Investment trusts have long been seen as a side-line to open-ended funds, suitable for illiquid or esoteric assets and a marginal part of the investment industry. However, new research finds that not only do investment trusts outperform their open-ended equivalents, it is the closed-ended structure that allows them to do so.
New research by CASS Business School shows that even setting aside structural factors such as holding more illiquid assets, or smaller companies, investment trusts still showed significant outperformance over their benchmarks and open-ended peers. This had little to do with advantages such as gearing and far more to do with the flexibility that the structure provides managers.
The research showed that even taking buybacks, a structural weight to smaller companies, gearing and portfolio construction issues into account, closed ended funds outperformed open-ended funds by around 80 basis points – 0.8%.
Why Are Closed-end Funds Less Popular?
With this in mind, why does the open-ended structure still dominate? Shouldn’t closed-ended funds attract far greater capital? There are historic reasons why open-ended funds have gathered more assets, notably that open-ended funds paid commission to advisers while closed-ended funds did not. However, today, with an apparently open playing field, this gap looks anachronistic.
The structure of open-ended funds gets around a number of thorny problems. For example, it solves the problem of liquidity. If a large investor needs to move in and out of an investment trust, not only can it be difficult, it may move the share price and it may even have an impact on index pricing.
Rob Burdett, co-head of the multi-manager team at BMO Global Asset Management, points out that many of the larger trusts are part of the major FTSE 100, 250 or All Share indices, and therefore any moves in or out can be tracked by passive flows and impact pricing
Investment trusts are also a problematic component of model portfolios and are therefore only lightly used by advisers. A lot of IFAs use model portfolios to ensure that they are compliant with the FCA’s ‘Treating Customers Fairly’ rules. These model portfolios will have an allocation to different assets, which will change over time, dependent on the manager’s view.
However, Burdett believes it would be wrong to see open-ended funds as merely convenient. He says that while having captive capital can be a better structure, with open-ended funds “you buy today, the manager you want, at NAV”.
There are other reasons why investment trusts might outperform, he says: “There is a lot of marketing risk and effort that goes into launching an investment trust. This means that fund management groups only launch a fund where they have a strong manager and know they are going to raise money.” This would affect the overall performance of open-ended versus closed ended funds, but doesn’t mean that structure is necessarily superior.
Burdett adds that open-ended funds are adopting some of the best practices of closed-ended funds, such as independent boards. He believes there is an argument that open-ended funds are now more transparent than investment trusts., given the new pricing disclosure that has come in under MiFID II.
At the same time, investment trust investors may need to consider the discount. During the recent difficulties over the Invesco Perpetual Enhanced Income trust, the share price has dropped 1.8% over the last three months, while the NAV has remained relatively stable at -0.3%. Investors may be giving up two or three years’ worth of performance on difficulties with the board.
That said, it is one of the rare occasions when private investors, without scale, are at a notable advantage to larger investors. The investment trust model tends to work for private clients but does not work well for commoditised investment. Therefore, if they have the choice between buying a manager in an open or closed-ended structure, and time to wait out the ebb and flow of the discount/premium, investment trusts may be a better option.
