InvestmentsFeb 13 2020

Closed-ended and open-ended behave in different ways

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Closed-ended and open-ended behave in different ways

Closed-ended and open-ended funds each have their place but they have different features and behave in different ways.

When a fund is open-ended there is no limit to the number of units available.

 As more people invest, more units are created. This means that the price is driven entirely by the changes in the underlying value of the investments.

 Richard Pursglove,  head of distribution at Sanlam says: “The value of an open ended investment company (Oeic) fund is determined by the value of the underlying assets. 

 “In simple terms, if you have a £100m and you have 100m shares in issue, then the price of each of those shares is a pound.

 “The value of a closed-ended structure, aka an investment trust is determined by the supply and demand for those stocks and  shares in the market in exactly the same way as the price of an equity is determined by the market”

 With a closed-ended investment trust there is a finite number of shares available, which means their price is not just determined by their value, known as the net asset value or NAV, it is affected by supply and demand too. 

 If shares in the trust are in high demand, the shares will trade at a price in excess of the NAV. This is what is known as trading at a premium. 

 If the shares are not in such great demand they will trade at a price below the NAV, in which case they are said to be trading at a discount.

 Steven Lloyd, Investment Director at Ascot Lloyd, says: “Another important difference is that investment trusts are companies in their own right.

 “This means they are not bound by the same investment rules as unit trusts, giving fund managers much more flexibility. 

“For example, fund managers on investment trusts are able to gear - that is they are able to borrow to invest. 

 "They are also able to smooth out returns for investors by holding back up to 15 per cent of their income in good years to bolster returns in the bad.

"As a result, investment trusts have a good track record for increasing dividend payments year after year.”

 This ability to borrow money and gear up the portfolio is one of the key differentiators for an investment trust.

The level of gearing that is available to an investment  trust is normally articulated in the articles of association that goes with the investment trust. 

Mr Pursglove says: “They will be normally stated limits on how much they can borrow and what this means for the manager.

“If they feel for instance there is a lot of value in the asset class they are investing in, they are able to borrow money to provide gearing for the portfolio.

"That is not ordinarily the case for an Oeic which would not have any borrowing powers at all.”

Nick Britton, head of intermediary communications at the Association of Investment Companies says that gearing or borrowing can help improve performance over the longer term, but it could also make the downside worse in the short term if markets go down, which would lead to investors losing more money.

Mr Britton adds: “If markets go up, you are going to make more money. Gearing is another reason why investment companies are good for those longer term investors who have time to benefit from that gearing.”

This is one of the reasons why he believes that the closed-ended fund structure may be suitable for those who want to invest for the long term.

When it comes to the type of investors the funds could be suitable for, Mr Britton says it also depends on what the fund is investing in and what the most underlying assets of the fund are.

He adds: “Because of the shares being traded on the stock exchange, the share price can actually vary from the value of the assets in the fund.

“As discounts and premium change over time it introduces an element of volatility, which means it is better to take a long term view, when you invest in a closed-ended fund.”

The other kind of investor can benefit from the closed-ended structure, according to Mr Britton, would be somebody looking for income.

This is because investment companies are able to reserve income, so they don’t have to pay  out all the income they receive every year.

With the income they hold back they can pay it out at a later date when they need to.

 Mr Lloyd adds: “Both structures can make sense for investors, provided they are sensibly allocated as part of a wider portfolio. 

“It is worth mentioning that because closed ended vehicles can gear and trade at a premium or discount to NAV this could, potentially, mean that they may be slightly more volatile than their open ended equivalent. 

“On the other hand, those investors wishing to invest in specialist asset classes for example, infrastructure may only be able to access this via closed ended structures.”

Scott Gallacher, director at Rowley Turton says open-ended funds (typically in the form of pensions or Isas) are suitable for anybody who wants to invest but there is a vast range from the very cautious to very risky. 

He stresses the importance of ensuring that any funds chosen are appropriate for the client’s own risk profile.

Mr Pursglove says “the beauty” of Oeics is that they trade at a net asset value. 

“From a retail perspective, if you are a private investor, everyday there is a price for the underlying assets that represents what they are actually valued at in the market, so it gives you a true value on a daily basis.

“In the closed-ended market, because they are a slightly more complicated market, I think they require a much better understanding as to what are the price drivers. 

“Ultimately, it can be shown, and there is evidence and research to show that over a certain five-year period, closed ended funds may outperform their open ended compatriots but in times of stress in markets, you may find the net asset value of an open-ended fund, may be slightly better than a closed-ended, because a closed-ended fund in times of market stress may find it self at a discount.”

ima.jacksonobot@ft.com