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Why zero discount policies aren't all they're cracked up to be

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Why zero discount policies aren't all they're cracked up to be

Calls for zero discount policies to become widespread have grown louder in recent months, but they could prove be costly for investors.

Holding up the likes of Personal Assets and Finsbury Growth & Income as examples of how investment trusts can keep discounts at bay, those in favour of strict discount controls say they could help the closed-end sector compete in the post-retail distribution review (RDR) world.

But experts warn that in the wrong hands, zero discount policies can cost shareholders dear. During a bad patch trusts could be forced to sell investments just to keep up with their commitment.

Address volatility, not discounts

Alastair Smith and Grant Challis, of Frostrow Capital, believe boards eager to introduce zero discounts should tread cautiously because it is not the fact trusts trade at a discount that bothers investors, but volatility.

They argue by curbing volatility, even trusts trading at a discount would ensure moves in its share price mimicked closely the shift in portfolio net asset value (NAV), and this would have the knock-on effect of addressing angry investors' concerns.

'Volatile discounts are what people don't like.  It's very different to the NAV return, what the fund manager is actually delivering,' said Smith, Frostrow's managing partner.

Moreover, Challis pointed out there are probably only a handful of trusts using zero discount policies because it would not be practical to introduce them across the sector.

While some commentators believe removing discounts would help trusts attract business in the post-RDR world, Challis said funds that invest in illiquid assets would struggle to cope.

He explained: 'Private equity and infrastructure are assets held in a closed-end structure for a reason.'

In order to meet zero discount rules, Challis pointed out some investment trusts could be forced to sell investments to return money to investors when shares are bought back, a popular means of keeping share prices in line with NAV.

There is also the problem of buybacks shrinking the size of investment trusts, something Atlantis Japan has arguably become a victim of.

Smith added: 'It's not realistic to apply a zero discount policy across the whole sector.

'Personal Assets is a good example that has done it well, [but it's also] the result of a 25-year marketing strategy and a shareholder base that makes regular savings into it.

'More volatile investors, or institutional ones, could decide tomorrow they no longer like the asset class,' Challis continued, with Smith adding that in some cases, a zero discount policy could make trusts 'look exactly like an open-ended fund.'

Annabel Brodie-Smith, of the Association of Investment Companies (AIC), said there was no 'one size fits all' approach that could be blanketed across the sector, adding that over the last 10 years discount management had come a long way, showing that managers and boards recognise the importance of keeping discount volatility in check.

Brodie-Smith said: 'Discount management techniques such as share buy backs have been successful and though discounts did widen out after the financial crisis, this was nothing like as much as has been the case in the past bear markets.'

However she cautioned: 'Calls for all investment companies to adopt zero discount targets or mandatory discount targets are wide of the mark and would cost some investors an awful lot of money. If an investment company has invested in illiquid assets - one of the advantages of the closed-end structure - these types of assets take time to sell and a zero discount target would not work for these assets.

'For example, after the financial crises many property and private equity investment companies took a hammering with discounts widening sharply.  Imagine if these companies had been forced to liquidise significant parts of these portfolios to fund buy backs to meet a hard discount target.

'Even assuming they could have found buyers, which is doubtful, they would have had to sell at massively distressed prices at perhaps the worst period in living memory.  A huge amount of shareholder value would have been lost.'

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