The discount can be a friend or a foe to investment trust shareholders. On the one hand, a narrowing discount can accelerate share price gains when a trust is performing better than expected or a sector is gaining in popularity, as with the Europe, Japan and technology sectors in the first half of 2015.
On the other hand, a widening discount can reduce a trust's share price performance if its net asset value (NAV) returns are below expectations or its sector starts losing its appeal - as demonstrated in the first half of 2015 by the US, infrastructure, UK equity income and global emerging market sectors.
Investors wanting to make the most of their trust holdings should therefore be alert to potential changes and try to turn them to their advantage by keeping ahead of the crowd.
INVESTMENT TRUST DISCOUNT CONTROLS
Average discounts in the investment trust sector have roughly halved over the past 10 years as more investors have woken up to the advantages of trusts' closed-ended format, independent boards and ability to gear.
The increasing adoption of discount controls has also contributed. Nearly 70 trusts are now explicitly committed to keeping their discounts below 10, 5 or, in some cases, 2 per cent, through share buybacks or intermittent tenders.
In sectors where discount controls are particularly prevalent, most notably global growth, they can reduce investors' fears of being caught out by a sudden widening of the discount; but they also reduce the scope for 'playing the discount'.
However, there is still plenty of discount volatility to be exploited. Trusts investing in less liquid sectors such as smaller companies and emerging markets generally avoid discount controls, on the grounds that one of their key advantages is their ability to avoid forced sales in hard times. Moreover, quite a lot of trusts that do have discount controls do not exercise them effectively.
In addition, volatility is liable to be more pronounced in difficult markets, when even large share buybacks and tenders may have minimal effect. In 2008 the average discount swung between 5 and 14 per cent. The investment trust team at Winterflood Securities notes that discount volatility widened in the first half of 2015.
Investors can try to capitalise on changes in the discount by backing trusts in sectors they consider to have been unjustifiably de-rated.
This is often the case with smaller company trusts after a market shakeout, which helps explain why four of the seven top-performing trusts in the first half of 2015 were smaller company specialists that saw their discounts contract, whereas five of the seven bottom performers were in increasingly unpopular sectors such as Latin America and mining.
Contrarian investors must be wondering if this signals a good buying opportunity.
The private equity sector demonstrates how effective backing an out-of-favour sector can be. The average discount on the sector soared to well over 50 per cent following the 2008 financial crisis, on fears that most of its constituents had recently paid exorbitant prices for highly leveraged investments that would go badly wrong.
Candover Investments, for one, has never fully recovered - but a lot of others have, providing rich rewards for investors such as Andrew Bell of Witan investment trust, who took stakes in Electra Private Equity, 3i Group and Princess Private Equity Holdings when they were deeply out of favour.
They can also benefit from investing in trusts that have adopted a new and more popular remit - as occurred when British Assets was transformed into BlackRock Income Strategies in February 2015, and when Monks investment trust announced a change of manager and approach a month later. Shares in Monks surged 15 per cent in the fortnight following its announcement, as the discount dropped from 14 to around 8 per cent.
Such changes do not always work, and some financial advisers are therefore reluctant to back incoming managers with new remits until they have a three-year record under their belts. Investors can capitalise on this by watching progress and then buying before the three-year deadline is reached.
MANAGER AND REMIT CHANGES
As an example, shares in JPMorgan Mid Cap (JMF) traded on a discount of close to 15 per cent for much of the first three years after Georgina Brittain took charge in March 2012, despite a progressive improvement in portfolio returns. But it moved to a 6 per cent discount over the six months to mid August.
This turned an impressive 117 per cent gain in JMF's NAV total returns over three years into a dazzling 159 per cent gain in its share price.
Strategic Equity Capital (SEC) was the only trust in the UK small- and mid-cap sectors to outperform JMF over that three-year period. Its NAV returns were almost identical, but its shares gained 192 per cent as they moved from a 20 per cent discount to an 8 per cent premium.
SEC's premium presents a conundrum for investors, as do the premiums on other trusts. Should they stick with the highly rated trust in the hope that its past outperformance and current rating can be maintained? Or should they switch either to an open-ended alternative with a similar mandate and the same manager (if there is one) or to a less highly rated trust in the same sector?
As there is no trust with a genuinely similar remit to SEC, another option might be to take a bit of profit and invest it in a trust on a much higher discount that appears to be emerging from the doldrums.
History indicates that it is very difficult for even the most talented manager with a sound investment process to sustain a substantial outperformance indefinitely. Investors may prove loyal enough to support a trust's premium rating despite a year or two of disappointing returns, as they did, for example, with Standard Life UK Smaller Companies, Hg Capital Trust and Murray International.
But if those poor returns persist, the trust's ratings will eventually tumble. The evaporation of Murray International's premium, for example, turned a 10.5 per cent fall in its NAV total returns over the year to mid August into an 18 per cent fall in share price total returns.
The other risk for a highly rated trust is that it will undermine its own rating by issuing a lot of new shares and/or attracting a lot of new competition, as renewable energy, healthcare, property and infrastructure trusts have.
This mops up investor demand, which is what supports the premium rating in the first place, but it can push up prices in the underlying asset class - which increases the value of current holdings, but is liable to restrict future returns.
Turning to the alternatives, switching to a similarly oriented open-ended fund cuts out the discount volatility, but it can result in more pedestrian portfolio returns because openended funds cannot gear and cannot invest as freely in less liquid companies.
This can make a big difference where talented managers are concerned, as can be seen, for example, by comparing the three-year returns of Fidelity Special Situations fund with those of Fidelity Special Values IT, and Henderson European Focus fund with Henderson European Focus IT.
WHAT ARE 'Z SCORES'?
Z scores indicate whether the discount on an investment trust share is significantly above or below its usual trading range. A score of -2 or lower suggests it is looking cheap, while a positive score of 2 or more suggests it looks expensive.
The scores must be interpreted carefully, as changes in the discount may be justified by changes at the trust or in the outlook. Nonetheless, they can alert investors to ratings that are sufficiently out of line to prompt a closer look.
Professionals have access to Z scores through the daily lists of various brokers - the AIC is looking into providing them for the Financial Adviser Centre, but not yet for retail investors. Morningstar's website includes them in its profiles of individual trusts, but investors must subscribe to Morningstar Direct to pull down a list of Z scores.
The best free alternative appears to be the discount table in the AIC's Analyse Investment Companies section online, which shows current discounts relative to their one- and three-year averages, and the one-year high and low.
Tables provided by Numis show that, as at 18 August 2015, trusts with one-year Z scores of +2 or more (looking relatively pricey) included Brunner, Fidelity Special Values, BlackRock Throgmorton, Dunedin Smaller Companies, Aberdeen Japan, Polar Capital Global Healthcare, 3i Infrastructure, Greencoat UK Wind and Target Healthcare Reit.
Trusts with a one-year Z score of -2 or more (looking relatively cheap) included Jupiter Primadona, Murray International, Scottish Oriental Smaller Companies and Standard Life European Private Equity.