Disclosure – Non-substantive Research
This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. With this commentary, Kepler Partners LLP does not intend to influence your investment firm's behaviour.
With the current bout of volatility and uncertainty in markets, discounts across the investment trust sector have widened out. The overall picture shows that conventional trust discounts have widened from near 5% level at the start of the year, to the current average discount of 7%.
The average masks much. The European Smaller Companies sector for example has seen the average discount widen from near par to c 9%. Private Equity trusts have also seen plenty of profit taking, and sentiment in the TMT sector is also sagging given the volatility seen in these stocks.
Discounts are one of the most visible attractions for many fund investors looking at investment trusts relative to open-ended funds. Certainly, it makes intuitive sense that buying an asset worth a pound for 85p - the equivalent of a 15% discount in the terminology of the investment trust market - is attractive. There's more to it, though; buying a trust on a decent discount offers a way to boost the income yield that an investor receives for the lifetime of that investment. Irrespective of whether the discount narrows subsequently, this income boost will last until the individual sells those shares.
However, theory and practise are seldom aligned. Discounts can sometimes be persistent, and it may be that the price at which an investment trust trades relative to the NAV never narrows. In such a scenario, investors will have fallen for a “mirage”, with a palpable narrowing of the discount never materialising. On the other hand, it is possible that an investor can materially enhance returns should sentiment towards a trust improve such that the discount does narrow.
Reflecting the fact that discounts for trusts tend to trade in bands, analysts have devised a ratio called a Z-score. A Z-score tells you - in this context - how many standard deviations away from the mean average discount the trust is trading on a given day. These are typically used to highlight value on a short term basis, and tend to be used by “traders” more than investors. Basically, they are designed to tell you whether a discount is unusual.
An alternative indicator of value, which we first introduced as a methodology nearly two years ago, looks at the average monthly discount of an investment trust going back ten years. Taking average monthly discounts gives us an opportunity to take into account broader peaks and troughs in sentiment rather than short term pricing anomalies, gives a more balanced view of where a discount stands relative to its own history.
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