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Widening discounts: Cause for concern or a bargain opportunity?

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15 April 2016

David Prosser gives his view on the discount figure for Q1.

To what extent should financial advisers be concerned about the widening of discounts we’ve seen in the investment company sector so far this year? Excluding private equity, hedge funds and property funds, shares in the average investment company were trading at an 8 per cent discount to the value of their underlying assets by the end of the first quarter, according to Winterflood Investment Trusts, compared with 4.8 per cent at the beginning of the year.

That’s a significant widening and, as a result, investment companies underperformed the broader market during the first quarter. The FTSE All-Share Index fell 0.4 per cent over the three months to the end of March, but the FTSE Equity Investment Instruments Index was down by 2.2 per cent.

Two factors were at play during this period. First, global markets were exceptionally volatile – the UK stock market was down 11 per cent at one stage – which naturally affected the performance of funds investing in them. But second, investor appetite for collective funds was muted. “We believe that this [widening in discounts] reflects a weakening in retail demand, which corresponds to the pattern shown in the Investment Association data of net retail sales of open-ended funds for the first two months of this year,” Winterflood’s analysts argue.

In the open-ended sector, of course, the effect of a drop-off in demand from investors is not so keenly and visibly felt; closed-ended funds, by contrast, see an immediate effect on valuations because of the very nature of their structure – fewer buyers for the same number of shares has a negative effect whatever is happening to the underlying value of the assets. As markets recovered from the worst of the first-quarter sell-offs, investment companies didn’t see the rising value of their assets fully translated into share price gains.

It’s worth pointing out that since 1990, the average discount in the investment company sector has been 9.6 per cent; over the last 10 years, however, that’s come down to 7.4 per cent. In other words, discounts now stand higher than their average in recent times.

So which way now? Are we going to see discounts widen further, towards their longer-run average, or begin to narrow once more as markets and investor sentiment improve?

Time will tell, but it’s important to understand why the discounts of the past 10 years have been so much lower. The most important explanation is that investment trust boards have been much more willing to intervene in the marketplace, engaging in share buy-back programmes and introducing corporate actions such as discount control mechanisms. These interventions have sought to confine discount volatility within a narrower (and lower) range.

That isn’t going to change any time soon – boards are as aware of these issues as they have ever been. On this basis, there’s every reason to expect discounts to begin to narrow once more – even if it’s difficult to make firm predictions about when, particularly given the uncertain outlook for global markets.

Meanwhile, investors and their financial advisers have a potential opportunity. In many sectors of the investment company universe, analysts are now pointing out investment companies that are trading on valuations that look very attractive by recent standards. Maybe now is the moment to go bargain hunting.

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