The question has long confounded the academic community, which likes to find definitive answers to financial conundrums of this sort.
For investors with real money to spend, the discount is a fact of life. It is a matter of temperament whether they choose to see discounts as an opportunity or a threat. The opportunity lies in the fact that discounts can fall as well as rise; when they do so, it gives the investor an additional return over and above any increase that the managers of his investment trust have obtained by their investment skills.
When they fall, on the other hand, discounts threaten investors with the flip side of this double whammy effect. It is quite possible for the asset value of an investment trust to fall and for its discount to widen at the same time.
The result, in these unhappy circumstances, is that the share price - which represents the current value of the shareholder's investment - falls by a disproportionately large margin.
The thousands of investors who put their money into Kepit, the popular European privatisation investment trust run by Kleinwort Benson, are among those who have experienced an unhelpful discount movement. Unsurprisingly, trusts with the best track records and most highly regarded managements tend to have the smallest discounts - unlike Kepit.
Fortunately for most investors, and indeed most investment trust managers, the recent record on discounts has been encouraging. On average, investment trust discounts have narrowed consistently over the past few years, as they tend to do in bull markets. (This part of the phenomenom, at least, is not in doubt.) Twenty five years ago, at the peak of the last great bull market, investment trusts generally traded within 5 to 10 per cent of their asset values. At their nadir in the 1970s bear market, discounts widened to more than 30 per cent on average. Since then, the progress has been nearly all one way, in the right direction.
The average discount now is back up to the 9-10 per cent level, though this single figure hides a wide range of divergent experience - ranging from Law Debenture and 3i, both trading at a premium, and Bankers Trust (on a discount of 1.2 per cent), to RIT Capital (at 16.7 per cent).
Investment trust shares tend to outperform the stock market as a whole when share prices rise (as they did from 1987 to 1990, and from 1992 to 1994), and vice versa. The discount tends to follow a similar path, narrowing in periods of strong performance and widening when markets are dull or falling. According to the trust-watchers at brokers Credit Lyonnais Laing, this relationship holds over longer periods too, though discounts tend to be backward rather than forward-looking, reflecting the most recent past experience, not the likely future direction of the market.
This in turn creates some interesting short-term anomalies. In the early part of this year for example, the discount in many sectors failed to keep pace with the general movement of the market, creating some good value opportunities, among the general trusts for example.
Experience shows that discounts can move quite rapidly over short periods of time. In the past year, for example, Foreign & Colonial has traded part of the time at a premium to net asset value, but also, at its low point, at a discount of 11 per cent.
In 1995, the discount movements over the year ranged from a positive improvement of 22 per cent to a 33 per cent deterioration - quite enough, in several cases, to offset the underlying change in the investment trust's portfolio.
One reason why this is the case, of course, is that the investment trust movement has grown so rapidly in the past 15 years that it is virtually unrecognisable from what it was in the 1970s. The emergence of specialist investment trusts, each one focusing on specific regions (eg Europe, the Far East) or types of investment (eg smaller companies), makes it much harder to generalise about the investment trust sector as a whole.
But the basic principles of investment trust investing remain the same. The decision to buy should be based on the fundamental suitability of the investment policy which the trust you like is pursuing. But in choosing between competing trusts in the same field, the level and recent history of the discount is a key secondary factor in deciding which trust is the better value.
At the moment, reckon Credit Lyonnais Laing, smaller companies and Japanese trusts both look quite good value on discount grounds. But they also rightly warn that it would be easy to be seduced into believing that the era of large discounts has gone for good.
In the short term, with the markets still looking quite robust, the risk of a serious downward correction is limited. But, although many investment management firms have become much more conscious of the need to manage their own discounts, the gearing effect of the discount factor is still there.Reuse content