Closed-end funds are companies whose sole purpose is to invest their capital, thus they are a collective investment fund; what sets them apart from unit trusts is their fixed capital (i.e., their “closed-end” structure) and their shares being traded on an exchange. Like other listed companies, closed-end funds conduct an Initial Public Offering (IPO) at which they raise money by issuing a fixed amount of shares. Anyone who wants to buy or sell shares then does so by trading over the exchange rather than redeeming them back to the fund; given private investors’ propensity for buying at the top of the market and selling at the bottom, this avoids the fund manager having to deal with unwelcome flows of money to invest in bullish times and having to sell assets to meet redemptions during market lows.
In the UK, closed-end funds are commonly known as Investment Trusts. This term has a specific meaning, in that the funds satisfy the requirements of the Income & Corporations Tax Act. Funds that are recognised as investment trusts are exempt from taxes on capital gains realised by selling investments in their portfolios. This avoids the unfair situation under which a shareholder would have their investment taxed twice--at the fund level and when they sell their investment trust shares. Increasingly, however, many London-listed funds are choosing not to seek investment trust status and instead domicile themselves offshore (e.g., in Guernsey or Jersey) as a way of avoiding the unfavourable tax consequences that would arise from being domiciled onshore without investment trust status.
The main reason for this is the restrictions placed on investment strategies by section 842: For example, a large part of the new issuance over the last few years has been by funds investing in direct property (i.e., as opposed to property shares); section 842 status is not available for funds investing in this asset class. New launches have generally focused on alternative and specialist asset classes, and many of the more recently issued London-listed companies have chosen to list on the AIM market. The result of this trend is that the London-listed investment company universe now consists of a much more diverse group of funds than was the case five years ago: Investors can now choose from funds investing in such esoteric sectors as eastern European/Indian or Chinese property, renewable energy, Shariah law-compliant investments, or even timber. The closed-end structure is ideal for investing in illiquid assets such as these as investment can be made for the long-term without the need to sell assets to fund redemptions.
This shift was recognised by the Association of Investment Trusts in late 2006 when it opened its membership to non-investment trusts and changed its name to the Association of Investment Companies.
Independent Board/Shareholder Rights
Like any listed company, each closed-end fund has a Board of Directors to ensure that the best interests of shareholders are represented. The board is responsible for appointing a fund management company to manage the fund’s investments and for regularly reviewing their performance; if performance is deemed unacceptable by the board over a period of time, they may install a new fund manager, as happened with the Edinburgh Investment Trust in 2002 when Edinburgh Fund Managers were replaced by Fidelity Investments. It is also the board’s duty to keep costs down, which may explain why closed-end funds typically have lower expense ratios than their open-ended counterparts.
As a shareholder, you have the right to attend AGMs and question the board, and to vote on issues affecting the fund.
Discount
The share price of a closed-end fund is, like that of any listed company, determined by supply and demand for its shares. As such, a fund’s share price can diverge from its net asset value (NAV): When the share price is lower than the NAV, the fund is said to be trading at a discount; if higher than the NAV, the fund is referred to as being at a premium. In the vast majority of cases, closed-end funds tend to trade at a discount to their net asset value making them attractive to bargain-hunting investors who can buy assets for less than their value, and lock in a higher yield than they could do through buying an equivalent open-ended fund. For example, buying a fund at a 15% discount means you are effectively paying 85p for a pound’s worth of assets; if this hypothetical fund is also paying a 5p annual dividend, you obtain a yield of 5.9% rather than the 5% you would achieve through buying an equivalent open-ended fund at the NAV of £1.
Of course, the discount can work against you if it widens after you have bought into a fund, resulting in exaggerated losses. However, the presence of arbitrageurs helps to keep discounts from growing too wide--these are hedge funds that seek to buy into closed-end funds at a wide discount and force the fund to open-end, wind-up or otherwise return capital to shareholders. The attractions of such a strategy are clear: Markets can stay flat and yet the arbitrageur still profits from effectively buying at the share price and selling at the NAV. To fend off unwanted attention from these firms, the boards of closed-end funds will often seek to minimise the discount by buying back shares or by stipulating that a continuation resolution will be put to shareholders if the average discount is over a certain level.
Gearing
Closed-end funds can borrow money to enhance, or “gear up” their returns. For instance, one of the oldest investment trusts, Merchants Trust, had almost £115 million of borrowings as at the end of July 2009 consisting of a mixture of bank loans and debentures. Its net assets were £326 million, giving it a total of £441 million to invest in the markets. This translates to a gearing figure of 1.35, calculated by dividing the total assets of £441 million by the net assets of £326 million, meaning that if the fund’s assets increased by 10%, the NAV would rise 13.5%. Of course, this effect can work in reverse as well: If the fund’s assets fell by 10%, the NAV would fall by 13.5%. Nevertheless, the ability to gear up gives closed-end fund managers another weapon in their armoury.
"The City’s Best-Kept Secret"
Often described as the City’s best-kept secret, investment trusts/closed-end funds have many advantages over unit trusts but are unknown to many. The fact that independent financial advisers can earn commission on selling a unit trust but not on an investment trust has surely had a large part to play in this, but the changes to the way IFAs are compensated (to being paid by the hour rather than on commission) may well result in the attractions of investment trusts becoming more widely understood over the coming years.
Having provided an overview of investment trusts, we will dig deeper into the inner workings of discounts and gearing, among other topics, in future articles.
