Investment trusts discounts are at their widest since 2008, so does this represent a buying opportunity?
Analysis from the Association of Investment Companies (AIC) has revealed that the average investment company traded at a discount of 16.9% at market close on 31 October 2023.
That is the widest discount since the depths of the financial crisis in 2008.
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It means investors could access unloved or underrated portfolios that are trading well below their net asset value (NAV).
There are risks to backing investment trusts with high discounts but Annabel Brodie-Smith, communications director at the AIC, says history shows that this could represent a buying opportunity.
“When discounts were last this wide at the end of 2008, the average investment company returned 39% over the next year and 119% over the next five years,” she says.
“The increasing presence of activist investors on investment company share registers shows that some, at least, recognise the value in the sector.”
Here is what to consider.
The importance of investment trust discounts?
Unlike a fund, investment trusts trade at a premium or discount to the underlying portfolio’s NAV depending on the demand for their shares from investors.
When there is high demand, the shares go up and there may be a premium but if the shares drop below the NAV, then they are trading at a discount.
A high premium can mean an investment trust is performing well but could also suggest it is overvalued, while a discount may mean an investment trust is being undervalued but it could also suggest underlying issues.
It can cheap to buy an investment trust when it is at a discount but it is risky if there is no prospect of the shares rising or if the price falls.
Why are investment trust discounts rising?
Average discounts started to widen at the start of 2022, when inflation and interest rates started rising and Russia invaded Ukraine.
They hit 12.5% by the end of 2022, according to the AIC.
But the AIC says average industry discounts have to be interpreted with caution, as some underlying assets of investment companies are valued less frequently.
This means that the discount for the end of October is likely to be revised in future, as new valuations become available.
Laith Khalaf, head of investment analysis at AJ Bell, says higher interest rates, cost-of-living pressures, and negative sentiment towards the UK stock market all feed into discounts.
“It seems bizarre that investment trust discounts today sit at their highest level since the financial crisis,” he says.
“There are plenty of risks out there in the market, but in 2008 the whole financial system looked like it might collapse. The apparent extreme level of discounts in the investment trust universe can be explained by a perfect storm of factors, some recent, others which have been building up for some time.”
Investment trusts also aren’t helped by general antipathy towards UK shares.
“Many investment trusts invest outside the UK, but they are structured as UK companies, trade on the London Stock Exchange and sit in the FTSE indices, so a reluctance to invest in the UK stock market does take a toll,” adds Khalaf.
Where are the largest investment trust discounts?
Investment trusts in the AIC’s private equity and infrastructure sectors have the largest average discounts, at 34% and 32% respectively, according to Morningstar data analysed by AJ Bell.
The average UK All Companies trust is currently trading at a discount of 13.6%, which Khalaf suggests investors may see as a double discount, given the low relative value of the underlying UK stock market.
The discount is also more than double that of the UK Equity Income sector.
“This is no doubt a reflection of the fact that the UK is seen as more of a destination for income rather than growth, but is also likely due to the fact that investment trusts can smooth their dividends, which makes them attractive for income seekers,” adds Khalaf.
“When income trusts are trading at a discount, that has a twin benefit for investors. They can buy a pool of assets below their market value, and on top receive a yield above that of the underlying portfolio.”
Khalaf says the dividend stream provided by UK income trusts is a major reason why they don’t stray from NAV to the same extent as trusts in the UK All Companies sector.
Discounts to NAV are an important metric but context is important.
A trust trading at a discount might actually be priced closer to NAV than it has been historically, and so might not represent good value.
Khalaf suggests looking at Z-scores, which provide an indication of how far a trust’s discount or premium is trading below or above its historical average.
A negative Z-score suggests the current discount or premium is below average levels, a positive score tells us it’s above average levels, which can be a useful way for investors to decide how cheap or expensive the share price really is.
“The average trusts in almost all sectors are trading at discounts below their longer term average,” says Khalaf.
“Many have an average Z-score of between -1 and -2, which suggests it’s a decent entry point for these sectors, and when you come to sell, chances are you will do so closer to the net asset value of the trust.”
| Header Cell - Column 0 | Average discount | Z-score 5 Yr |
|---|---|---|
| Private Equity | -34.0 | -0.8 |
| Infrastructure | -32.2 | -2.0 |
| Renewable Energy Infrastructure | -30.2 | -2.8 |
| Property - UK Commercial | -29.6 | -1.1 |
| Flexible Investment | -21.7 | -1.3 |
| North America | -19.1 | -1.1 |
| Global Smaller Companies | -17.8 | -1.2 |
| UK Smaller Companies | -15.2 | -0.2 |
| UK All Companies | -13.6 | -1.0 |
| Asia Pacific | -11.7 | -1.7 |
| Europe | -10.8 | -0.5 |
| Global | -10.6 | -1.1 |
| Japan | -7.6 | 0.0 |
| Global Equity Income | -6.6 | -1.3 |
| UK Equity Income | -6.2 | -0.8 |
| Global Emerging Markets | -0.5 | -1.0 |
Source: Morningstar to 6 November 2023
Is now the time to buy an investment fund?
The high discounts mean investors can gain access to portfolios trading significantly below their NAV and may pick up a bargain.
But as with any investment, it is important to do your research, especially as many of the sectors with the largest discounts such as infrastructure and renewable energy are the most illiquid.
“Investors shouldn’t be tempted into an asset class, sector or trust simply because of a discount, if it doesn’t fit in with the rest of their portfolio, or sits outside their risk tolerance,” says Khalaf.
“Ultimately it’s the underlying assets within a trust which should do the heavy lifting in terms of generating long-term returns for investors, and picking up trusts at a healthy discount is just the icing on the cake.”
