Institutional shareholdings and the investment trust discount as an agency cost

Abstract

In this paper the relationship between the proportion of investment trust shares held by institutions and the size of the investment trust discount is considered. Fund managers, in the absence of frequent takeovers or unitizations, will not choose to hold investment trust shares instead of replicating the underlying portfolio unless the price is sufficiently lower than net asset value to compensate for the higher risk and lower returns that holding investment trust shares entails relative to the underlying portfolio. The hypothesis that when the principal shareholders are institutions, the mean discount for a recognizable sector, although fluctuating, has a zero trend is tested and verified, with the trend only becoming negative in the late 1980s when private investors reentered the market through investment trust savings schemes and personal equity plans. The behaviour of individual trust discounts is shown to be mean reverting to the sector average, showing that individual shares cannot fluctuate too far from the sector average for fear of either being taken over if the discount becomes too large, or of capital loss if the discount becomes too small relative to other trusts in the same sector. These patterns of mean reversion are observable but possibly too long in length to suggest market inefficiency. The zero trend sector mean discount is identified as an agency cost, showing how the same asset is priced differently according to its management structure, without any need to consider vague notions such as perceptions of sub par management performance