There’s no getting away from discounts

Financial advisers and investors often feel uncomfortable with the fact that investment company shares typically trade at a discount or premium to the value of the underlying assets. This effect is simply a consequence of the structure of an investment company; with a fixed number of shares in issue, the price depends on supply and demand in the market, which may not be in sync with what’s happening to the underlying portfolio. Still, since the discount may rise or fall independently of asset price changes, it adds an extra complexity when investing in a closed-ended fund.

In that context, new research published by the investment company analyst team at Stifel makes interesting reading. It points out that with stock markets in the UK and US having hit all-time highs in recent weeks amid positive investor sentiment, investment company discounts have narrowed markedly. The sector as a whole currently trades on a discount of 5.1 per cent, its lowest level for two years – and well below the 11 per cent plus discounts seen in the immediate aftermath of last year’s EU referendum.

There’s two ways to look at this narrowing (and in some cases, individual funds have even moved on to premiums). Advisers and investors who feel uncomfortable with wide discounts may be reassured by the tightening that has taken place over the past few weeks and months, especially since it has been driven by a strong run of returns. On the other hand, as Stifel itself points out, the investment company sector could now be vulnerable to even quite subtle shifts in sentiment; if markets appear to be running out of steam, you would expect to see discounts begin to widen once again.

In the end, however, it’s a mistake to get too hung up on the absolute level of investment company discounts, unless you’re looking for opportunities to gamble on apparent mis-valuations in the market.

For one thing, investment companies should be considered long-term portfolio holdings for most investors. Short term discount shifts are clearly going to be far less significant in the context of a five or 10-year investment.

But also, it’s important to recognise that attitudes towards discounts in the investment company sector have changed substantially in the past five to 10 years. Where investment company boards that paid close attention to their discount position were once in the minority, today they are absolutely the norm. Discussions about discount control are commonplace; boards frequently take action to tackle discounts – share buyback programmes, for example, are regular events in the sector.

The cumulative effect of this shift in attitude is that while investment company discounts do still shift day-to-day, the range of movement tends to be narrower than in the past. Take a look at a graph of average discounts over the past five years and you’ll see that apart from a post-referendum spike last year, the average has traded within a tight range of around five percentage points.

That’s important because it gives investors and advisers much greater certainty about the potential impact on their returns. Just as excess market volatility isn’t something investors welcome, so discount volatility is difficult to accommodate.

In the end, there’s no getting away from discounts in the sector – they’re a fact of life given the structure of funds, and advisers and investors have no choice but to get to grips with that. Still, the evidence of recent times is that this is an issue which should pose far fewer questions than in the past.