David Prosser explains how investment company discounts depend on market sentiment.
Who says politics don’t matter? After the general election, the discounts on which investment company shares are trading relative to the value of their underlying assets have narrowed notably, according to a note published this week by Simon Elliott, an investment company analyst at Winterflood Securities.
According to Elliott, the average discount for the 44 investment trusts that invest predominantly in the UK was 6.0 per cent at the start of 2015. This had widened to 8.6 per cent by the eve of the general election, with funds that invest predominantly in smaller and medium-sized UK companies seeing their discounts move from an average of 10.4% to 12.6%.
Last week’s unexpectedly decisive election result has pushed discounts back down. “Discounts narrowed to 8.3 per cent for investment trusts exposed to UK equities and 11.9 per cent for UK mid and small-cap funds,” Elliott reports.
The point to grasp here is that, in the very short term, investment company discounts (and premiums in some cases) depend on market sentiment. When investor demand is strong, discounts tend to narrow, while at times when there are fewer buyers, they slip back out. The run-up to the election, with all its uncertainties, was a case of the latter, while the week since then has been a period of the former.
Many financial advisers feel uncomfortable with investment company discounts. They don’t like the fact they’re not paying face value for the fund’s underlying assets. And they worry about how to second-guess discount narrowing or widening while they’re also trying to assess the merits of the fund itself. There are several answers to those concerns. The first is that discount volatility is a short-term phenomenon that should not cause anxiety to advisers and investors buying for the long term (as one would hope buyers of investment companies are). A fund may move to a discount or a premium in the short term, but this will tend to correct itself over time, as investors close in on a value opportunity, or move out of a fund that is over-valued.
The second point is allied to this issue. Discounts can offer moments of opportunity. Those UK equities funds trading on a discount of 8.3 per cent are effectively offering you the chance to buy exposure to their underlying assets on the cheap. And when discounts widen, the offer becomes even more compelling.
The current environment may be a case in point. As Winterflood points out, despite the narrowing of the past week, discounts “remain wider than their 12-month averages and we believe this presents a value opportunity”.
The final argument for advisers to consider is that investment company discounts today are far narrower than in the past, when double-digit discounts were the norm. The most significant explanation for this is that investment company boards have recognised that over-wide discounts can be off-putting. Many now take decisive action if they see their discount widening to a level with which they don’t feel comfortable. In some cases, discount control mechanisms are automatically triggered once discounts reach a certain level.
Advisers should be reassured by these developments. Shares in investment companies will always have the potential to trade at a discount or premium to the value of the underlying assets – this is a function of their closed-ended structure. But we should not get hung up on the short-term. Nor is it likely that we will see the excessive valuation gaps of the past - and those advisers who get comfortable with discounts can learn to exploit them.