A valuable debate?

With investment company discounts at low levels, the question of whether there is value in the sector may not be a worthwhile one, writes David Prosser.

Are investment companies too expensive? This is the question asked in a lengthy (and mostly positive) article just published by the Financial Times, which points out that discounts in the sector currently sit at historic lows. Shares in the average investment company currently trade at a discount of 3 per cent to the underlying assets, compared to 9 per cent a decade ago, and 17 per cent in the immediate aftermath of the financial crisis. In which case, the FT ponders, have investors and advisers missed the chance to find value in the sector?

This is a debate that resurfaces periodically when discounts fall – but it may not be a sensible discussion. Not least this is because it misses the point of why most investors put their money into a closed-ended fund: they’re generally not trying to secure a short-term trading advantage by picking a stock where there appears to be a valuation opportunity; rather their aim is to select an asset that offers a good match to their long-term financial planning goals.

In which case, the important question is not the level of the fund’s valuation today compared to, say, a few months ago – rather investors should be focused on the potential for the investment company to deliver the long-term returns they require.

It’s an important lesson because too often, when we talk about investment company valuations, we conflate two very different activities. There certainly are people out there – both professional and retail – who spend their time looking for short-term pricing opportunities in investment company stocks, but they’re speculators. This isn’t what investors (or their advisers) should be doing; rather than behaving like traders, their interest is the long-term outlook, in which pricing today is largely going to be an irrelevant consideration.

This isn’t to say investment company investors should just forget about discounts. It is important they understand why discounts and sometimes premiums occur – with a fixed number of shares in issue, the price of a fund is determined by demand and supply at any given time, rather than the value of the underlying assets. Investors are entitled to expect investment companies to manage discounts over time, so that they’re not exposed to extremes, or unacceptable levels of volatility.

Equally, it’s worth pointing out that no one suggests an open-ended fund is over-valued or expensive because it always trades at a price that fully reflects the value of the assets in its underlying portfolio. Such a fund is, technically, more expensive than an investment company trading on a very small discount, but we just don’t think in those terms: open-ended fund pricing is a function of fund structure, just as is the case in the investment companies sector.

In truth, the issue of discounts and premiums has always been a problem for the investment company sector. It appears to make investment in closed-ended funds more complex – or even to add an extra layer of risk. These factors have in the past been offered up as reasons to look elsewhere for fund investments, often by intermediaries actually motivated by different considerations, such as remuneration structures.

The reality, however, is that investors buying funds and holding them for the long term as part of a well-considered financial planning strategy do not need to worry about discounts. An investment company either is a good match for such a strategy or it isn’t – and if the former, trying to second-guess or time the market makes no sense when the investment may be held for five to 10 years or even longer.