Investment trusts versus open-ended funds

When investors found out the UK had voted to leave the union, there was a run on open-ended property funds with daily dealing.

The problem is, property by its very nature is an illiquid asset so while investors were trying to pull their money out, management groups including Threadneedle, Aviva Investors, Standard Life Investments, M&G and Henderson suspended trading in their property funds.

Those invested in property investment trusts, also known as real estate investment trusts (Reits) did not suffer the same problems as investors in these vehicles can buy or sell their shares. 

Having two fund structures run by the same manager gives options for investors if there are capacity constraints on the open-ended fund.James Carthew

Annabel Brodie-Smith, communications director at the Association of Investment Companies (AIC), recalls: “Of course, share prices were adversely affected and discounts for the Property Direct – UK Sector widened out last summer but investors were able to sell their shares if they wanted to. 

“Interestingly, sentiment changed quickly and property investment company discounts have narrowed significantly with the Property Direct – UK Sector now currently on an average premium of 3 per cent.”

Figure 1: Premium (discount) of AIC Property Direct - UK Sector

Source: AIC

She adds: “Even in good times managers of open-ended property funds will need to retain a chunk of the fund in cash so they can meet redemptions.”

Many portfolio managers run portfolios which are available as an open-ended fund and an investment trust.

Pick and choose

According to Canaccord Genuity, there are 51 examples of open-ended funds and investment companies run by the same manager with a similar mandate.

But investors may favour one structure over the other for a number of reasons, and liquidity is one reason. The referendum was an example of investment trusts’ ability to invest in less liquid assets.

James Carthew, head of research at QuotedData, notes: “Closed-ended vehicles don’t have the same need to maintain liquidity to meet redemptions and so can go further down the market cap scale to invest in more illiquid assets.”

He explains how this works in practice: “Having two fund structures run by the same manager gives options for investors if there are capacity constraints on the open-ended fund. 

“For example, the Fidelity Asian Values open-ended fund has just soft-closed, but the investment trust vehicle run by the same manager is still accessible. The closed-ended structure of Fidelity Asian Values Trust works to its advantage, as the manager is fishing towards the smaller end of the cap scale, searching for value opportunities where the market has not recognised their potential.”

“Open-ended funds satisfy investor demand by simply creating more units; conversely sellers are accommodated through the cancellation of units,” notes Dion di Miceli, head of investment companies at Gravis Capital Partners. 

But he admits this can be “disruptive” for investment managers as it necessitates a constant rebalancing of the fund portfolio. 

“Such rebalancing is relatively simple for a liquid portfolio of large-cap equities.

"However, as recent gating and suspensions on open-ended property funds have shown, rebalancing a portfolio comprised of less liquid assets presents its own challenges, with managers facing the difficult choice between disposing of properties to fund redemption requests, holding substantial cash balances or simply denying investors access to their cash.”

This was precisely the scenario managers of open-ended property funds found themselves in following the vote in June 2016.

“Listed investment companies – including investment trusts – provide daily liquidity at all times to their shareholders through a live price on the London Stock Exchange, in the same way as any listed share,” Mr di Miceli continues.

Through this closed-ended structure investors have been able to obtain access to a wide range of investment asset classes from student residential accommodation through to the debt funding of UK infrastructure assets.Dion di Miceli

“This means investment managers can focus on long-term portfolio returns rather than the provision of short-term liquidity. Through this closed-ended structure investors have been able to obtain access to a wide range of investment asset classes, from student residential accommodation through to the debt funding of UK infrastructure assets.”

Outperformance

There is evidence investment trusts outperform their open-ended counterparts.

Ms Brodie-Smith refers to research by Canaccord Genuity, which has identified that out of the 51 investment trust and open-ended pairings with a relevant five-year record, 84 per cent of the investment trusts outperformed their open-ended counterparts over five years on an NAV basis.

James Burns, partner at Smith & Williamson, observes often some of the best ideas will have a greater presence in the investment trust portfolio than in the open-ended one as very few managers run their portfolios identically, “but they know they have slightly more freedom in the investment company structure because they don’t have to worry about redemptions and inflows”.

He acknowledges: “There’s a lot of research that shows over the longer term the investment company run by the same manager will tend to outperform the open-ended fund for those reasons. Gearing used sensibly can add value and that slightly less liquid portfolio with potentially better ideas can add a lot of value as well.”

Investors need to be aware investment trusts can expose them to a bit more volatility though and, of course, in some cases an investment trust might not always outperform its open-ended counterpart.

“Although investment companies generally have a stronger long-term performance record than open-ended funds they are more volatile than open-ended funds,” says Ms Brodie-Smith. 

“This is because when markets are poor, sentiment affects investment company share prices and discounts usually widen. Gearing will also be a drag on performance in poor markets.” 

An investment trust can use gearing, which can obviously boost returns but can also lose more money too.Tony Yousefian

She notes, however, the closed-ended structure allows investment companies to “bounce back” fairly quickly from market volatility. 

“Investment company managers can take a long-term view of their portfolio and do not have to worry about meeting redemptions by selling stock which is a concern for open-ended fund managers,” she continues. 

“Similarly when times are good, investment company managers do not have to worry about inflows into the fund, whereas open-ended managers will need to manage and invest these.”

No right or wrong

Essentially, says Mr Burns, advisers and their clients need to do their research, making sure if they are comfortable with the investment manager, and with the differences in the investment company structure, notably the gearing and the discount mechanisms.

As FundCalibre investment trust specialist Tony Yousefian notes: “Whether you invest in an investment trust or an equivalent open-ended fund from the same manager really comes down to personal preference and there is no right or wrong answer.

“An investment trust can use a revenue reserve to provide a more stable and sustainable dividend, but not all investors want this.

“An investment trust can use gearing, which can obviously boost returns but can also lose more money too. Therefore high gearing can increase risk."

He adds: "An investment trust can trade at a premium or discount so while you may be able to pick up shares at a bargain discount, you could also be penalised by a discount if you need to sell your shares at a certain point."

Therefore, weighing up the pros and cons of each structure before choosing which product to invest in is crucial.

eleanor.duncan@ft.com