For all investors, the starting point for whether a given investment trust might make for an attractive investment is performance.
Conversely, the presence of a discount, especially its volatility, is the most common reason cited by investors to shun investment trusts. As liquidity is ultimately determined by there being buyers to match sellers, it can be seen that discount control is a critical factor in overall liquidity.
Some do believe that a discount can act as a ‘safety valve’ or as an ‘insurance policy’ – especially in highly volatile or bear markets. Occasionally, the value seeking investor may find the discount a buying opportunity (such as when arbitraging between a discounted investment trust and its equivalent open-ended fund in the same management stable). Generally however, value investors are out for a quick profit, and arbitrageurs are generally bad news for an investment trust once on its share register, being a sign of failure of the investment strategy or communication of the prospects for the trust with investors.
Long-term investors universally hate discount volatility. For the intermediary market, discounts have been the most commonly cited reason for avoiding investment companies.
Gearing, complicated structures may be others, but an inability to say anything positive about the discount shows that it is the beast that most needs to be tamed.
Low net-asset value (Nav) volatility is of little use if the share price is highly volatile. It is the share price that matters to investors because the share price is what they ‘get’. According to research by JP Morgan Asset Management published in 2011 and designed to educate intermediaries in the run up to the RDR, investment trust shares are more volatile than their open-ended counterparts. That means, for comparable performance, open-ended funds are less risky than investment companies.
Many investors look at the sharpe ratio in helping determine how much risk they are taking. The sharpe ratio is a measure of how much return has been generated, minus the risk free rate divided by the annualised volatility of those returns, a number greater than one being the target to beat.
Many believe that discount control mechanisms should be used to control the volatility of the discount and to try to narrow its range, rather than target an absolute level. There is no point in pretending that the underlying assets are liquid or attractive at a point in time if the market suggests otherwise.
Investors need asset appreciation and if there is no belief that an investor will make money, then the discount becomes intractable. Continuation votes used to be in vogue – but it is generally believed they do not work as a means of controlling discounts in isolation. According to Morningstar more than 180 investment companies currently have continuation votes, or roughly half the sector.
Simon Coulson is the author of the report ‘Secondary liquidity in the investment company sector’ published by the Association of Investment Companies in December 2012
