Investment company discounts in times of volatility

In the immediate aftermath of the UK’s decision to vote for Brexit back in June, financial markets unsurprisingly saw a spike in volatility. The currency markets made the headlines as the pound plummeted (it has continued to fall in the months since the vote), but there was plenty of turmoil elsewhere too. Investment companies, with holdings in a broad range of asset classes, as well as exposure to changing investor sentiment, were always going to be affected by that.

So it proved. In the weeks following the referendum, the discount at which the average closed-ended fund’s shares traded relative to the value of its assets peaked at 11 per cent, having begun 2016 at around 5.5 per cent. And for many financial advisers, that will have been a concern – one traditional worry about investment companies in the adviser community has been the propensity of funds to slip to wide discounts.

Since then, however, discounts have narrowed once again. By the end of September, following a substantial re-rating, the average investment company’s discount to net asset value was back down to 6.7 per cent. That’s still up on the level of the beginning of the year, but nonetheless reflects a significant improvement in sentiment.

It’s also noticeable, by the way, that investment companies have outperformed the market this year in share price terms, even after that discount widening. “So far in 2016, the investment trust sector is up 12.5 per cent compared with an increase of 12.4 per cent for the FTSE All-Share,” reports Winterflood Investment Trusts. “Over the last 12 months, the sector is up 19.7 per cent compared with a rise of 16.8 per cent for the wider market.”

Leaving aside this outperformance, useful though it is, the most important lesson from the narrower discounts we’ve seen now that the immediate post-referendum panic has subsided, is that this whole issue is far less significant than in times gone by. Looking back as far as 1990, the average investment company has traded on a discount of 9.5 per cent. By contrast, over the last 10 years – a period of considerable market volatility – the average has come down to 7.4 per cent.

There are good reasons for this. Investment company boards have worked hard over the past 10 years to get on top of discounts, with strategies ranging from share buy-back programmes to discount control mechanisms.

Some boards have been more overt in their focus on discounts, with publicly stated policies, while others have preferred a more ad hoc approach, intervening on a discretionary basis. Either way, however, investment companies have increasingly recognised that trading on a wide discount to the value of the fund’s underlying assets has been off-putting for advisers and investors – and that discount control is an important part of any strategy aimed at attracting a wider audience. And as investment companies have become a more mainstream proposition, since the retail distribution review of three years ago, this has been even more of a priority.

Discounts will inevitably ebb and flow over time, in line with the changing market environment, but the trend in recent years has been for this volatility to be confined within a much lower range. The experience of the sector since the referendum provides another example of what this means in practice.