The discount and premium of investment trusts can tell you more than just its ‘street value’ and how far its market price is away from its NAV. Given that active management is built on the premise that markets are inefficient, discounts reflect a lot of prevailing sentiment in the market. Buying funds at a discount is often compared with shopping in a sale: effectively buying assets at less than their true worth. Intuitively, if an investor does not have much conviction in a fund, its fund manager or an asset class, or associates that fund with higher risks, he or she will be less willing to pay a high price.
Let’s take the example of private equity funds, which are perceived to be more risky than listed equities and are somewhat illiquid in nature, thus they tend to trade at quite a wide discount to their NAV, particularly at times of stress in the market when liquidity is paramount. Contrast that with infrastructure funds, which have been in vogue for the last several months due to the high income they pay. The average infrastructure closed-end fund has been trading at a premium of more than eight percentage points over the last six months. But these funds are just as, if not more, illiquid when you drill down into the underlying assets.
So when we look at the average discount across the London-listed Investment Trust sector and the extent to which it has narrowed, does this mean investors are getting over confident? The latest Morningstar Asset Flow report showed net redemptions from fixed income and money market funds over the last three consecutive months, while inflows into allocation funds slowed noticeably, as did net inflows into alternative funds. The winners were equity funds.
But not all fund managers share that optimism. Some warn that fundamentally companies continue to be under pressure and that the UK economy has not turned a corner yet. Just this week, Sebastian Lyon, fund manager of Personal Assets Investment Trust, commented that in his view investors are getting somewhat carried away with the steep gains they have made in the last four years, while forgetting the lows from which those prices have risen; they see markets going up, and their fear of missing out means they allocate money to higher risk asset classes at precisely the wrong time—just before something spooks the market again.
The reality is that nothing lasts forever. Given that we have had more than four years of an upward trending market and indexes are reaching new heights, perhaps it’s time to be a bit more cautious and remind ourselves of one of Warren Buffett's classic rules: "Be fearful when others are greedy".
