Dispelling the discount doubts

Do investment company discounts worry you? If so, you’re not alone. Investors often say they’re wary about investment companies because shares in these funds may trade at a discount to the value of their underlying assets; financial advisers sometimes share that anxiety. Moreover, discounts have increased sharply in recent times: the average investment company now sits on a discount of 11%, compared to just 3% two years ago.

Still, while such concern is understandable, there are good reasons to look past discount anxiety. Above all, it’s important to understand what causes a discount – this isn’t some dangerous idiosyncrasy that dogs the investment companies sector; rather discounts are simply a reflection of how the funds work.

Investment companies are closed-ended funds – that is, they have a fixed number of shares in issue at any given time. To get exposure to the fund, investors buy those shares on the stock market, with the price depending on demand and supply at the time they want to buy. Sometimes, therefore, that price can get out of sync with the value of the fund’s assets: the shares may be cheaper than they should be given that value or more expensive – that is, they may trade at a discount or a premium.

This structure actually has advantages compared to the way other types of funds are set up. Investment company managers don’t have to worry about dealing with inflows and outflows of money, for example. And they never have to sell the fund’s investments simply because large numbers of investors want to withdraw their money. With illiquid investments such as property and infrastructure, that can be hugely important.

Nonetheless, investors aren’t keen on wide discounts. That’s understandable – if you own, say, £100 worth of assets, why should you only be able to sell them for £89, which is what the current 11% investment company discount implies? There is also the possibility of the discount widening – in which case, your investment may lose value even though nothing has happened to the value of those assets.

The good news is that investment company boards recognise those concerns. There will inevitably be times when discounts widen – stock market sentiment over the past year has been depressed by factors such as war in Ukraine, soaring inflation and the prospect of recession. But boards can take action in order to try to force discounts back down again.

Indeed, many investment companies now operate with discount control mechanisms – these compel the board to intervene if the discount goes above a certain level. This can give investors comfort – they know the fund will act in the event that the discount becomes unacceptably wide. At smaller investment companies, which are more susceptible to discounts, that’s especially reassuring.

However, even investment companies without these formal arrangements in place will often take action when the discount widens. The most common strategy is for the board to buy back shares in the fund, which are then cancelled. By reducing the number of shares in issue without any changes in the underlying portfolio, you should automatically start to drive the discount down.

In this context, new data from Winterflood Research reveals that investment companies bought in £246m of their own shares during April, 24% more than in the same month of last year. And separately, data from Peel Hunt shows that investment companies bought a whopping £3.5bn worth of their own shares in the 15 months following the beginning of 2022.

Buybacks work. Peel Hunt points out that funds that have engaged in buyback programmes have, on average, seen a third less volatility in their discounts than those not buying back shares. Average discount volatility for funds that conducted at least one buyback was 4.1%, compared to 6.1% for trusts with no buybacks during the period studied.

The bottom line for investors is that discounts – and sometimes premiums – are a reality of life with investment companies. But in recent years, discounts have tended to be much lower than in the past. And investment companies appear to be determined to keep it that way most of the time. As market sentiment improves, discounts should fall, with interventions by boards accelerating the adjustment.

In the meantime, there are plenty of analysts who regard the current level of discounts as an opportunity. After all, if you don’t already own an investment company, you’re currently being offered the chance to buy it with 11% knocked off what the purchase price should really be. Who doesn’t like a bargain?