Why Do Investment Trusts Often Trade at a Discount - Essay Example

Why do investment trusts often trade at a discount? Investment trusts trade their shares in a manner that is very different from the other stocks trading in the stock markets. This is because; the shares of the investment trusts are not tied to the actual value of the business entity selling the shares, but more on external market factors (Bird, 1997:18). The shares selling in the stock market operate on the basis of the value of a company, as well as its ability to generate profits and be able to give returns back to the investors and the shareholders to the company. However, the basis of determining the price of the shares for the investment trusts is not entirely defined, due to the fact that the value of the shares of an investment trust is tied both on the external market predictions as well as the investment trust manager’s ability (Lozhnikova, Akkerman, Muravyov & Kirpotin, 2014:769). Thus, since the external future market conditions cannot be accurately predicted, while there is no accurate measure of the manager’s ability, it therefore becomes entirely difficult to set the price of the investment trusts shares at certain level, necessitating that other measures should be applied in order to entice and attract the potential investors to purchase the investment trusts shares. The most adapted mechanism of attracting investors to purchase the share of investment trusts is through trade discounting, where the shares of the investment trusts are sold at a price that is lower than the Net Asset Value of the shares (Berman & Sumaila, 2006:212). The factors that account for investment trusts trading at a discount include: Bull and Bear market cycle The cycle of the bull and bear market has a great influence on the prices at which the investment trusts will trade their shares. This is because, the investor confidence in the investment trusts shares is purely pegged on the probability of the trusts performing better or poorly in the market, as opposed to the net asset value that they hold at the moment (Thomson, 2009:34). Thus, when the cycle of the stock market is tending towards the bullish market, there is the tendency of the investors hoping that the investment trusts will create more value on the property already held, causing a rising optimism that may require low discounting offering. However, when the stock market cycle is tending towards the bear market, there is an increase in the pessimism of the investors on the possibility of the investment trusts generating more value on the property already held. This causes the investors to be cautious in purchasing the investment trusts shares, causing the investment trusts to offer their shares at a price lower than the net asset value of the shares, in order to attract and entice investors to purchase the share (Pellerin, Sabol & Walter, 2013:195). Therefore, more than any other types of shares, the investment trusts shares are highly prone to the external market forces of future projections, causing the shares to trade at prices that are not reflective of the true asset value of the investment trusts, since without doing so, the trusts may not attract enough investors. Illiquidity of the trust shares The investment trusts are considered to be fairly illiquid compared to the other stocks that are traded in the stock markets (Edgerton, 1918:447). The investment trusts cannot be easily converted into cash on demand, as happens with the rest of the shares that are traded in the stock market, which an investor scan easily turn into cash by selling his/her shares at whatever time the investor deems appropriate. Therefore, the investment trusts are reminiscent of long-term investments in property that cannot be turned into liquid cash easily, requiring that the investors who are interested in the investment trusts shares are the only ones with the need for long-term investment. Thus, it becomes very difficult for the investment trusts to attract regular investors who would like to take advantage of the suitable economic conditions by buying shares when the economic market conditions are promising and then disposing them off immediately there is the fear of adverse economic conditions in the future (Chandler, 2009:35). Therefore, such investors will rarely trade on stocks that can only be turned into cash much longer into the future, and as such they are less interested in the investing in stocks. Therefore, it becomes inevitable for the investment trusts to offer their shares at a discount, if they are interested in attracting and enticing the regular investors into buying their shares (Martin & Wood, 1997:91). The promise of large discounts enables the investors to hope to earn more benefits, although much longer into the future, and thus compensate for the advantage they would have had by liquidating their shares sooner than they can do with the investment trusts shares. The benefits of high interests arising from the discount offering by the investment trusts to the investors provides the advantage for spreading the benefits, such that the overall effect of the discount offered is to make the investors benefit equally or even more than when they would be trading in short-term stocks with high liquidity (Reinhardt, 2005:248). High risks The investment trusts are associated with high risks compared to the normal stocks that are traded in the stock market due to their long term liquidation requirement (Paz, Marín-Solano & Navas, 2013:227). The investors trading in the regular stocks are prone to low risks, since such investors can easily sell out their share on the event that they predict the future market conditions to be unfavorable (Berman & Sumaila, 2006:213). However, the case is different for the investment trusts shares, which restricts the investors from trading them immediately they want to turn their stocks into cash owing to their illiquidity nature. These delays in allowing the investors to turn their shares into liquid cash posses a high risk threat to the investors, since they are likely to be affected by the adverse economic conditions that are projected to occur in the future. Consequently, the investors find the investment trusts more risky, and as such are less motivated to purchase these shares. In this respect, the investment trusts are left with little option but to offer their shares for sale at a price lower than their actual net asset value (Lozhnikova, Akkerman, Muravyov & Kirpotin, 2014:772). Additionally, the risk management process for the investment trusts shares is not entirely left at the discretion of the investors or the shareholders. The risk management is also shared with the managers of the investment trusts, who have to devise the measures to leverage for possible risks associated with the shares of the investment trusts (Berman & Sumaila, 2006:217). Thus, due to the fact that the investors are not in a position to determine the necessary measures they can take at a time of perceived high risks on the investment trusts shares, they are prone to more risks that may arise as a result of the poor implementation of measures to leverage the perceived risks by the investment trusts managers (Reinhardt, 2005:249). The mere fact that the responsibility and the powers to control the risk measures that are essential to leverage the share-associated risks is borne by another person on behalf of the investor makes the investment trusts shares highly unattractive. This is because; investors always want to be in control of their investment, so that they can take the measures they deem appropriate to leverage against potential risks, at the time and opportunity they deem necessary (Paz, Marín-Solano & Navas, 2013:231). Therefore, to compensate for the perceived high risk associated with investment trusts shares, the investment trusts must offer their shares at a discount, in order to entice and attract investors to purchase them due to the perceived high interest rate capacity. Future charges The investment trusts operate on the basis of generating revenues through charging the owners of the investment some service charges, which are then utilized towards the payment of the salaries of the investment trusts managers, as well as applied towards the expenses of running the investment trusts normal businesses (Bird, 1997:18). This mode of charging the investors is different from the charges that the investors incur when trading with the regular shares in the stock market, where the management salaries are not accounted for as part of the charges that the investors will be deducted directly, but rather as part of the normal operating expenses of the business (Chandler, 2009:35). Thus, the future charges that the investors are likely to incur on the shares they hold makes the investment trusts relatively unattractive, causing the managers of the investment trusts to device measures that would attract the investors to purchase the trust’s shares. The most viable option to attract investors to purchase the un-seemingly attractive shares of the investment trusts is to offer such shares at a discount (Bird, 1997:18). Thus, by offering the discounts on the real net asset value of the share of an investment trust, the managers are able to show the investors that the high interest rate associated with purchasing the shares at a price lower than the actual value of the shares is capable of making up for the future charges that the investors are likely to pay on their shares. Low market accessibility The investment trusts shares are traded in the stock markets like the normal publicly trade shares offered by companies (Edgerton, 1918:451). However, the extent to which the investment trusts shares are sold in the stock exchange market platforms is normally limited, with most of such markets limiting or even restricting the sale of the investment trusts. The consequence is that the investment trusts have only limited access to the stock exchange markets, as well as being limited in access to other platforms that are involved in trading other financial tools (Lozhnikova, Akkerman, Muravyov & Kirpotin, 2014:771). This becomes a great disadvantage for the investment trusts shares, since with the limited access to the stock market and other financial market platforms; there comes a restriction in the ability to convert the stocks into cash (Martin & Wood, 1997:91). The illiquidity nature of the investment trusts shares therefore means that the shares become less attractive to regular investors, and only attractive to the long-term investors who have no liquidity conversion needs in the near future. Consequently, the investment trusts managers are left with little options other than to offer a discount on the shares of the investment trusts, so that they can entice the investors towards purchasing them (Reinhardt, 2005:248). It is for such reasons that most of the share of the investment trusts ends-up being sold at a price that is much lower than their net asset value price, so that the potential investors can be lured by the potentials of higher interest earning on the investment trusts shares, though much later into the future. Uncertainty over Asset and property price fluctuations The asset and property market is one of the most volatile markets of the economy, owing to the fact that a slight change in the economic conditions of a given economy has a huge impact on both the asset and property prices (Bird, 1997:18). Thus, owing to the fact that investment trusts are entities buying and holding assets and properties for sale, they are prone to the uncertainties of the high fluctuations of the asset prices. The uncertainty on the other hand affects the investors negatively, since most investors would like to deal with a market that they are sure of the future prospective (Berman & Sumaila, 2006:217). Thus, the high volatility of the asset and the property markets causes potential investors to prefer investing in other stocks offered at the stock exchange market, which are not highly prone to the price fluctuations. Therefore, for the managers of the investment trusts to attract potential investors into investing in the shares of the trusts prone to high uncertainties, they need to offer discounts and sell their shares at prices lower than their net asset value (Paz, Marín-Solano & Navas, 2013:229). This gives the investors some confidence that even if the prices of the assets or properties held by the investment trusts may highly fluctuate, they already have a discount that can cover for the falling of the prices in the future. This way, investors are enticed to purchase the investment trusts shares, since they are already covered for a possible fall in the prices of the assets and properties held by the investment trusts, which may in turn reduce the actual net asset value of the trust shares. References Berman, M., & Sumaila, U. R. (2006). Discounting, Amenity Values, and Marine Ecosystem Restoration. Marine Resource Economics, 21(2), 211-219. Bird, L. (1997, April 3). Discounting discounters. Wall Street Journal - Eastern Edition. p. B18. Chandler, A. (2009). Cut to the quick. Brw, 30(50), 34-35. Edgerton, H. W. (1918). Premiums and Discounts in Trust Accounts. Harvard Law Review, 31(3), 447-469. Lozhnikova, A. V., Akkerman, E. N., Muravyov, I. V., & Kirpotin, S. N. (2014). The ‘tyranny of discounting’ in economic efficiency evaluation of capital investment projects susceptible to ecological and climatic changes. International Journal of Environmental Studies, 71(5), 768-773. Martin, C., & Wood, C. 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