Investment trust funds are priced by the market, which means that the price of an investment fund can be lower or higher than the estimated net asset value of the asset. When the price is above the net asset value, which for UK trust funds is conventionally 100p, then the fund is said to trade at a premium.
When the fund trades at a price below the net asset value, then the investment trust is said to trade at a discount. In the stock market, such stocks are ironically referred to as “net-nets” and trade below their book value per share.
However, most of them end up being value traps rather than highly undervalued investment opportunities. This is because one of the reasons why investors try to stay away from net-nets is because of the risk associated with their business.
It could be poor leadership, falling market share, or issues to do with insolvency and debt. If the company is highly indebted, it would be forced to pay off creditors before distributing the remaining liquidation value to common shareholders.
Do investment trust funds involve the same risk?
Unlike regular net-nets, investment trusts are low-risk investments that are well-diversified across a pool of several assets. This means that if a single company in the pool goes bankrupt, then the other assets in the pool will help to reduce the overall impact on the portfolio.
However, this aspect can change depending on the level of gearing on the fund. Too much debt can be good for the fund when the performance is good. It means that the investment trust is using debt to increase shareholder return.
On the other hand, when the fund is performing poorly, this increases the interest rate risk, which then affects the bottom line. If the investment trust fund is highly funded by debt, then this can affect the funds distributable to shareholders.
Essentially, what this means is that the top line will be low when the fund is not performing well, and once the accounts net the interest rate expense, then the bottom line falls even lower.
This can result in a discount valuation of investment trust in the market. A case in point of a discounted investment trust fund is Henderson Diversified Income Trust Plc (HDIV), which currently trades at 87.60p compared to an estimated net asset value of 92.50p. This represents a discount of about 2.92%.
Just like the name suggests, the fund is well-diversified across fixed income securities. The reason why its stock price has fallen to trade below the net asset value could be related to the adverse effects of covid-19. Global government yields have fallen with several central banks cutting the base interest rate to close to zero, or lower.
This has a ripple effect on all interest-based investments, especially fixed income. The lower the base interest rate set by central banks, the lower the bond yields. Therefore, the Henderson Diversified Fixed Income Trust fund is discounted because of increased market risk rather than business risk.
As soon as the government lending rates rise, the investment trust should recover as well. As such, the fact that this fund is trading at a discount in the secondary market could be an opportunity to buy, rather than a call to sell.
The case could be different for other funds
This does not apply to all funds that trade at a discount. Just as I mentioned in the beginning, some funds are invested in specific assets. If you have a fund that invests in high growth stocks in, say, the cannabis sector, this is a high-risk market, which means that an undervalued trust fund could take ages before it bounces back.
Therefore, it is important to take into account how realistic the discounted valuation is before concluding that it is worth investing in.
Conclusion
In summary, the stock market can be a tricky customer for investors without deep knowledge. Investment trusts present a compelling avenue to profit from the market without getting into the nitty-gritty stuff.
If you come across an investment trust trading below its net asset value, then this could be a huge opportunity to invest in an asset that could pay income on a consistent basis even during bear markets.