discount rate increases, this indicates that there are more chances that the discounted shares will be priced higher in future. This suggests that the investment trust shares are quite attractive especially against those investment trust shares, which are currently trading at a premium (Baums and Buxbaum, 1994). However, this mechanism is not as easy and simpler as it appears, had there been such a potential in the discounted investment shares for a possible price increase, the whole market would have tried to exploit this situations. In this way the investment trust shares would have exceed the NAV and started trading at a premium, thus, effectively would have resolved the problem. Causes of Discount Trading There are few reasons due to which the share of investment trust trades at a discounted price. Following are some of the factors that cause this discount-trading problem: Illiquid Assets Most often, the share of the investment trusts are considered as illiquid assets as compared to the individual stock holdings of the corporations. Investors generally feel that their investments have already gone astray therefore they should dump them into investment trusts (Redhead, 2003). Because of this, they do not tend to invest too much into investment trust and consequently the share prices fall below to NAV resulting in a discount. Sceptical Mindset of Investors Investors also believe that whatever the NAV is being quoted by the investment trust is not the actual claim. It leads towards sceptical mindset of investors, as they tend to realize a rather lower value of the shares of the investment trust. This is more common especially with those investment trusts, which have maintained a poor performance (Davis, 2001). Lack of Faith At times, the investors also do not have good faith in the ability of management to increase the NAV. Because of this, the share prices suffer discount trading which eventually leads to capital losses to both the investors as well as the investment trust. Discount Control and Protection Mechanism Marketing and Promotion Around a decade ago, there have been more targeted efforts made in order to stimulate the investment trust shares. This was mainly done through effective marketing, advertisement and promotional efforts to convince the both the existing and potential investors. Fund managers also supported this idea by providing more education and awareness regarding the investment in the shares of investment trust along with direct selling as part of their marketing strategy (Redhead, 2008). In its initial years of launch, investors showed satisfactory confidence and response in taking the investment trust shares in their trading and investment portfolio, but these efforts were badly sabotaged by the allegations of the mis-selling of investment trust shares especially the split-capital ones. From 2000 to 2003, the overall markets experienced a bearish trend, which also halted the evolution of investment trust shares. Since then, there has been no considerable effort made in order to bring the investment trust shares as the preferred investment zone for the investors and consequently, the problem of investment shares trading at a discounted price still prevails. Under the existing market situation, there is still a room for the marketing and promotional schemes to draw the attention of new buyers to invest in the investment trust shares. However, these efforts are subject to the better stock market performance as well as the suppliers’ apatite of holding the shares so that any possible sell off can be avoided which would eventually safeguard the investors from discounting losses especially for investment trusts. Demand and supply There are two types of alternatives in order to bring the share price of investment trust closer to NAV. Firstly, suppliers are encouraged to hold the investment shares for a longer tenure and do not bring those shares in the market for trading purpose (Levy and Post, 2005). Conversely, potential buyers are worked out to show deeper interest in the investment trust shares being currently underpriced. However, the potential buyers may have the concern about the likelihood of investment trust to fall in the near future once they complete the inclusion of investment trust shares into their portfolio (Fabozzi, 2009). However, the new buyers should also change their mindset regarding the returns of investment shares and should switch their preference from short-term investment goal towards long-term investment goal especially when dealing with investment trust shares in order to avoid losses due to investment trust shares trading at a discounted price. On the supply side, there are some moves taken by the board of directors of the investment trusts. These can also be regarded as the artificial moves in order to protect the share prices of investment trust from discounts to NAV. The BODS of increasing number of investment trusts have applied the protection on discount on a share price such that the share price of the investment trust can no longer fall below a certain price, which is commonly known as discounting floor (Books, 2010). This floor is an artificial tactic played by the board of directors, which is however not in accordance with the free market momentums. Generally, this move is vastly welcomed by both the existing and potential investors. Existing investors are relaxed that their investment would not decrease after a certain level of decline. Similarly, new investors also keen to invest especially in those securities where the margin of discounts has been substantially lowered. In other words, the risk of reduction in the share prices of investment trust is transferred from the investors to the investment manager such that if there occurs a real fall in the share prices of the investment trust, the share price will stop declining after a certain level. However, the losses, which would arise afterwards, they would have to be borne by the investment manager. Hidden Problems associated with Control Mechanism This means that the board of directors of investment trust has made an assurance to safeguard a certain level of discount by utilizing the trust’s statement of financial position to provide liquidity in order to purchase shares from the open market (Mayo, 2007). On theoretical grounds, this approach is justified as in case if these shares not purchased, the additional supply over demand in the stock market would lead the discount to continue in respect of shares prices of investment trust until the shares start catching the interest of the investors. However, this move squeezes the overall size of investment trust yet it is a way to provide a better exit strategy to the short-term investor. Even after doing so, if the shares keep trading at a discounted price and the investment trust would again bring a floor on the share price and consequently use its cash to buy back the shares. This move would in turn lead to cease the investment trust at the end of the day after continuous floor and buy backing strategy. However, this was never the purpose of the investors to invest their money in such investment trust, which liquidates their money by doing artificial moves just in order to avoid share trading at a discounted price. Therefore, it can be concluded that the board of directors of the investment trust should not only maximize their efforts in strengthening the supply side of investment shares but also take reasonable steps in order to stimulate the demand side, which can effectively keep the share prices closer to NAV. Another important consideration that can be made in order to avoid discount trading is the change in approach of the investment trusts’ top management. The investment trust should bring flexibility in their approaches while taking decisions especially with respect to buy backing their own shares from the market in order to stay closer to NAV. However, in case of insufficient cash, the shareholders’ wealth will be destroyed if buy back stays continued. Stringent rules of corporate governance have also provided a substantial impact on protecting the shareholders’ wealth such that that they have imposed restrictions on percentage of discount floor and quantity and amount buy back of shares in a specific period Conclusion Even though there are serious considerations taken in order to avoid the shares of investment trusts to trade at a discounted price, however, these discount control mechanisms whether natural or artificial, have never proved to correct. Most of the times they have incurred losses for shareholders either in the form of capital losses through share prices trading at a discounted price or because of liquidation of investment trust through excessive buy back of own shares. References Baums, T. Buxbaum, R. , (1994), Institutional Investors and Corporate Governance, Walter de Gruyter, Berlin. Books, G, (2010), Institutional Investors: Insurance, Hedge Fund, Mutual Fund, Institutional Investor, General Books, New York. Davis, E. Steil, B., (2001), Institutional Investors, 2nd ed, MIT Press, New York. Fabozzi, F, (1999), Investment management, 2nd ed, Prentice Hall, Michigan. Fabozzi, F, (2009), Institutional Investment Management: Equity and Bond Portfolio Strategies and Applications, Edition of book, John Wiley & Sons, New York. Levy, H. Post, T., (2005), Investments, Prentice Hall, London. Mayo, H, (2007), Investments: An Introduction (Book Only), Cengage Learning, New York. Redhead, K, (2003), Introducing Investments: A Personal Finance Approach, FT Prentice-Hall, London. Redhead, K, (2008), Personal Finance and Investments: A Behavioural Finance Perspective, Taylor & Francis US, Chicago Read More