Discounts: challenge or opportunity?

David Prosser explains investment company discounts and premiums.

Should you worry about getting a discount? It sounds like a bizarre question – who doesn’t like buying something on the cheap?

In the world of investment funds, however, the “problem” of the discount has often been cited as a reason to steer clear of investment companies – though very often by those with a vested interest to encourage people to buy different types of fund instead.

Why discounts (and premiums) occur

There’s no mystery to investment company discounts – they are simply a function of the way funds are set up. Investment companies are closed-ended funds: that is, they have a fixed number of shares in issue at any one time. The price of those shares is therefore determined by demand and supply for them in the market. In turn, this is determined by investors’ response to movements in the value of the assets in which the fund is invested – as well as other factors, such as how people expect those assets to change in value in the future.

Now, sometimes demand and supply for an investment company’s fund gets slightly out of sync with the value of its underlying assets. When an investment company’s share price undervalues the assets in the fund, it is said to be trading at a discount to net asset value. Sometimes, though less often, the shares may overvalue the assets – in which case, the fund trades on a premium to net asset value.

Open-ended funds, by contrast, are structured differently, so premiums and discounts don’t arise. If an investor wants to put money into the fund, the manager simply issues more shares in it. If an investor wants his or her money back, their shares are cancelled. Each share therefore reflects the prevailing value of the fund’s assets at all times.

Challenge or opportunity?

Since the discount issue gives investors something else to think about, investment companies are routinely described as more complicated than other types of fund. But that feels like a cliché: most people, when the jargon is explained, are perfectly capable of understanding what’s going on here.

Moreover, the crucial point to grasp is that just with any other type of investment funds, the returns you’ll earn from an investment company over the medium to long term will depend on the performance of the assets that it owns. Investment company shares may be volatile over short-term periods (though not necessarily) but over time they’ll rise or fall in line with the fund’s assets.

In fact, many investors see discounts as an attractive feature of investment companies, rather than a complexity. After all, a fund trading on a discount is really offering you the chance to buy a share of assets for less than they’re really worth.

You’ll need the discount to narrow in order to realise that value, but the investment company sector continually throws up opportunities in this way. Mick Gilligan, the head of fund research at stockbroker Killik & Co, says this is one of the ways in which he chooses investments (or avoids them). “We regularly screen for instances where these discounts become unduly wide or narrow, or where premiums develop, and do not adequately reflect the short-term risks to performance or opportunities to make gains,” he says.

Discounts on the way out?

Finally, it’s worth pointing out that investment company discounts are, in any case, far less of an issue today than they once were. By the end of last year, the typical stock market-focused investment company was trading on a discount of just over 5%, close to an all-time low. Average discounts have now been in single digit figures for several years, after decades where the norm was 10% to 20%, or even higher.

The biggest single factor in this narrowing of average discounts is that investment company boards have taken the initiative. They recognise that many people are spooked by unduly wide discounts, so they’ve taken action to tackle them. Many funds routinely buy back shares when supply appears to be exceeding demand and discounts are rising. Some have formal discount policies that require them to intervene when discounts hit a pre-determined level.

Many investors will welcome these initiatives, but in the end there is no need to get unduly worried about the discount question. The more important issue is whether a fund will deliver strong returns. The bottom line is that far from being a reason to avoid investment companies, discounts are just another feature of them.