|Investment trust (IT) discounts
are sometimes named as additional risks that disadvantage ITs
against Unit Trusts. But are they.......?
What are they?
The market value of the underlying assets of an Investment Trust
(IT) can be computed and compared with the price of its shares.
The extent to which the value of the shares is below the value of
the assets, expressed as a percentage, is called the discount.
For example, if the assets are worth 100p per
share and the share price is 80p the discount is 20%.
Discounts fluctuate with share prices: the prices
of ITs fluctuate under market pressures; the prices of individual
shares fluctuate under market pressures; so the difference between
them, which is the discount, fluctuates under the same market pressures.
Why are they?
ITs almost invariably trade at a discount. The economic reason is
that an IT adds an additional layer of cost which reduces the value
of the assets it owns. Many commentators pretend not to understand
this, because it is the embarassing proof that a layer of professional
fund management cannot add value to the assets it manages.
Other factors will contribute to the discount:
belief in the skill of the managers, confidence in the legal structure
of the IT and some technical matters connected with the way an IT
'manages' its discount.
Does it matter?
Some commentators mention the discount as a disadvantage of ITs
as compared with Unit Trusts, being an "additional risk". We regard
this as simplistic.
First, when the discount is 20% (for example)
it can't be bad to buy 100p of assets for 80p: it is hard to understand
how paying 20% less for the same pool of assets can be 'risky',
particularly for the long-term investor.
Second, the discount, if it is a risk at all,
is only a risk in the extreme short term. High discounts eventually
revert (otherwise someone would buy the Trust, liquidate the assets
and pocket the discount). Negative discounts (premiums) eventually
revert because investors will prefer to buy the assets rahter than
the (more expensive) trust holding them. So the long-term investor
who buys when the discount is high can be sure he will eventually
be able to sell when the discount is lower.
Third, formulaic pricing (as operated by unit
trusts) cuts the investor off from the information that any market
pricing system sends. You will always pay more for a unit trust
when you buy (because you will be denied the discount). But you
will not necessarily receive more when you sell (because unit trusts
have the power to suspend sales in the sort of market conditions
when a free market would have generated a large discount).
Watch out for.....
If the discount is large the market is signalling that something
unusual is going on. Proceed with care. Very occasionally the discount
is negative (called a premium). This may be because the company
is not a "pure" trust but has an additional business that is worth
more than its assets (Law Debenture Trust, for example). Or it may
be that the market is signalling that it is particularly enamoured
of the stock-picking skills of the investment managers. In which
case, again, proceed with care (Star