5 essential charts on investment trust discounts

Important information - the value of investments and the income from them can go down as well as up, so you may get back less than you invest.

Chart 2: can it pay off to invest at a big discount?

History would suggest that, when investment trusts are on big discounts, that can be a good time to invest.

Data from the Association of Investment Companies (AIC), the investment trust trade body, going back to 2008 found that the average investment trust performed better in five-year periods that began with discounts of 10% or more than in five-year periods that began with discounts of less than 10%.

In five-year periods that began with double-digit discounts, the average investment trust returned 86.5%. Whereas in five-year periods which began with discounts smaller than 10%, the average return was 53.8%. Please remember past performance is not a reliable indicator of future returns.

The former would have grown a £5,000 investment to £9,325 while the latter would have grown the same investment to £7,690.

However, it’s important to remember that these numbers are averages for the sector as a whole. Each investment trust will face its own unique circumstances and it’s important to do thorough research before investing.

Buying a trust at a discount only makes sense if you would have wanted to invest in it anyway.

What’s more, investment trusts can trade at a discount for any number of reasons - some may be temporary issues, others may be long-term structural problems. It’s crucial to understand what’s going on “under the bonnet” before investing.

Chart 3: can you expect discounts to narrow?

Investors buying trusts at a discount will be hoping that discount narrows over time. Trusts can perform very well while remaining at a discount, however, if that discount widens, it will act as a drag on returns.

Investment trust discounts can narrow for many reasons, including improved performance, a change of manager, or because the sector it is in has become popular with investors.

One factor that can rapidly close discounts is when an investment trust undergoes some kind of corporate activity - for example, if it is merged with another investment trust, acquired by another manager, or if it goes into liquidation.

Essentially, if there's a merger or acquisition, the assets will need to be sold or rolled into another vehicle and so their actual value is likely to be realised (minus costs). 

As you can see from the chart below, since 2023 corporate activity in the investment trust sector has been high - potentially closing discounts for some investors.

However, the behaviour of an investment trust’s discount in the face of corporate deals will depend on the individual circumstances. If there’s uncertainty about whether the board will be able to execute the deal or concerns about a change in strategy, discounts can widen.

Chart 4: do discounts still matter over the long-term?

If you’re obsessing about finding the biggest discounts and investing at the right time, you may not need to be so worried.

The best investors are usually those that are in it for the long-term and data show that the longer you stay invested, the less discounts should matter.

Say an investment trust enjoyed an NAV return of 7% a year (admittedly that’s a high bar).

Below you can see what your annualised share price return would be in three different scenarios

1. where the discount narrows from 20% to 10%,
2. where the discount widens from 10% to 20%
3. no change in the discount

You can see that, over a one-year time frame, what happens with the discount has a huge impact on the return (or not) that you receive.

A widening discount over one year can mean you lose money, even when the NAV return is 7%. While a narrowing discount can mean your return is significantly more than 7%.

But as that time frame increases, the impact of the discount widening or narrowing becomes less and less important. By the time you reach a 20-year time horizon, the differences between those three scenarios become small.

This means, if you’re planning to buy and hold a trust for the long-term, you don’t need to be so focused on whether you’re buying at a discount and what that discount then does.

Chart 5: how does regular investing impact the effect of discount movements?

Another key principle of good investing is to invest regularly, drip feeding your money into markets.

The data suggests that this approach too could smooth out the impact of discount movements over time.

Again, we have three scenarios:

1. where the discount narrows from 20% to 10%,
2. the discount remains at 15%
3. where the discount widens from 10% to 20%

The chart below shows the return you’d achieve after 10 years if you invested a lump sum of £10,000 at the start of the period versus if you invested £1,000 per year over the period.

The lump sum investor enjoys better overall returns because their money has been invested for longer, giving it more time to grow. However, you can see that what happens with the discount has much more of an impact on the lump sum investor than someone drip-feeding their money into the market regularly.