Why you shouldn’t be distracted by discounts

Investors sometimes get spooked by investment company “discounts” – so the news that discounts are currently at their widest level for more than a decade could be disconcerting. But it’s important to understand why discounts are part and parcel of investing in investment companies – and once you do, this is an issue that feels much less significant.

In truth, it’s not a difficult concept. An investment company owns a portfolio of investments and offers investors exposure to those assets through shares that can be bought or sold on the stock market. It is said to be trading at a discount when those shares don’t reflect the full value of the fund’s investments.

In theory, the total value of all shares in an investment company that owns £100m worth of assets should be £100m – because it is the fund’s shareholders who ultimately own those assets. In practice, however, that won’t always be the case – and if the total value of those shares is only, say, £90m, the fund is trading at a discount of 10% to the value of its underlying assets.

What causes discounts?

Discounts occur because of the way in which investment companies are structured, with a fixed number of shares in issue. Over time, the price of those shares rises and fall in line with the value of the fund’s investments. But what determines the price at a given moment is demand and supply for the shares as they’re traded on the stock market. And sometimes, demand and supply gets out of kilter with the underlying asset value.

In a perfectly efficient market, this wouldn’t happen – demand and supply for investment company shares would automatically track the value of the fund’s assets up and down. But markets aren’t perfect. For one thing, investors don’t always have the full picture, particularly about what might happen in the future. For another, investors aren’t always rational – they sometimes panic when things go wrong, or get over-exuberant in good times.

The result is an anomaly. The share price of an investment company may slip to a discount to the underlying value of the fund when demand from investors for its shares lags supply. Equally, it could move to a premium, if demand for the fund’s shares runs ahead of what its assets are worth.

Should I be concerned by widening discounts?

Investors – and financial advisers too – often feel that discounts and premiums are an added complexity they could do without. It doesn’t help that the phenomenon tends to be stronger in more unusual times, when investors are already likely to be worried. Right now, following the market volatility of the past few weeks, the average investment company’s shares trade at a discount of around 12.5%.
 

To put that figure into context, average discounts began the year at around 3% and have only been in double figures on a handful of occasions in the past two decades. The most notable examples came during the global financial crisis and immediately after the Brexit vote.

Equally, if you don’t hold investment companies right now, but have been thinking about investing, this might seem like an odd time to go for it. But actually, it may be an opportunity to pick up a bargain – you’re effectively being offered the chance to buy assets at a cut price. If you had been intending to buy those assets in any case, there is a lot to be said for picking them up cheaply.

One word of warning, however – the above may not apply to investment companies that invest in hard-to-value assets like property or private companies – particularly in volatile times like the present. These assets are valued infrequently, so the reported discount may be based on a stale valuation.

It’s always a bad idea to make decisions that are purely based on discounts, but this is doubly true when the underlying assets are hard to value and markets are volatile.

Focus on the future

The bottom line is that investors should always be focused on the long-term – their ambitions for five to ten years’ time, say. If your time horizons are shorter than that, you probably shouldn’t be investing in assets with the potential to fall as well as rise in value, since you may not have time to recoup any losses.
 

Taking the long-term view means not allowing yourself to be distracted by short-term movements in the price of your investments, including discounts (or premiums) in the case of investment companies. If you’re convinced a particular fund is the right option for you, given your current financial objectives, stick with it – and try not to worry about what is happening to its price on a day-to-day basis.