Investors paying premium prices for an income stream from investment trusts could be doomed to disappointment.
With even the best savings accounts paying 2.5% interest, it's no wonder income seekers are flocking to Growth and Income funds and investment trusts.
Indeed, popular investment trusts such as City of London (LSE: CLIG), Edinburgh Investment (LSE: EDIN), Murray Income (LSE: MUT), Temple Bar (LSE: TMPL), and Perpetual Income and Growth (LSE: PLI) are currently trading at a premium to their underlying assets.
This could be a risky sign. These investment trusts are often priced at a discount to their Net Asset Value (NAV), and canny investors usually prefer to buy cheap, not dear.
Investors in these trusts are paying above market rates for portfolios mainly consisting of FTSE 100 companies, which isn't my idea of a good deal.
More importantly, they risk the trust reverting to a discount to NAV for all the wrong reasons.
What is a premium and why does it matter?
Like their popular counterparts in the unit trust world, equity income investment trusts aim to provide a growing income stream from a portfolio of dividend paying shares, and capital growth in the long-term.
But unlike unit trusts, investment trusts are companies listed on the stock market. This means their share price fluctuates according to investors' views.
Since an investment trust essentially consists of one or more managers running a portfolio, their share price mainly reflects what that portfolio would be worth if sold -- the trust's NAV -- with the perception of the manager's skill adding a small extra variable.
Investment trusts are also subject to supply and demand, like any other share.
If a lot of people want to buy a particular trust, its price will go up. At other times -- such as when the trouble at the banks became clear last year -- a dearth of buyers will see the share price fall.
When the trust's share price is less than its NAV, it is said to be trading at a discount. When priced higher, it's at a premium.
The discount or premium is expressed as a percentage of the NAV. A trust trading at a discount of 5%, for example, can be bought for 5% less than its investments are worth.
Where did all the discounts go?
There are a few reasons why income investment trusts could be trading at a premium.
Firstly, investors may have chased up prices in their quest to secure an income stream in this era of record low interest rates.
Besides attractive yields relative to cash, income investment trusts usually set aside reserves to smooth out payments from their portfolios. This stability could be important to someone living off their investments, compared to holding dividend-paying shares directly.
Secondly, premiums could reflect a belief that the underlying assets are priced too cheaply.
If shares held by an investment trust rise in price, the NAV clearly also rises. Investors buying investment trusts priced at a premium may be betting its portfolio contains particularly undervalued assets, and so are prepared to pay for that selection.
Finally, some investors may just be happy to pay a premium for a manager to make their decisions for them after 18 months of a horrible bear market.
Buying at a premium is a risky business
There are obvious dangers with buying investment trusts at a premium.
Firstly, the equities they hold may be depressed for good reason. Another big round of dividend cuts could cut the income stream paid out by income-orientated investment trusts, likely reducing their popularity, their NAVs, the premium -- and the share price.
But the main risk is that the price drifts back to a discount to NAV. Assuming the trust's NAV remains unchanged, you'll make a loss simply because investors stop paying the premium.
Alternatively, if the NAV grows to narrow the discount rather than the share price falling, you might not make a loss -- but you'll fail to capture all the profit.
A shift from a 5% premium, for example, to a 5% discount due to NAV growth of 10% will see you lose out compared to if you'd bought the underlying investments yourself.
Now, if your trust invests in palm plantations in Indonesia, say, making the same investment directly might not be feasible.
But the popular Growth and Income investment trusts generally invest in easily tradable FTSE 100 companies.
The premium is an extra hurdle that your investment must overcome to profit, and the chances of management outperforming the FTSE 100 aren't great.
Don't pay something to get nothing
I like equity income investment trusts, but I wouldn't buy right now. The premium gives you no benefits and adds an extra risk to investing.
In contrast, buying when a trust is on a discount gives you more exposure to its underlying portfolio, as well as the potential for price appreciation if the discount narrows (or become a premium!)
There's also a small boost to the yield, since you're getting the same amount of dividend income for a discount price.
If you think shares are cheap, then with the FTSE 100 yielding around 5%, why not buy the market via a low-cost tracker or ETF?
You still face the risk of dividend cuts and capital loss, but there's no discount risk.
Alternatively, you might consider buying shares directly according to the high yield portfolio strategy that's popular on The Motley Fool discussion boards.
If you really want to put your money with a manager, now might be one of the rare times when buying an unit trust/OEIC instead of an investment trust is a better idea, again because it removes the discount risk. But don't forget to invest via a fund supermarket to avoid high initial charges.
More from Owain Bennallack:
