investment
Investment Trusts Trading At Discount
TOPIC # 3
Introduction
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,
TOPIC # 3
Introduction
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,
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