Change in the air

In what has been a very difficult year for investment companies, one statistic really stands out in the AIC’s recently published review of 2023. The average fund has spent the entire year with its shares trading at a discount of more than 10% to the value of its underlying assets. That’s the first time this has happened since the financial crisis of 2008.

Now, there have been lots of headwinds facing investment companies over the past 12 months, from rising interest rates to the market and economic uncertainties caused by international conflicts and tensions. But are we really saying that financial markets face the same kind of challenges as they did during a period when it looked possible that the global banking system might collapse?

The truth is that stock market investors remain as susceptible to over-reaction as they ever have done. It has been consistently risk-averse sentiment that has held so many investment companies back in 2023, rather than some fundamental breakdown at individual funds or across the sector as a whole.

In that context, discounts are not such an evil, even though they leave investors holding assets that they can’t sell at anything like their true value. The discount is effectively a release valve – it is part of the structure of an investment company, which allows investors to exit without the manager having to sell assets to pay them out. A discount will correct itself as sentiment shifts, but shares sold at disappointing prices represent value lost for good.

The more optimistic news, moreover, is that we might finally be seeing the beginning of a shift. In recent weeks, global stock markets have made strong progress – the US market is at a record high on some measures. Investors have welcomed the fact that we now appear to be at the peak of the interest rate cycle. The mood in markets suddenly feels far more upbeat. More parochial factors, such as progress on the regulatory issues around investment company charges, are pushing in the right direction too.

In time, all of this should mean discounts on investment companies come back down. In fact, this is already happening – the average discount in the sector is now just over 11%, down from close to 17% three months ago.

For investors, this offers the prospect of a double performance whammy. They’ll benefit as asset prices rise, but they’ll also get an extra lift as the discount narrows. If the current sense of optimism is maintained, there is good reason to be hopeful about returns over the coming months.

The private equity sector of the investment companies industry provides an example of what is possible in these circumstances. This year, it has been the best-performing sector of all in the industry, registering a 49% gain to date. That partly reflects rising asset values, but investors in many funds have also seen discounts narrow very sharply; private equity funds had been an extreme example of negative sentiment undermining valuations, so they performed especially strongly as this began to unwind.

None of which is to suggest 2024 will be plain sailing for investment companies and their shareholders. Risk remains elevated – Western economies are flirting with recession, for example, and the geopolitical backdrop could certainly not be described as easing.
Nevertheless, we do now seem to be seeing a market acknowledgement that valuations in the investment company industry have become unduly pessimistic. Let’s hope many funds are able to capitalise on this shift over the next year.