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If the current share price is above the NAV, the investment trust is said to be trading at a premium, i. When the share price is below the NAV, this is known as trading at a discount. An investment trust's share price is determined by supply and demand.
In theory, if more people are willing to buy than to sell at the current price, the price will rise. Similarly, the share price will fall if there are more investors selling than buying. If a trust or the area in which it invests is particularly popular, demand might push the share price to a premium over the NAV. Another reason why investment trusts trade at a discount is taxes. According to Jin , full taxes on the realized capital gains of a fund are paid 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 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 approaches include individual portfolio movement. On comparing British and U. In addition, shareholders 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. Thus, it can be concluded that discounts in investment trusts and closed-end funds cannot be explained based on country-specific tax factors. Many researchers have focused on the aspect of investor sentiment as a reason for discounts in investment trust trading. 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 rational investors. They have the tendency of either overestimating or underestimating the expected returns on investment. Therefore, when investment trust shares are traded, noisy 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 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. Chan et al.
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. 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.
This 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 of 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. Barnhart, S. Financial Review, 45 4 , pp. Berk, J. The Journal of Finance, 62 2 , pp. Bradley, M. Activist arbitrage: A study of open-ending attempts of closed-end funds. Journal of Financial Economics, 95 1 , pp. Chan, J. Market segmentation, liquidity spillover, and closed-end country fund discounts. Journal of Financial Markets, 11 4 , pp.
Cherkes, M. A liquidity-based theory of closed-end funds. Review of Financial Studies, 22 1 , pp. Halkos, G. Behavioural and fundamental explanations of discounts on closed end funds: an empirical analysis. Applied Financial Economics, 16 5 , pp. Hartzell, J. The effect of corporate governance on investment: evidence from real estate investment trusts. Real Estate Economics, 34 3 , pp.
Jin, L. Capital gains tax overhang and price pressure. The Journal of Finance, 61 3 , pp. Kousenidis, D. Journal of Applied Business Research, 27 4 , pp. Yanran, W. Imperfect Rationality, Sentiment and Closed end fund Puzzle. Economic Research Journal, 3, pp.