Managing discounts in volatile markets

There are many positive reasons why financial advisers have embraced investment companies in ever-increasing numbers in recent times, but one important factor has certainly been that discounts in the sector have become less of an issue. Advisers have often felt uncomfortable with the fact that investment company shares trade at a discount (or sometimes a premium) to the value of their underlying assets, but have been comforted in recent times by the relatively narrow average discounts in the sector.

The long-run average discount in the sector, going back all the way to 1990, is 9.5 per cent; by contrast, over the past 10 years, the average stands at 7.4 per cent – and as recently as the end of last year, the prevailing average was 5.4 per cent.

The question, then, is what happens if and when discounts start to widen once more. This is what you would expect to happen during periods of market uncertainty and volatility, such as the climate we’re now heading into following the Brexit vote. In fact, we’ve already seen a significant widening – by the end of June, the average discount across the sector was back up to 9.4 per cent.

Will financial advisers start to drift away from investment companies in such an environment? While an investment company whose shares trade at a discount of almost 10 per cent to the value of its underlying assets might represent an opportunity to some, others will be more concerned with the prospect of investors suffering further if the discount gets even wider.

This issue is particularly important for those funds with a tilt towards income; in the low interest rate environment of the past few years, such funds have been hugely in demand – many now trade at premiums or discounts far below the average. Might they suffer a particularly harsh correction in a market downturn?

The short answer is probably no. For one thing, there is little likelihood of income-oriented investment companies falling out of favour any time soon. If anything, there is likely to be greater investor appetite for these funds, given that the Bank of England has cut interest rates to 0.25 per cent.

Moreover, the big difference between today and times in the past when market volatility has sent discounts soaring is that investment company boards are far more actively engaged with the management of their valuations.

An analysis published this month by Money Observer magazine of the 20 largest income-oriented investment companies launched in the past five years, shows that all but five have publicly-stated discount control mechanisms or policies in place. Some promise to intervene with share buybacks if the discount hits a certain level – others even pledge to offer a continuation vote under certain pre-specified circumstances.

It isn’t only income-focused funds that are taking this proactive approach to discount management – a roughly similar proportion of the whole investment company sector has published similar information.

The truth is that it isn’t always possible to manage the discount. Some volatility is inevitable and in more illiquid asset classes – property is the most obvious example – discount control mechanisms are less appropriate. Nevertheless, financial advisers worried about discounts should be reassured – investment company boards that might once have been prepared to let valuations slide are far more closely tuned into this issue today.