This article is part of Morningstar.co.uk's Equity Investing Week.
In the last quarter of 2012, equity funds enjoyed €13.7 billion of inflows, according to the latest Morningstar data. That’s an encouraging signal that market sentiment towards equities is improving after months of net outflows from equity funds. But massive inflows and outflows can be problematic for fund managers because it can create buying and selling pressure at potentially unsuitable times.
Closed-end funds (aka investment trusts) do not have these inflow/outflow problems and tend to have lower fees
If you're looking to invest in equities via funds, these inflow and outflow pressures may worry you. On top of that, you have to pay fees and annual ongoing charges to invest in these funds, which can eat into your returns.
Thankfully, traditional funds (aka OEICs and unit trusts) are not your only option for accessing a diversified portfolio of equities. Closed-end funds (aka investment trusts) do not have these inflow/outflow problems and tend to have lower fees. Exchange-traded funds (ETF) are also known for having extremely low fees.
In this article we will look at selected characteristics of closed-end funds to help you assess whether these funds are suitable for your equity investments. Some characteristics enhance a fund's performance, while others may weaken performance.
Closed-End Fund, Closed-End Structure
One of the key advantages of closed-end funds is their fixed pool of assets. An investment trust manager starts with a certain amount of money and then manages that money in a relatively uninterrupted fashion. A trust is not subject to waves of inflows and outflows as investors try to jump on trends, and managers are not forced to sell investments at inconvenient times when investors want their money back.
This means if you want to buy into a trust, you must find a seller. Similarly, if you want to sell out of a trust, you must find a buyer. Trusts are listed on public exchanges, just like equities, and that is where you buy and sell, unlike traditional funds (aka OEICs and unit trusts) where buyers and sellers can come and go as they please. The trust structure is particularly suitable for investing in relatively illiquid assets, such as commercial property.
Gearing: Added Risk and Added Return
Gearing is another feature that sets investment trusts apart from their open-end peers. Gearing refers to the practice of borrowing money to make investments, which increases a fund’s upside potential but also magnifies its downside risk. It increases the fund’s volatility, but allows a fund manager to amplify his or her investment in certain stocks or themes.
Academic studies show that, when used well, gearing adds value over the long term. We can see this in practice in action too. Sarah Whitley, fund manager of the Silver-rated Baillie Gifford Japan Trust (BGFD), has proved gearing can add value even in markets such as Japan, which has been a challenging market. Since taking over the fund in January 1991 to the end of January 2013, Whitley has comfortably outperformed the fund’s Morningstar category peers as well as the MSCI Japan and Topix indices. Gearing was a key contributor to the fund’s success.
Discount: Buying Assets for Less Than They’re Worth
With traditional funds, you can be assured that the price you pay or receive when you buy into a fund is directly linked to the fund’s net asset value (NAV). Closed-end funds operate differently.
With an investment trust, the market price should reflect the NAV, but is ultimately based on the forces of supply and demand prevailing in the market for the trust’s shares. If demand for an investment trust is high, shares may trade at a premium to their NAV. If demand for an investment trust is low, shares may trade at a discount to their NAV. This investment trust quirk creates an additional level of volatility, but also creates some opportunity.
Many investment trusts trade at discounts to the value of their underlying assets, which means that you can buy into a trust for less than the NAV. You can hypothetically pay 80p for a share that is actually worth £1. What a bargain!
However, to realise this value, discounts must narrow from the level at which the investor buys in. Unfortunately, there can be no certainty that a discount will contract, but there is a risk that a discount could widen out further.
Board of Directors: Another Pair of Eyes
Last but not least, we hold the role of the board of directors in high regard. A well-constructed board can add value for investors, as well as providing another level of oversight, the costs of which are wrapped up in the fund’s Ongoing Charges. A strong board will not hesitate to take major steps to protect shareholders’ money, if the situation requires it.
Edinburgh Investment Trust (EDIN) provides a good example of how a board operates to protect investors. This trust is one of the oldest investment trusts still in existence today. In 1996, the fund landed in the Edinburgh Fund Managers’ stable, following their acquisition of Dunedin Fund Managers. In the years following this acquisition, Edinburgh Fund Managers struggled and collapsed. But before its collapse, the board of the Edinburgh Investment Trust served notice to its parent and appointed Fidelity in 2002. It was run by Fidelity for a number of years, until the board decided, in conjunction with shareholders, that the mandate needed more of an income orientation. A tender process followed and the board appointed Neil Woodford at Invesco to manage the trust in 2008. This example demonstrates how a board can take major steps to protect shareholders’ money.
Boards have generally been improving over the years, and the AIC has been instrumental in bringing about a more rigorous standard of board independence, but we think there’s still room for a little more improvement.
