So if you are new to the closed-ended world, or perhaps want a refresher, it is worth looking at the different statistics you will see compared to the information available for open-ended investment companies (Oeics).One important point worth noting is that some advisers incorrectly believe they need
to hold a securities qualification to advise on investment companies such as investment trusts and VCTs – they are, after all, listed securities –
but this is not the case because they are also collective investments and specifically listed as such alongside Oeics, allowing advisers to advise clients on them without the need for specific securities examinations.
NAV and share price returns
You will be used to, and will understand, the net asset value (Nav) – broadly the price at which investors will buy and sell open-ended funds – along with the bid/offer prices and spreads. This is underpinned by the fact the manager can create or cancel units/shares to accommodate transactions by investors in the fund.
Closed-ended funds, however, have a fixed number of shares in issue and so the managers can not create or cancel shares when investors want to trade them. When an investor buys investment trust shares, for example, they do not go to the manager to execute the transaction but instead buy them from one or more willing sellers in the marketplace. This means the underlying net asset value is unaltered by the transaction and the number of shares in issue remains unchanged; all that happens is that the ownership of some of the existing shares changes.
Consequently, the share price (the price at which the shares change hands) is not directly linked to the value of the underlying assets (the net asset value) and may be more or less than the nominally attaching Nav per share. This gives rise to either a discount (share price below Nav per share) or premium (share price above Nav per share) to the net asset value. By purchasing at a discount, an investor is thus able to acquire the fund’s underlying assets (and the income arising from them) for less than the price that it would cost to purchase them in the open market.
When looking at performance, both Nav past performance and share price past performance are available. So what is the difference? The Nav past performance is the performance of the underlying portfolio and so is comparable to the Nav performance of an open ended fund – it is a measure of the success of the manager’s investment strategy.
The share price performance on the other hand shows how the share price (the price at which the shares trade) has changed over time. When assessing the actual return a client has achieved on an investment trust holding, it is the share price performance that is more relevant because it is the share prices at which they bought and sold which determine the return.
When it comes to fund objectives, as with their open-ended cousins, closed-ended funds are categorised into certain sectors. However, and this applies to any fund, it is worth drilling down to understand the fund’s specific objective, as not all funds in any one sector will be the same.
In terms of governance, Oeics will have an authorised corporate director (ACD) but closed-ended investment companies have an independent board of directors to oversee and monitor the company’s performance against its objectives, peers and benchmark in the interests of its investors. This independence affords the board the ability to appoint a manager or managers for the fund’s portfolio and to change that manager if it feels such a move would be in investors’ best interests. The governance is therefore slightly different to that with which an investor in open-ended funds might be familiar but it is worth noting that it can be very effective.
Gearing
Gearing represents one of the biggest differences and can be explained as follows. OEICs cannot borrow to invest while closed-ended investment companies can and do, although currently only about 50 per cent of closed-ended investment companies are borrowing. This is known as financial gearing.
The aim of gearing, as with any asset funded by debt, is that the performance of the asset will offset the cost of the borrowing over the long term and thus deliver a net gain to the fund compared with an identical one without gearing.
Gearing has a number of effects, one of which is increased share price volatility. We all know that volatility is measured by standard deviation – the movement of a fund’s share price around its mean – and this applies equally to closed-ended investment companies. A company with gearing will be likely to have a higher volatility than one holding an identical portfolio without it.
However, as with raising a mortgage to fund the purchase of a property, remember the aim of gearing. If an investor expects that, in the long term, a particular market will rise and they are willing and able to accept the associated short-term volatility, then it can be worth looking at a geared fund. Most funds which employ gearing have stated a clear gearing range to give investors and their advisers guidance as to the percentage of gearing to which they are likely to be exposed, so you can review this information to see whether it is consistent with your client’s risk capacity, requirements and tolerance before recommending that they own any closed-ended fund.
Charges
Before the RDR it was easy to see that the ongoing charges on mainstream closed-ended investment companies were generally lower than those of their Oeic counterparts. The reason for this was that closed-ended funds could not legally pay commission to intermediaries (since this would effectively be coming from shareholders), whereas Oeics could (since it came from the management company).
Since the implementation of the RDR the lack of commission, along with increased competition from low-cost passive vehicles, has changed the situation for Oeics and we have seen their charges reduce.
Perhaps most pertinent now, given the new retirement freedoms, closed-ended funds can offer a reliable income stream. As Steve Groves, CEO of Partnership, explained at this year’s IFP conference, an average 65-year old male can expect to live to 86.5, with over 20 per cent expected to live to 95.
With the recognition of increasing longevity due to medical advances, many investors are looking for a part of their post-retirement portfolio to be invested in equities.
Investment companies should have a role to play in helping with that equity content. A significant number of investment trusts have paid a rising income every year for over 30 years now. The track records of these dividend heroes speak for themselves.
