Staying on top of the discount issue

The discounts at which the shares of investment companies trade relative to their assets appear to be on the rise. As Winterflood Investment Trusts points out in a note published this week, more than two-thirds of closed-ended funds have seen their discounts widen since the beginning of the year. As a result, the average discount across the sector as a whole has moved from 4.8 per cent at the end of 2014 to 7.1 per cent today.

Should independent financial advisers be worried? After all, the discount issue is often cited by advisers as a reason to be cautious about investing in closed-ended funds. It adds complexity and risk compared to an open-ended fund, they argue.

Well, the first point to make is that 7.1 per cent is pretty low by historical standards – discounts have routinely traded in the double digits in the past. The trend on discounts over the past five years has been steadily downwards, notwithstanding short-term periods of volatility.

Moreover, as Winterflood points out, “there is no obvious reason” to explain the discount widening we have seen. Global markets have performed well – the FTSE 100 Index has even managed to finally break through its all-time high – and while there is no shortage of headwinds, we certainly haven’t seen the sort of problems that might precipitate a wholesale loss of confidence in equity investment.”

The potential explanations for wider discounts feel more short-term than fundamental. It’s notable, for example, that investors have been putting less money into open-ended funds this year. Demand for closed-ended fund shares may have eased at the same time. It could be that investors are nervous about valuation levels, particularly amid the ongoing turmoil in the eurozone. And record market highs often prompt investors to pause for thought.

It will certainly be interesting to see what happens during the individual savings account (ISA) season, the period between now and the end of the tax year, when both open-ended funds and investment companies typically seek a spike in demand as investors scramble to use up their tax allowances. Such a spike might well be enough to reverse the trend seen on discounts so far in 2015.

None of which is to suggest that discounts will definitely come back down. Indeed, it is possible they will creep higher, particularly if caution proves to be the over-riding sentiment amongst investors in the months ahead – and May’s general election might give people another reason to sit on their hands for a while.

Crucially, however, the investment company sector is well-placed to respond to any sustained rise in discounts – certainly far more so than in the past. In recent years, it has built a strong track record on taking action against rising discounts. Many funds have introduced discount control mechanisms, which enable them to take action if the discount widens – share buybacks are the most obvious response.

“If discounts do remain extended for some time we expect boards and fund managers to come under pressure to step up their buyback programmes,” says Winterflood. That is no doubt right, but the evidence of recent years is that even without such pressure investment companies are proactively taking action to stay on top of the discount issue.