What is driving narrowing discounts on investment trusts?

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Japan: All Japanese investment trusts have outperformed the Topix over the last six months

Rising markets, the hunt for income or discount control policies – what has been driving the continued narrowing of discounts across the investment trust industry?

Investment companies trade at a discount when the share price of the trust is lower than the company’s NAV. If and when a discount narrows, investors can achieve a return that is better than the performance of the underlying assets

Association of Investment Companies communications director Annabel Brodie-Smith argues the main driver of narrowing discounts has been rising markets. She says: “Markets have performed well recently, and when they do this, investment companies have a tendency to outperform and discounts narrow.”

Brodie-Smith looks to data from Morningstar, which shows the contrast between discounts during 2013 compared to the height of the financial crisis in 2009.

The overall weighted average discount (excluding VCTs) for the investment trust industry between April 2009 and April 2013 has narrowed from -11.8 per cent to -5.65 per cent.

Brodie-Smith says: “You have got to look at where we have come from since 2009. This really shows how when markets pick up, investment companies start outperforming and discounts come in.”

Morningstar data details that the average discount for the Japan sector was -6.46 for the end of April 2013. By comparison, the average discount was -14.65 per cent at April 2009.

Wins research analyst Kieran Drake points out that all Japanese investment trusts have outperformed the Topix over the last six months.

He highlights the Baillie Gifford Japan Investment Trust which has seen a 73 per cent increase in its share price, leading to the discount tightening.

He says the current discount is around 5 per cent, compared with approximately 10 per cent six months ago.

Drake also notes that up until the fall in the Japanese market during mid-May, the trust had been trading on a premium and was issuing new shares.

The surge in investor confidence and appetite for risk as a consequence of rising markets has also led to narrowing discounts in sectors such as private equity, as demand increases for riskier and more niche sectors.

Drake notes that discounts have “narrowed significantly” across private equity trusts as a result of a rerating in the sector. Morningstar data provided by the AIC also shows that over the period from April 2009 to April 2013, the discount for the private equity sector has narrowed from -36.73 per cent to -14.94 per cent.

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Brodie-Smith notes the increased demand for income has contributed to significant tightening of discounts across income sectors. 

She says: “As a result of the drive for income, a lot of the income-focused trusts have been pushed up and their discounts have come right in.

“Some of them are now on a premium. The demand for income has been phenomenal for investment companies.”

According to Morningstar data, various sectors with an income focus were trading on a premium at the end of April 2013.

The sector currently on the largest average premium is the specialist Infrastructure sector on a premium of 9.13 per cent.

Although premiums can prompt concerns that a trust may becoming overvalued, Klonowski & Co Financial Planning Consultants principal Francis Klonowski stresses this may not necessarily apply in all instances.

He says: “I do not think you can generalise about premiums and discounts. You have to look at each trust individually. You should always look at why that trust may have a particular reason for a widening premium or a discount.”

Foreign & Colonial head of investor relations for investment trusts Simon Cordery also notes a recent discount trend over the last two to three years emerging from a demand for income.

However he argues alternatively that the narrowing of discounts goes back further than this. He says: “There has been a very long-term trend of discounts narrowing.

“This is more to do with the discount control policies that a lot of companies within the sector have adopted over a decade or more. That has been driving discounts in.”

Cordery goes on to say it is not as simple as thinking that when markets are strong, discounts are narrower and when markets are weak, discounts will be wide.  

Alternatively, there are also a number of opportunities to tap into outperforming sectors that are still trading on substantial discounts.

Brodie-Smith highlights the current average discount of -12.73 per cent for the UK Smaller Companies sector as representing “massive value.”

She says: “They have performed extremely well recently and they are still on an average discount. It is an opportunity.”

“UK Smaller Companies trusts have dominated our 20 most consistent and best performing companies over the last decade. “