How trusts can beat open-ended funds

But when a trust and a fund with the same strategy are both run by the same manager, why do the majority of closed-ended funds outperform their open-ended sister funds?

In a recent presentation the Association of Investment Companies notes that out of 19 pairs of sister funds, only three open-ended funds outperformed over 10 years, compared with 16 investment trusts, according to data from Morningstar.

On average, across the 19 examples, the investment trust version of the strategy produced an additional return of 32 percentage points across 10 years to June 30 2015, based on the share price total return on £100 investment.

In particular, strategies focusing on Europe and emerging markets saw investment trusts deliver the largest outperformance of their open-ended sisters, while UK-focused strategies tended to perform better within the open-ended format.

Nick Britton, head of training at the AIC, says the ability of investment trusts to use gearing can help them get ahead in periods when markets go up, although it also makes performance more volatile. Narrowing discounts in the past 10 years have also enhanced trust share price returns.

But he adds: “There are other factors that are less obvious, but perhaps equally important in supporting investment company performance.

“For example, the closed-ended structure means fund managers can focus on the investment portfolio, without having to worry about managing inflows and outflows.

“This cuts out cash drag and enables managers to make buy-and-sell decisions for pure investment reasons, rather than having their hand forced by money entering or leaving the fund.”

James Budden, director at Baillie Gifford, agrees the structure of investment trusts is a clear advantage, not only for gearing but also the ability to invest in less liquid assets that would not be possible in an open-ended structure.

“In some cases, especially in smaller companies and the like, there is the ability to invest in illiquid stocks, such as unlisted companies and that sort of thing. You can get outperformance from those sorts of investments,” he explains.

Mr Budden says the structure of a trust also makes a big difference.

“Investment trust managers can run their winners, while open-ended fund managers are likely to trim back winners because they have to have a certain amount of liquidity to meet redemptions.”

Nicky McCabe, head of investment trusts at Fidelity, says investment trusts share many benefits with open-ended funds such as the ability to pool resources to get economies of scale, while allowing greater diversification of assets to manage risk and enhance returns.

But she agrees they also have “some unique advantages” such as gearing and issuing a fixed number of shares, which not only limits inflows and outflows but also reduces dealing costs.

“Importantly, it also means they can invest in more illiquid securities, such as smaller companies, real property or companies that are not available on a stock exchange. There is [also] greater shareholder engagement through investment trusts, with an independent board and an AGM to discuss the direction of the company with shareholders.”

The outperformance trend of the investment trust structure is not limited to trusts with a sister fund.

Quarterly research from Canaccord Genuity for the AIC shows that across one, three, five and 10 years to June 30, investment trusts have outperformed their open-ended counterparts in five out of 15 sectors. In a five-year period, this increases to 12 out of 15 sectors.

In addition, a recent review from Winterflood reveals that in the 12 months to the end of August “investment trusts outperformed their open-ended equivalents in 11 out of 17 sub-sectors” when comparing share prices for trusts with open-ended net asset values.

It states: “The largest outperformance by investment trusts came in Japan, where they outperformed the equivalent open-ended sector by 12.4 per cent over the 12-month period.

“There was also strong performance from investment trusts in UK All Companies. This was primarily a result of the investment trust sector’s bias towards the mid-cap segment, which significantly outperformed large-cap over the period.”

Nyree Stewart is features editor at Investment Adviser

TRUSTS’ LONG-TERM EDGE

Andy Sowerby, head of sales, marketing and client service at Martin Currie, says some of the best long-term investment strategies are not suitable for open-ended structures “due to the mismatch in the liquidity profile of the assets held and the fund wrapper”.

He adds: “Trusts can, however, be perfect in that they provide access to these investments within a liquid structure, but enable the manager to have a fixed level of permanent capital to invest without the sales and redemption aggravation caused by the open-ended counterpart.

“This phenomenon is most evident in areas such as infrastructure, where the underlying investment is illiquid, but for a long-term investor such as an investment trust, the return and yield characteristics can be attractive.”

Neil Donaldson, chairman of Securities Trust of Scotland, points out the benefits of ‘dividend smoothing’ is a bonus for investors looking for income.

“For retirees and other income seekers, their central need is to have reliable, regular and predictable income.

“This can be difficult for an Oeic structure to deliver, whereas an investment trust has several levers in its arsenal that can help it meet shareholders’ needs.

“This would not be available in an open-ended structure, where reserves cannot be built up, as all income earned each year must be distributed, nor can capital be used for support inn an environment where dividend payments are challenged, for example, in a recession.”