Measuring the merits

As the Covid-19 crisis unfolds, all of us are beginning to think about what life after the pandemic might look like, including in the financial markets. After such a seismic shock, it is inevitable we will start to look at long-held certainties and established views through a new lens. Could the discussion of the merits (or otherwise) of investment companies be a candidate for reappraisal?

For many years, investment company sceptics have focused on the discount. They were uncomfortable with the idea that investment company shares do not always trade at the value of the underlying assets as a flaw. They worried about discounts and premiums moving against them. They complained that being forced to think about valuations added unnecessary and unwanted complexity to their investment decisions.

However, there is another way to think about discounts – and the Covid-19 crisis has provided as clear an example of this in practice as you could wish for.

Take a look at the year-to-date chart of average investment company discounts in 2019. It shows the sector trading on a discount of less than 5% for almost all of January and February, before taking a precipitous plunge in March, to a low of 22% at the height of the Covid-19-induced market crisis; since then, discounts have slowly but surely narrowed once again, to just over 8% at the time of writing.

What happened in March, of course, was that investment company shares were dumped alongside everything else in the market panic. Sellers rushing for the exit doors offloaded their investment company shares at such a rate that the average fund was down 30% or so in share price terms at the low point.

Crucially, however, from a practical perspective, this mattered not a jot to investment company managers. Their funds’ share prices may have been in freefall, but this made no difference to the day-to-day job of portfolio management. Managers have not had to sell holdings to meet the cost of investor redemptions, or worry about inflows and outflows of cash destabilising their funds.

In other words, the investment company structure has provided an invaluable safety valve during this crisis. The sharp rise in discounts we saw during March was a release of steam as the pressure in the markets intensified. As market conditions have eased, the steam has dissipated. Discounts are getting back to their pre-panic levels, with no damage done to the underlying portfolio.

It’s such an important point to grasp. If you own investment company shares, it was naturally upsetting to see the value of your shares dive last month. But assuming you didn’t sell, you can take comfort in the knowledge that your manager did not have to do so either; portfolio losses will not have been crystallised and the asset base is intact to benefit from recovery.

In fact, investment companies, at least in aggregate, have bounced back strongly. The sector has outperformed the stock market as a whole by around 10 percentage points since the middle of last month. Although the comparison isn’t entirely fair – not all investment companies are stock market-invested – the point stands.

None of which is to suggest that the worst is definitely behind us. In this crisis, there will inevitably be more ups and downs – markets may yet fall back once again. Still, one lesson we should have learned already is that the investment company structure, often criticised as too complex for many investors, actually offers some valuable protections.