Where are discounts heading?

Are financial advisers feeling more comfortable today with investment company discounts than in the past? For many years, the fact that investment company shares tend to trade at a discount to the value of the fund’s underlying assets (or, less often, at a premium), was a reason given by advisers for steering clear of the closed-ended sector. They didn’t like the additional complexity represented by discounts and premiums.

However, more than two years after the retail distribution review, which got rid of the financial disincentive that also tended to put advisers off the sector, many have a much better understanding of investment companies. They’ve become much more familiar with the way in which the closed-ended structure of an investment company means that its share price movements don’t always exactly replicate movements in the prices of its underlying assets.

The issue is particularly pertinent today because after a prolonged period of narrowing, discounts have been creeping up in recent weeks. Shares in the typical investment company are still trading at a discount in single figures, but there has nonetheless been some widening over the past month, even in popular sectors such as UK growth and UK income.

Investment company analysts regard this as something of a pause for breath. For example, Charles Stanley’s Stephen Peters told the Sunday Telegraph last week: “Over the past month, there has been a movement to bag profits and move into cash given the uncertainty around the election outcome and the implications this will have on the UK stock market.”

There are two ways to look at this trend. The first is to wonder whether this might be the start of a prolonged period of discount widening. Might we be about to see discounts heading back towards 10 per cent and higher, as they often traded at in years gone by?

Financial advisers with a good understanding of the investment company industry will reject that prospect as unlikely. In recent times, investment company boards have recognised the importance of keeping discounts under control. Many now have formal discount control mechanisms that require them to take action, such as buying back shares, if the discount hits a certain level. Even those that don’t have set rules in place are taking action where necessary.

The second way to look at the recent widening of discounts, then, is as an opportunity. At those funds now trading on a wider discount than a month ago, it is possible to buy exposure to the underlying assets more cheaply than in the past.

It’s never a good idea to invest in a closed-ended fund simply because a widening discount appears to have thrown up a buying opportunity. But for advisers who believe in the underlying appeal of a particular fund, a wider discount may make now a more attractive time to buy exposure.

The growing sophistication of financial advisers when it comes to investment companies may help this idea to become self-fulfilling. The more advisers who see wider discounts as a potential buying opportunity, rather than a reason for alarm, the more investment will flow into funds at this time – and that will automatically bring the discount back down again.