Independent financial advisers will have to consider the performance of closed-ended investment vehicles in the wake of the retail distribution review, but how do they perform?
The run up to the introduction of the new regulatory regime has seen investment trust groups much more proactive in making their case to the adviser market. The rational has been that, once RDR comes in, advisers will need to take investment trusts into account before making a recommendation to their clients. And the basis for encouraging those charged with taking investment decisions to add the closed ended variety into their range of options is their superior performance.
The reality is not quite that simple, given the added complexity of some investment trusts, but there is evidence to suggest that closed-ended vehicles do generally perform better than the open-ended variety. The reasons are not hard to find. Most investment trusts enjoy a lower total expense ratio than unit trusts or Oeics though rather perversely, one side effect of RDR is to drive down the management charges on the open ended side.
Then there is the beneficial effect of gearing in a rising market. Of course, the reverse is true when share prices tumble, though many managers of investment trusts will tell you that the ability to vary the borrowing level is a great advantage when it comes to seeking better performance. Gearing can, of course, be perceived as adding risk – something the regulators have had a view on in the past. Perhaps it is best considered as a two edged sword.
But the strongest argument the managers of funds with a fixed capital can advance might be considered to be the lack of pressure to sell investments to meet redemptions in difficult market conditions. This applies particularly to situations where liquidity is limited, such as smaller companies. Indeed, many investment trust managers will highlight the opportunities that can be thrown up when investors take fright and good shares are sold, perhaps for the principal reason that they can be.
In the end the proof needs to be in the pudding, so it is worth looking at how the two sides of the investment spectrum stack up when it comes to performance. The results are interesting, firstly because it is not a one way street, with open-ended funds leading the field in some categories, but also because the margin of difference can be surprisingly wide. Moreover, in some sectors where liquidity issues look likely to favour investment trusts, they actually fail to capitalise on their perceived advantage.
European Smaller Companies, as an example, find investment trusts trailing over one, five and 10 years – not massively, it must be said, but sufficient to clearly favour Oeics and unit trusts. The fall of 23.6 per cent over one year for investment companies, compared with just 15.4 per cent for the open-ended variety, can be easily explained by changes in discounts and/or gearing. Over five years both categories lost money on average, -22.2 per cent and -7.9 per cent respectively, but the underperformance over 10 years (119.5 per cent for investment trusts and 149.5 per cent for unit trusts/Oeics) is altogether more difficult to understand.
But the overwhelming weight of evidence suggests that investment companies do better, particularly over the longer term. Just two of the eight sectors reviewed saw investment companies underperforming their open-ended competitors over one and five years and a sole sector – Japan, hardly the easiest of markets in recent years – had open-ended funds coming out on top over 10 years.
Of course, life is never as simple as picking the best performing investment vehicle and trusting that it will continue to reward you handsomely in the future. Many additional factors need to be taken into account when assessing relative performance between these options. How has share price movements been affected by changes in the share prices relationship with the underlying asset value, for example? And there can be exceptional circumstances that flatter – or sometimes flatten – an investment company’s performance.
Take Northern Investors – a private equity trust that returned 32.3 per cent in the year to the end June this year. Private equity is undoubtedly an asset class that is far better suited to a closed-ended structure than to Oeics or unit trusts, but its recent sterling performance owes much to the fact that it is being wound down. Investment trusts are, after all, public limited companies and can be subject to take over bids and the decision to liquidate – as well as being potentially buffeted by the winds of supply and demand in the market.
In the past I have been involved with several initiatives to encourage advisers to engage more with investment trusts. The success ratio has not been encouraging, but this time could certainly be different. It is interesting to look at those firms, so-called DFMs, which specialise in managing portfolios for private clients – increasingly on behalf of IFAs who wish to shed themselves of this responsibility. Investment trusts are highly likely to feature in their range of options. Perhaps RDR will make a difference after all.