Where next for discounts?

Should financial advisers and investors with exposure to investment companies brace themselves for a period of widening discounts between the share price of their funds and the value of their underlying assets? After all, discounts widen when there is a mismatch between market sentiment and asset value – and there is no doubt that in the three weeks or so that have elapsed since the Brexit vote, sentiment has turned downwards at a rate not matched by what’s actually happening to the value of most funds’ assets.

In fact, we are already seeing the effects of this. Winterflood Investment Trusts points out that by the end of June, the average investment company’s shares traded at a 9.4 per cent discount to the value of its underlying assets. That was up from 7.9 per cent at the end of March, and from 5.4 per cent at the end of 2015.

Indeed, discounts suddenly appear to be reverting to their long-run norms. While the average discount over the past 10 years has been 7.4 per cent, Winterflood says the long-run average discount in the investment company sector, going all the way back to 1990, has been 9.5 per cent. That was almost the level we were back to by the end of June.

These statistics will worry many financial advisers. The discount issue has long been cited by advisers who are reluctant to include investment company exposure in their clients’ portfolios – they say the fact that an investment company may trade at a discount or premium to the value of its assets represents an additional complexity that many investors can simply do without. And that argument feels all the more compelling at times when discounts are widening. Investors see the value of their savings fall at an exaggerated rate.

In that context, the shift in sentiment in the investment company sector in the run-up to the Brexit referendum – and its aftermath – is an unwelcome potential stalling point for closed-ended funds, which have made a real breakthrough with financial advisers over the past couple of years. Advisers are far more likely to recommend investment companies to their clients today than ever before.

However, it would be wrong to be too disheartened by what is happening with investment company discounts. The first point to make is that discounts (and premiums) are simply a function of the structure of a closed-ended fund. With a specific number of shares in issue at a given moment, ebbs and flows in demand for those shares are what determine price; there will inevitably be periods when that demand moves out of sync with what’s actually going on with the fund’s assets.

Moreover, the investment company industry is in a completely different place today than in the 1990s, when average discounts would routinely tip up to two or three times’ today’s levels. A reform of tax legislation in 1999, which made it far less costly for investment companies to conduct share buybacks, has been a crucial factor; since then, funds concerned about their discounts have felt far more comfortable buying in their shares in order to support valuations.

At the same time, many investment companies have become much more engaged with the issue of discounts. Large numbers now have formal discount control mechanisms that require them to intervene if the fund’s discount reaches a certain level. Many others apply similar policies even if they are not formally mandated to do so.

This is not to say discounts are a thing of the past – the very structure of an investment company means it will never be possible to say that. However, the difference between today and 20 years ago is that investment company boards are now far more likely to take action if their discount begins to widen unacceptably – and they have the tools with which to do so.

The volatility seen across the entire stock market in the wake of the Brexit vote was bound to affect investment companies too. It is this short-term effect that has seen discounts widen. In time, however, as the natural stabilisers kick in – and boards take action - there is good reason to expect discounts to tick back down below the long-run average towards the level that has been more typical over the past decade.