Case closed on funds

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Case closed on funds

Fans of investment companies often extol their performance advantages over similar open-ended funds over the medium to long term.

Sceptics point out that investment company returns have been more volatile, with bigger losses in falling markets. Both have a point – but before getting bogged down in numbers, it is important to first understand all the reasons investment companies might perform differently from Oeics.

First, the obvious ones. Staring us in the face are the two issues of discount/premium pricing and gearing, both features of investment companies not shared by open-ended funds.

The return you get from an investment company is clearly dependent on its share price, which may be at a premium or discount to net asset value. If the discount or premium changes during the period you hold the shares, it affects the return you get. For example, over the past five years average investment company discounts have narrowed, adding a certain gloss to returns. But if they widen again, some of the shine will come off.

Then there is gearing, the practice of borrowing money to invest, which open-ended funds are not allowed to do. A geared investment company will tend to perform better than an equivalent Oeic if markets go up, and worse if markets go down. This is one reason investment company returns tend to be choppier than those of Oeics, but assuming you expect markets to go up over the long term, a moderate level of gearing is likely to be a tailwind.

There are some more subtle reasons investment companies might perform differently from open-ended funds. Until the RDR brought us clean share classes, investment companies had a clear cost advantage, with substantially lower ongoing charges. That advantage has been eroded (thankfully for investors), but investment company boards have responded to a more competitive environment by chipping away at fees further. Eighty-seven companies have changed their fee structures to the benefit of shareholders since the advent of RDR, while 39 have abolished performance fees.

A less tangible advantage, though no less important, is the fact that investment companies are closed-ended, and do not have to manage inflows and outflows. Instead, shares are traded between investors on the stock exchange, with no effect on the underlying portfolio.

This has a number of implications. First, investment companies do not need to keep a portion of their portfolio in cash to meet redemptions, so there is no ‘cash drag’ on returns. Investment companies can, of course, hold cash if they want, but that would be for investment reasons.