Morningstar Education
Investment Trusts Solutions
Discount Control Mechanisms and How They Work
Slide 2: Discount Control Mechanisms and How They Work
Many investment companies have measures in place through which they attempt to control their discount and the volatility of that discount. Some will state a specific discount target level which, if breached, will prompt them to take action. This also helps deter any corporate activity from potential arbitrageurs. The most common measure is for the company to buy back its own shares and cancel them. This bolsters the fund's NAV per share, but it means the fund's costs as a proportion of total assets increase. Other methods of controlling the discount are to restructure the fund, provide a tender offer or hold a continuation vote.
Slide 3: Discount Control Mechanisms and How They Work

Share buybacks can be effective for large companies but less practical for smaller companies with fewer assets under management. Likewise, they are less ideal for companies which invest in illiquid asset classes such as property: the company may not be able to raise sufficient cash to execute the share buyback upon breach of any target.


When looking at a company's stated policy (if they have one), check other funds in that company's Morningstar/AIC sector too. If one has a stated target that is significantly different from others, then that may present an opportunity for arbitrageurs to step in.

Slide 4: Discount Control Mechanisms and How They Work

Under a tender offer, the company offers to acquire shares from its shareholders for cash, usually at or close to the company's NAV. The costs may be factored into the tender offer price, so that remaining shareholders aren't paying the costs for others to exit the company. Typically, the amount of a shareholding that can be surrendered under a tender offer is capped at a certain percentage of that shareholder's total holding.

Slide 5: Discount Control Mechanisms and How They Work
A restructure of the fund may be proposed when the board thinks a buyback or tender offer won't have enough of an effect. They may consider turning the fund into an open-ended company or they may propose a change to investment strategy to try and unlock value for shareholders.
Slide 6: Discount Control Mechanisms and How They Work

The last resort is a continuation vote under which shareholders can vote in favour of winding up the company. This would see all assets realised and cash distributed to shareholders. This makes the investment manager a forced seller of assets and, while he will endeavour to get the best price possible, any time restrictions imposed on the wind-up could see assets being sold for less than their value, to secure a buyer (particularly in the case of less liquid assets such as property).

Slide 7: Discount Control Mechanisms and How They Work

Extreme volatility in markets can cause problems for mechanisms and 2008 is a good example of this. Check the wording carefully to see if it's a "hard and fast" rule or a guideline only, with scope for flexibility.


For some investors, a stated discount control mechanism offers some reassurance that the board will be proactive when/if the discount widens significantly. But it doesn't guarantee that the gap will narrow.

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