Special Report on Investment Trusts (2): A buyer's fluctuating market: Does buying at a discount mean that you are getting a bargain or a burden? Heather Connon looks at the facts and explains the tricks

ONE OF the most confusing things about investment trusts is the discount. For virtually all trusts, the market capitalisation - the price of all the shares added together - is worth less than the total assets such as shares in other companies, cash and the like which are owned by the trust.

For shareholders, that looks like a bargain. For example, someone looking for an international trust with a broad exposure to well-known companies could have bought shares in Alliance Trust for pounds 15.56 on Monday, but its net assets per share - the proportion of the total assets of the trust divided by the number of shares - was pounds 17.66 at the end of December. That means its share price stands at an 11 per cent discount to net assets.

But, as with the January sales, bargains are not always what they seem. Just as shareholders can buy trusts at a discount, so they are likely to have to sell them at a discount. And the only way actually to take advantage of the discount is to choose a share where it is likely to narrow, or to hope that the trust's managers will decide to wind the company up and return all the money to shareholders.

The question which has taxed investment trust managers for years is why there should be a discount at all. Many devote all their energies to reducing it as much as possible. The simplest explanation lies in the law of supply and demand; there are more investment trust shares than there are willing holders or buyers which means shareholders may only be prepared to buy at low prices.

There are two solutions to that problem: either reducing the number of trusts or increasing the number of potential buyers. A number of trusts have been taken over in recent years. Globe, one of the largest trusts, was acquired by the British Coal Pension Fund which was attracted by the chance of getting a large pool of assets at a discount. But many more have been launched, so the supply continues to grow.

And investment managers have been conducting a concerted campaign to encourage shareholders to put their money into trusts, by introducing savings schemes and more complicated structures, such as split capital trusts. Some of these new structures do expressly provide for the trust to be wound up at a certain date which, the managers hope, will encourage investors to buy closer to the asset value. These measures have reduced the discounts slightly over recent years, but it is a long and slow process.

Some trusts do trade at a premium. For example, those which specialise in new and exciting areas - such as the emerging Far Eastern markets; those which have performed badly in the past but are now expected to improve dramatically, usually because new managers have been brought in; or those which have respected managers who are expected to do better than the average, such as Aberforth's smaller companies trusts.

It is worth remembering, however, that fashions can change. Japan and Europe were all the range a few years ago; now trust specialising in those areas trade at average discounts of 15 and 17 per cent respectively.

The level of discounts does fluctuate, either because the share price increases, or the value of the underlying assets falls. With Alliance Trust, for example, if its shares rose to pounds 16.50, but its asset value stayed the same, its discount would fall to 6.6 per cent and shareholders would reap 94p profit. Similarly, if net assets fell by pounds 1 and the share price stayed the same, the discount would also narrow - although with no benefit to shareholders.

In practice however, the prices of most trusts tend to move in line with net asset value. The trick is to spot the exceptions to the rule, and exploit the ones which will bring profit. That does not necessarily mean buying those with the largest discounts. That will often signify poor management, or a portfolio which is likely to do badly in the future.

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

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