Do discounts really matter?

Old stock market hands have a saying: “Never catch a falling knife”. It’s a warning not to try to call the bottom of a market when prices are dropping or depressed – there’s always the danger of getting hurt if assets end up taking a further tumble.

That adage came to mind this week when the AIC published research on the investment trust sector’s current problems with discounts. Shares in the average investment trust have now been trading at double-figure discounts to the value its underlying assets for 29 months, the longest period in 20 years, the AIC points out.

The implication, of course, is that better times must be coming soon. Indeed, the AIC explains that following previous periods of extended discounts, investors have enjoyed souped up returns – additional performance worth an average of 4.3 percentage points a year, to be exact.

Having repeated the AIC’s data, it seems sensible to refer to another well-known investment rule – that past performance is no guide to the future. The fact we’ve seen that historical pattern of excess returns in times gone by doesn’t mean we can count on them this time around. In any case, we may not yet have reached the bottom of the market.

The reality is that discounts have remained wide for an extended period for a variety of reasons – some more enduring than others. Market sentiment has certainly been a drag, with investors anxious about rising interest rates, particularly in a number of important investment trust sectors. That may now be improving. On the other hand, structural issues, particularly with diminishing demand for investment trusts from some big investors, such as wealth managers, may prove stickier.

None of which is to undermine the case for investment trusts, which remains as compelling as ever. These are professionally-managed funds with strong long-term performance track records, competitive charges and a bunch of advantages related to their structure and governance. In many asset classes – particularly illiquid areas such as property, infrastructure and private equity – they give investors options for exposure that are largely lacking elsewhere.

However, seeking to benefit from a narrowing in discounts isn’t the ideal reason for investing now – particularly if you’re focused on short-term gains. Discounts may indeed begin to come down, in which case investors will get an extra performance boost. But they may stay wide for a little longer yet – whisper it quietly, they could even widen further.

A better way to look at investment trusts is to forget about discounts altogether – because in the long term, they are far less of an issue. What should interest you most is the total return you could earn over an extended period.

There’s every reason to investigate investment trusts on that basis. The ability of funds to take on gearing can drive long-term capital gains. The option of building up dividend reserve funds give investment trusts opportunities to deliver consistent – and often rising – levels of income. Competitive charges reduce the drag of fees on returns.

All of which is a reminder of one final stock market saying that wise heads often swear by. “Buy shares, take sleeping pills,” the greybeards say. In other words, pick your investments to suit your long-term financial objectives and, barring disasters, stick with them rather than imagining you can second guess the short-term ups and downs of the market.