Reasons Why Investment Trusts Trade at a Discount

AbstractThe particular that coronation trustfulnesss and close-end property in general interchange at a discount has elicited debates among financial scholars and practitioners, oft referred to as the closed-end mystifier. Based on this, this paper explores and explains some of the intellects that investment trusts change at a discount. It too provides an in-depth explanation of characteristics of close-ended cash and conditions that lead to the classification of the sh atomic number 18 price as both a discount or a premium. Investment trusts trading at a discount ar those trading at prices that atomic number 18 below their pelf asset shelter. Those trading at a price higher than the net asset value be considered as being sold at a premium. Some of the main reasons that are explored in this paper include misreckoning of the net asset values of the investment trust, taxes on realized capital gains, agency be, managerial abilities and investor sen clippingnt. Even with the explanations that are provided in this paper, the closed-end fund prize puzzle continues to be debated upon and researched.IntroductionThe item that investment trusts often trade at a discount is an aspect that has drawn interests from academics and practitioners in the field of finance. To have a better understanding of these reasons, it is ideal to provide an exhaustive definition of investment trusts. Investment trusts, which are typical to the United Kingdom, are defined by Barnhart and Rosenstein (2010) as types of investment firms that are formed with the primary aim of holding securities for other companies and the obtainment of capital from the public issue of shares trading on the stock commercialize. They are also referred to as closed-end silver because they only offer a fixed quantity of shares that new investors female genital organ purchase from already existing shareholders (Hartzell et al., 2006). The prices of shares of investment trusts are pay backd by the forces of supply and demand in the share market. As a consequence, there are incidents where the price of a share may either be higher or scorn than its net asset value. Whenever a share trades at a price that is higher than its net asset value, it is considered to be trading at a premium. On the contrary, if a share trades at a value that is lower that its net asset value, it is considered to be trading at a discount (Berk & Stanton, 2007). In this regard, this report intends to discuss reasons why they trade at a discount.Reasons for discounting Investment Trusts atomic number 53 main characteristic of investment trusts and closed-end funds in general is the fact that they are permanent capital ventures and thus, the shares supply is fixed (Chan et al., 2008). Numerous attempts that have been made by researchers and practitioners to explain the investment trust discounts, and have resulted in conflicting results, commonly referred to as the closed-end fund puzzle. Even th ough these funds are known to trade at discounts, it is important to descent that newly opened investment trusts and closed-end funds in general, usually begin trading at a premium of approximately 10% of their net asset value. After their initial premium trading, they shift towards trading at a discount that is at average rate of 10% within the first cxx days. After which, discounts remain substantial. In gaucherie closed-end funds are closed or terminated, there is an increase in their share prices, which in turn eliminates the factual discounts (Cherkes et al., 2009). Explanations for investment trust discounts that have been made by researchers include the essay of liquidity, the past and upcoming performance of shares on the market and the miscalculation of the funds net asset value. Investor sentiment is also a nonher reason for discount trading in investment trusts (Yanran & Liyan, 2007). This section intends to provide a more in-depth parole of these reasons.Misestima ting the Net Asset Value (NAV)This reason has been pointed out by Halkos and Krintas (2006), who argue that such miscalculations of the NAV can result from a possible accumulation of capital gains illiquid assets that had not been realized. The reason why funds with high capital appreciations that have been unrealized ought to trade at a discounted share price is that potential holders of such funds will assume a potential tax liability. In a research that was carried out by Kousenidis et al. (2011) on the effect of liquidity on closed-end funds, he established that there is a possibility of illiquid assets to be traded at a discount to provide higher expected returns. In support of inaccuracy of NAV measurement as a reason for discounts in closed-end fund trading, Yanran and Liyan(2007)suggested that when closed-end funds own enlarged amounts illiquid assets or restricted stock that are not fairly trading in the market, their NAVs can fail to provide an accurate reflection of the ir true value. As a consequence of this, the shares might either trade at a lower or higher value than the NAV. Investment trust discounts are also affected by restricted stock holdings. However, given that such holdings are often quite small or at a zero value, they do not hold as valid reasons for investment trusts trading at a discount. For investment trusts, there is usually no assurance that there will always be an available market. Therefore, this lack of an assured redemption of shares makes their valuation to be discounted. In addition to this, investment trusts that hold relatively liquid securities are valued lower than their net asset values (NAVs) at the marketplace (Cherkes et al., 2009). position appropriate measures in place to avoid miscalculation of the trust net asset value is vital to solve this issue.Agency Costs and Managerial talentDiscounts in closed-end funds could be a reflection of poor performance in the management of the fund or an overcharge of managem ent angles (Bradley et al., 2010). Agency be may also vary according to the agency issues or conflicts that may occur due to different interests between agents and principals. Managerial abilities have also been listed by researchers as being among the main factors that determine whether investment trusts can trade at a premium or a discount. The theory that investment trusts can trade at a discount if the managers charge a fee was originally proposed by Boudreaux in 1973 (Berk & Stanton, 2007). He suggested that if fund managers charge investors a fee but fail to add value to their investments, then the value of the fund is likely to be less than its NAV. In a case where managers add value to the investment trust, the reason why it might trade at a discount is when investors are made to believe that the funds managers are not broad(a) at investing their funds. If investors believe that their money is being managed by people who are good at selecting viable investments, then the fund will trade at a premium. In a research carried out on the ownership of closed-end funds Cherkes et al.(2009) established that investment trusts with larger percentage of insider ownership are likely to trade at higher discounts. This is because investors of funds that are selling at higher discounts stand a chance of receiving windfall gains in case the funds undergo immediate liquidation at their net asset value. He also established that higher expense ratios lead to higher discounts of funds because management fees are considered as being deadweight losses. Thus, discounts are used to represent the capitalization of the management fees value. Management of trusts also affects their future performances in the market, which also determine whether investment trusts are to be traded at a discount or premium. Halkos and Krintas (2006) argue that in cases where investment trusts are managed in a highly schoolmaster manner and with a positive track record, investors may have the wi ll to pay a premium for a share of the funds. This is also due to the fact that such trusts are often expected to maintain their superior performances in future. On the other hand, funds that are expected to underperform in the market are expected to be traded at higher discounts, mainly because of the scepticism that potential investors may have for the fund (Berk & Stanton, 2007). Estimation of future performance of investment trusts can be done by comparing trends in the NAV, which are estimated on a frequent basis. It can also be done by evaluating the managerial capabilities of the fund. It can be thus argued that investment trusts whose management has a good reputation tend to perform well in the market and therefore, trade at a premium. On the contrary, poorly managed trusts fail to thrive in the market and therefore, are likely to trade at a discount.TaxesAnother reason why investment trusts trade at a discount is taxes. According to Jin(2006), full taxes on the realized cap ital gains of a fund are gainful for by the current shareholders, even though the highest percentage of their gains was accumulated before the investors bought the shares. Based on this, it can be argued that funds whose accumulated gains are large ought to trade at a price lower than their NAVs also suggests that investment trusts that have a high appreciation of unrealized capital sell at discounts because holders of such funds assume potential tax liabilities that depend on the holding periods of the investors. Berk and Stanton (2007) posit that discounts in closed-end funds are partially caused by the fact that investors usually lose valuable opportunities to trade tax because of holding shares in closed-end funds. Some of the tax trading comees include individual portfolio movement. On comparing British and U.S. closed-end funds, Cherkes et al.(2009) established that British funds do not have the freedom of distributing capital gains as the US funds do. In addition, sharehold ers have no liability in case the invested capital gains tax, except if they decide to put the holdings that they have in the fund up for sale. Yet U.S. and British closed-end funds behave in a quite similar manner. Thus, it can be concluded that discounts in investment trusts and closed-end funds cannot be explained based on country-specific tax factors.Investor Sentiment some(prenominal) researchers have focused on the aspect of investor sentiment as a reason for discounts in investment trust trading. This hypothesis was proposed Lee, Shleifer and Thaler in 1991 (Yanran & Liyan, 2007). According to them, premiums and discounts in closed-end funds are determined by the attitudes of opinions that investors have about them. To explain this hypothesis, two kinds of investors are identified. These are the noise investors and sharp-witted investors. Whereas the expectations of discerning investors on their asset returns are rational, noise investors expectations are influenced by sent iment. They have the tendency of either overestimating or underestimating the expected returns on investment. Therefore, when investment trust shares are traded, stertorous and rational investors make their investments based on their respective judgments. Due to the risk associated with assets and the fact that every investor is risk averse, closed-end funds ought to trade at equilibrium prices that reflect opinions of the noisy and rational investors, which are often discounts. A proposal was made by Halkos and Krintas (2006) that noisy investors tend to concentrate more on the closed-end fund ownership than on the ownership of the underlying assets of the funds. Pessimism by noise traders on the future of fund drives down its price to a value lower than its NAV. This causes rational investors to avoid the buy the funds shares because of the risks associated with trading the funds at a discount. Chan et al. (2008) also argue that the sentiment of noise traders is stochastic and, therefore, cannot be accurately predicted by rational traders. Particularly, it is impossible for rational investors to make a perfect forecast whether noise investors will either be pessimistic or optimistic at the time that they intend to sell their assets. Due to the fact that rational traders are careful about the prices with which they will resale their assets, the unpredictable nature of noise traders sentiment increases the level of risk on the assets they intend to trade (Kousenidis et al., 2011). The biggest risk associated with noise investors is that they will be pessimistic at the time when rational investors intend to sell their assets, causing a drop in prices. Since there is always a risk of an adverse sentiment shift, the possibility of trading shares at a discount is always lively (Yanran & Liyan, 2007).ConclusionThis paper has provided an in-depth explanation of some of the reasons why investment trusts usually trade at a discount. Apart from this, other aspects o f investment trusts have been explained. One of the main characteristics of investment trusts that has guided the establishment of reasons discussed in this paper is that it is a closed-end fund. This means that supply of shares is fixed, regardless of the market dynamics. Therefore, fluctuations of these funds that result into premiums or discounts are mainly caused by demand factors. The main reasons why investment trusts trade at discounts include the attitudes that investors have on the fund, commonly referred to as investor sentiment, agency costs and managerial abilities, taxes and miscalculation of the net asset value of the fund. However, the factor that is contented upon by most researchers in this field of finance is investor sentiment, which is a behavioural approach of understanding this concept. Some of the other reasons that have been cited in several other researchers include the institutional ownership and performance of the trust in the market. In future research, a more specific research could be carried out by focusing on a specific investment trust in the UK.ReferencesBarnhart, S.W. & Rosenstein, S., 2010. modify?Traded Fund Introductions and Closed?End Fund Discounts and Volume. Financial Review, 45(4), pp.973-94. Berk, J.B. & Stanton, R., 2007. Managerial Ability, Compensation, and the Closed?End Fund Discount. The diary of Finance, 62(2), pp.529-56. Bradley, M., Brav, A., Goldstein, I. & Jiang, W., 2010. Activist arbitrage A study of open-ending attempts of closed-end funds. ledger of Financial Economics, 95(1), pp.1-19. Chan, J.S., Jain, R. & Xia, Y., 2008. 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