Discounts and premiums

Who’s afraid of an investment company discount? There was a time when financial advisers and investors routinely expressed discomfort with the way that the closed-ended structure of an investment company gives rise to its shares trading at a discount or premium to the underlying assets. But more recently, as advisers have become more engaged with the sector, this has become less common.

Still, at first sight at least, discounts do appear to add an additional layer of complexity to the investment decision. A recent reader’s letter to Investors Chronicle magazine underlines the point: the author, a novice investor, said she was drawn to the investment company sector but unsure about how she should time her investments in funds trading at discounts or premiums.

It’s a reasonable question and the magazine offered lots of sensible advice about what might constitute expensive or cheap when it comes to investing in closed-ended funds, and what a discount or premium might signify. One important point, however, was notable by its absence: in the long run, the decision about whether to invest rests on your views about whether the underlying asset class is right for you and whether the fund in question is the best way of getting exposure to it.

In that context, the issue of discounts and premiums becomes much less relevant. No-one like likes to overpay for anything – and we all love a bargain – but trying to second-guess investment company valuations is too akin to trying to time the market. Chances are that you’ll call it wrong, plus you’ll be distracted from the more important matter of making the right long-term financial planning decisions.

Does that mean we should ignore discounts or premiums altogether? Not necessarily – if a fund is rated out of line with its sector or its typical rating over the longer term, that’s worth investigating. It may not be a cause for alarm or excitement, but it should be checked out. Funds fall to a wider discount when there is uncertainty about the manager’s future, for example.

As for those advisers and investors who are put off investment companies by these considerations – after all, you don’t have to worry about discounts in an open-ended fund – it’s worth thinking about this issue in a different way. You could choose to look at an investment company discount as a useful safety valve.

One thing we all know about investment markets is that people tend to over-react, both in the good times and the bad. They get over-enthusiastic and unrealistic when markets are rising and panic when they’re going the other way. The price of investment funds tends to fluctuate accordingly, with investors rushing in or out at certain stages of the market cycle.

That can prove disastrous for investors who just want to be in the fund for the long haul – their managers are constantly coping with inflows and outflows of cash; in the worst cases, they’re forced to invest when markets look over-valued or to sell up at the bottom.

Investment companies, however, don’t have this problem. With a fixed number of shares in issue, it’s the discount or premium that takes the strain when large numbers of investors are selling or buying; the manager, meanwhile, is free to continue running the portfolio. Over time, the investment company’s rating will revert to more normal levels, and the underlying assets will have been unaffected.