Investment Trust Discounts And Market Cycles: How They Fluctuate And What It Means For Investors

Investment trusts frequently trade at a discount or premium relative to their net asset value (NAV), but these pricing discrepancies tend to follow predictable patterns influenced by market cycles. While some investors worry about widening discounts, others see them as opportunities to buy high-quality assets at a lower price.

Understanding how investment trust discounts behave in different market conditions can help investors make more informed decisions. This article explores why discounts occur, how they shift across bull and bear markets, and how investors can capitalize on these changes.

Understanding Investment Trust Discounts

What Is an Investment Trust Discount?

An investment trust discount occurs when its share price trades below its NAV. For example, if a trust’s NAV is £1.00 per share but its market price is £0.90, it is trading at a 10% discount. Conversely, a premium happens when the share price exceeds NAV.

Why Do Discounts Exist?

Several factors influence whether an investment trust trades at a discount:

1. Market Sentiment: If investors are pessimistic, they may sell shares, widening the discount.
2. Liquidity Constraints: Unlike open-ended funds, investment trusts have fixed capital, meaning shares trade on the stock market and can be subject to supply and demand imbalances.
3. Performance and Sector Exposure: Trusts investing in volatile or out-of-favor sectors may experience deeper discounts.
4. Gearing (Leverage): Trusts that use borrowing can see wider discount swings, as leverage magnifies both gains and losses.

How Investment Trust Discounts React to Market Cycles

Investment trust discounts do not remain static; they fluctuate with broader market cycles. Here’s how they typically behave in different phases:

1. Bull Markets: Narrowing Discounts and Premiums

During bull markets, investor optimism fuels demand for investment trusts. This often leads to:

• Narrowing discounts as buyers drive up share prices.
• Some trusts trading at premiums, particularly in high-growth sectors.
• Outperformance of well-managed trusts with strong historical returns.

Example: In the technology boom of 2020-2021, many AI and innovation-focused trusts saw their discounts disappear, with some moving to premiums as investors rushed into high-growth themes.

2. Market Corrections: Discounts Widening Rapidly

When markets experience corrections, investment trusts often see discounts widen as risk appetite declines.

• Investors shift to safer assets, causing outflows from investment trusts.
• Discounts widen as selling pressure increases, even if underlying assets remain fundamentally strong.
• Growth-oriented trusts tend to suffer the most, while defensive sectors see less impact.

Example: In 2018’s market correction, technology-focused trusts saw their discounts expand quickly as investors became more risk-averse.

3. Recessions and Bear Markets: Deep Discounts and Bargain Hunting

During deep market downturns, investment trust discounts can reach extreme levels as panic selling intensifies.

• Investors often sell risk assets indiscriminately, pushing discounts wider.
• Trusts with illiquid assets (e.g., private equity, infrastructure) see the most significant discount expansions.
• Long-term investors start bargain hunting, taking advantage of mispriced opportunities.

Example: During the 2008 financial crisis, some property and private equity trusts traded at discounts of over 50%, despite holding high-quality assets. Those who bought at extreme discounts saw substantial long-term gains.

Key Factors That Influence Discount Volatility

Sector Sensitivity

• Growth-focused sectors (technology, biotech) tend to have more volatile discounts.
• Defensive sectors (utilities, healthcare) see more stable discounts due to consistent income streams.

Interest Rates and Inflation

• Rising interest rates can negatively impact highly leveraged trusts, widening discounts.
• Inflation-protected assets (e.g., infrastructure, commodities) may experience lower discount volatility.

Investor Sentiment and Institutional Flows

• Retail investors may panic-sell during downturns, widening discounts.
• Institutional investors often step in to buy deeply discounted trusts when valuations become attractive.

Strategies for Investors: Using Discounts to Your Advantage

1. Buying at Deep Discounts in Market Downturns

• Identify high-quality trusts trading at excessive discounts.
• Look for trusts with strong management and a history of discount recovery.
• Avoid trusts where the discount reflects deeper structural issues.

2. Selling When Discounts Narrow in Overheated Markets

• Recognize periods when discounts shrink excessively or move to premiums.
• Take profits when market sentiment is overly optimistic.
• Rotate into trusts with more reasonable valuations.

3. Dividend Yields and Discounts: A Hidden Opportunity

• Discounts can boost effective dividend yields.
• Investors can achieve higher income by buying income-focused trusts at significant discounts.

4. Discount Control Mechanisms: Understanding Buybacks and Structural Adjustments

• Some investment trusts use share buybacks to manage discounts.
• The role of trust boards in protecting shareholder value.
• Be aware of trust restructurings that could affect discount levels.

Conclusion

Investment trust discounts fluctuate based on broader market cycles, making them an important consideration for investors. While discounts often widen in downturns, they can present compelling buying opportunities for long-term investors. Conversely, periods of narrow discounts or premiums may signal a good time to take profits.

By understanding the factors influencing discount movements and applying a strategic approach, investors can make more informed decisions and capitalize on pricing inefficiencies in the investment trust market.

Author: Ricardo Goulart