Investment Trusts: The incredible shrinking discount

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INVESTMENT trusts share with unit trusts the underlying principle that collective ownership of equities makes more sense than each investor individually trying to build up his own portfolio.

But investment trusts differ from unit trusts in one important respect. Whereas a unit trust's price always reflects the exact value of its underlying shares and assets, the market price of an investment trust does not directly correspond to the assets held.

Logic might suggest that people would be prepared to pay a small premium to have their money professionally managed. But share prices of investment trusts are decided by the simple operation of supply and demand, and the markets have determined that investment trusts are traditionally traded at a discount to the underlying asset value.

For much of the 1970s and 1980s the discount was substantial. For ordinary investment trusts (as opposed to split capital trusts, where the calculations become more complicated), average discounts reached around 40 per cent in 1976, before hovering for many years around 20-30 per cent.

More recently, discounts have fallen dramatically and now average around 6-7 per cent, having climbed slightly from around 4 per cent earlier in the year.

The average figure hides wide differences, however, and some investment trusts are trading at a surplus.

The incredible shrinking discount has meant that investment trust share prices have in general considerably outperformed the actual assets they have held.

While this is excellent news for anyone who has been holding investment trusts for several years, it would worry anyone investing at the moment - what is there to stop the same process happening in reverse in the future?

If discounts widen again, investors will find that their returns are not matching the returns which the investment trust itself is achieving.

Hamish Buchan of NatWest Markets says: 'If you'd suggested 10 years ago that discounts could be in single figures, people would have thought you were off your head. But the environment now is different.

'You can't say that discounts have gone for good. I could see discounts going into double figures, but discounts back over 20 per cent would be very unlikely, unless the Government did something dramatic or the stock market became very weak.'

Discounts have fallen in recent years for various reasons, partly simply because investment trusts in general have become more popular.

Regular savings schemes and PEPs have helped by bringing new money into the sector and investment trust companies have tailored their products more closely to what particular sections of the market want.