Find the investment trust premium sweet spot

Given that shares in most investment trusts can be bought at a discount, investors should think hard before buying a trust that's trading at a premium to its net asset value (NAV).

If a trust offers something genuinely different and attractive, it may be worth paying more than its NAV per share. Investors in unit trusts and open-ended investment companies do this each time they pay an initial charge. But paying a premium means getting less bang for your buck than buying at a discount, reduces the yield, and raises the downside risks.

If a trust loses the edge that has secured its premium rating, and reverts to a discount, its share-price performance will be worse than its NAV performance, just as any earlier move from a discount to a premium rating will have enhanced its share-price performance.

Capital Gearing Trust illustrates the point. It is managed by Peter Spiller, whose multi-million pound personal shareholding means he pays the trust close attention. He pursues an exceptionally unconstrained and risk-aware approach.

Lindsay Vincent interviews the fund manager in:Peter Spiller: Japan offers value.

Over 10 years Capital Gearing's NAV total returns of 163% are almost three times those of the FTSE All-Share total return. But its share-price returns are even more impressive at 187.9%, because it has moved from a discount to a 7.7% premium. Over the past year the trust has again done well at the NAV level, notching up a gain of 11.5%.

However, those who invested at the end of November 2010 paid a 13.8% premium, and the subsequent fall in the premium means their shares have gained only 4.5% over the year.

Most trusts currently selling at a premium fall into one of two groups. There is a small group of absolute return-oriented trusts and a larger group of trusts with attractive yields.

As with Capital Gearing, most of the first group derive their appeal from a willingness to invest in an exceptionally wide range of asset classes, an emphasis on avoiding losses, and the commitment of long-standing managers - motivated by large personal stakes - who have achieved very creditable long term returns. They include RIT Capital Partners, Personal Assets Trust, Lindsell Train Investment Trust and Ruffer Investment Company.

An important difference between them is that whereas Lindsell Train, Capital Gearing and RIT make relatively modest efforts to control swings in their discount/premium, Ruffer, and more especially Personal Assets Trust, take measures to keep their share price close to NAV. This means there is less downside risk in paying a premium.

With the income-producing trusts, it is easy to understand the appeal of an above-average and growing dividend, but investors should investigate how sustainable it is. Factors to check include how fast the dividend has been growing, whether it is usually covered by earnings and how much the trust has in revenue reserves.

In addition, has dividend growth been achieved at the expense of capital? As a guide look at the five-year NAV capital-only returns in the AIC interactive statistics and compare them with others in the same sector and the FTSE All-Share index.

For instance, the NAV per share of Merchants Trust has fallen 27.6% over five years, whereas the FTSE All-Share index (capital-only) is only 9% adrift. Compare that with Perpetual Income and Growth and Temple Bar, which have suffered falls of only 1.4% and 3% respectively. That means they are better placed than Merchants to generate future income.

Murray International demonstrates the type of trust that deserves to trade at a premium. It aims for capital and income growth from investing predominantly in an international portfolio of equities. Since Bruce Stout look charge in 2004 it has consistently outperformed its benchmark and pulled ahead of most other global trusts.

Its dividends, which are paid quarterly, have grown by an average of 14.3% a year over five years, have always been covered by earnings, and are backed by revenue reserves equal to nearly 18 months' distributions. Despite trading at a premium of 7.6%, the shares yield 4.2%, and the board tries to control the discount through regular new share issuance.

The trust's NAV capital-only returns over five years have been 35.8%, compared to 5.5% for the FTSE World index, so it clearly has not suffered from over-distributing its income.

For Peter Temple's guide to the sector, read:Analysing... Investment trusts.