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 Managers).