Catching Z’s

Should advisers and their clients ever consider bargain hunting in the investment companies market? On the one hand, sensible investment means taking a long-term approach to fund selection, choosing vehicles appropriate to your financial objectives as part of a diversified portfolio strategy. On the other, the structure of an investment company means there are times when the price of a fund does not fully reflect the value of its assets, potentially presenting an opportunity to buy on the cheap.

The latter argument is part of the ongoing debate about the merits of investment companies. Closed-ended funds offer exposure to a portfolio of assets that constantly moves in value through a fixed number of shares whose price at any given time is determined by demand and supply. This means the shares will sometimes trade at a discount to the value of the assets and sometimes – less often with most funds – at a premium. Some advisers have historically felt this feature of the sector makes it riskier while others have been more sanguine.

That debate aside, however, changing investment company valuations are widely followed. Clearly, there’s a difference between trading – looking for short-term profits, often from pricing anomalies – and investment, which is all about the pursuit of a long-term goal. But if you’re focused on a particular sector of the market or a certain type of asset, and an opportunity to buy exposure on the cheap comes along, it surely makes sense to consider it.

The systematic way to do that is to study “Z scores”. These statistics, published by a number of investment company analysts, provide a means to consider whether an individual fund is currently priced cheaply or whether it’s expensive. To be precise, a fund’s Z score shows how the premium or discount at which the fund currently trades relates to its historical valuation. A negative Z score suggests the fund is cheap compared to how it has been priced in the past, while a positive score suggests the opposite. The higher the score either way, the cheaper or more expensive the fund’s current valuation, at least in relation to the past.

Z scores are useful indicators, since they make comparisons of different funds – in the same sector or more broadly – much easier. On the face of it, two funds currently trading at a discount of 10 per cent look to be similarly valued. But if one has historically traded at discounts of more than 15 per cent while the other has rarely featured a discount above 5 per cent, their current valuations are actually very different.

Nevertheless, Z scores aren’t infallible. There may be all sorts of reasons why a fund’s rating moves out of sync temporarily – some of which might give you pause for thought before investing. An obvious example is a change of manager: where a less well-known manager replaces an incumbent with a strong track record, for example, you can see why the fund might trade cheaply for a while, but once under new management, historical comparisons no longer make so much sense.

Also, valuations, in themselves, don’t give you much clue about the prospects of a fund in terms of absolute returns. Two funds investing in a market that looks set for a prolonged downturn may be valued very differently, but you probably don’t want to be in either.

Still, it’s worth getting to know about Z scores. At the very least, they provide a yardstick with which to make meaningful comparisons of investment company valuations. Used as one part of the decision-making process, they can support long-term investment as well as facilitating shorter-term trading.