Are open-ended funds as volatile as closed-ended funds?

This is partly due to the fact that if investors wish to exit the fund, the fund manager may be forced to sell investments which may or may not be the most liquid.

In June last year, Neil Woodford's flagship Equity Income Fund was gated after Neil Woodford was unable to meet redemptions. 

The event has reignited the debate as to whether open-funds are more volatile than closed-ended funds, and vice versa. 

Redemptions

Alasdair McKinnon, lead fund manager of the Scottish Investment Trust, says: “Investments trusts are closed-ended and so the amount of money the trusts can invest is not affected by redemptions in the way that open-ended funds can be. 

He adds: “In open-ended funds such as unit trusts, the size of the fund depends on the underlying demand for it. If more people want to invest, more ‘units’ in the fund are created.”

According to Mr McKinnon the ability to create more units under open-ended funds is not an issue when the fund is thriving, but can prove to be very tumultuous during times of economic turmoil. 

“When multiple investors choose to leave the trust at the same time, the fund manager of a unit trust may be forced to sell investments to buy back units from the departing investors, which can be particularly problematic if some of the underlying investments are illiquid,” 

 Comparison 

But many in the industry warn that investment trusts and open-ended funds should not be compared, and neither is more volatile than the other. 

Christine Cantrell, sales director at BMO GAM (EMEA) says: “My view is that one should not be inherently more volatile than another.

"This is mainly because both open-ended and closed-ended collectives cover a variety of different asset classes and strategies, and those should be more influential drivers of the volatility than the vehicle structure.”

This point is echoed by Jason Hollands, managing director of Tilney Investment Management. 

“I would caution against generalised comparisons, because the open-ended fund and investment companies universes are different in nature, with the latter including higher proportion of strategies focused on alternative and esoteric asset classes.”

Mr Hollands acknowledges that investment companies can be particularly volatile at certain times. 

But he finds this unsurprising as investment trusts also reflect the dimension of movements in share price discount or premium, as well as changes in the net asset value of the portfolio. 

He says:  “Open-ended funds will also often have higher cash positions than their closed-ended counterparts, because of either new money coming in to the fund or in order to meet redemptions.”

But despite this, he still favours close-ended funds over open-ended funds when it comes to volatility. 

“I do think that closed-ended companies are an advantageous structure for investing in high beta, volatile markets – like emerging and frontier markets, as well as illiquid assets classes – where sentiment and capital can ebb and flow significantly.

He adds: “When investors switch into a risk-off mode, managers of open ended funds are left having to grapple with outflows, which can mean having to trim positions in the more liquid positions.”

Gearing 

Ms Cantrell highlights that while investment trusts may sometimes have less liquid holdings, the fact that investments trusts allow for gearing, also known as leverage can be beneficial for clients. 

 Investment trusts have the ability to borrow money which are often used to purchase shares or assets in a process known as gearing.

This can increase returns when markets are rising, but lead to reduced returns when a market falls.

 Ms Cantrell says: “Due to the asset classes that are more often included in investment trusts, the underlying holdings may be less liquid and less frequently valued such as direct property and private equity."

 “Equally, the investment trust structure allows for leverage, and capital can be often distributed to smooth out yields, which can be beneficial for clients’ income management,"she adds. 

 This point is also made by Mr Hollands. 

 He says: “Of course in a rising market, you’d also expect a closed-ended fund to perform slightly better, because of lower cash positions, the ability to use gearing to enhance returns and a narrowing of the discount if demand is high.

"It is a case of horses for courses.”

 Ms Cantrell says open-ended funds have more of a skew towards direct equities and volatility should reflect this. 

 “Some open-ended structures can operate a swing pricing mechanism where any client who submits an order could get a price which reflects whether that fund had significant flows (positive or negative) on that given day,” explains Ms Cantrell. 

 She adds: “This should not necessarily be seen as price volatility, rather it is a way to ensure existing shareholders are not impacted by flows in or out of the fund.”

 All in all, open-ended funds and closed-ends both can be equally volatile at other points. 

 saloni.sardana@ft.com