In the interest of investors

The advantages of a closed-ended structure.

A view from David Prosser, former Business Editor of The Independent, Personal Finance Editor of the Daily Express, and Deputy Editor of Money Observer magazine.

Words matter more than we sometimes realise. Closed-ended funds are “investment companies” and, while the jargon might be off-putting, the term is important. It tells you something about the nature of these funds that is potentially very significant for investors.

The contrast is with open-ended funds. These are effectively financial products launched and run by investment management firms that hope to earn a living by taking fees from investors who put their money into the funds. By contrast, an investment company is an independent entity: it usually appoints an investment management firm to manage its assets – and pays it to do so - but it is not one of the firm’s products.

Who do we serve?

This distinction is important because it raises the question of whose interests are the priority for collective investment funds. In the open-ended sector, managers want to perform well on behalf of investors because that’s the way to attract more of them, but the fund ultimately exists in order to generate fee income for the product provider.

An investment company, on the other hand, is subject to company law. Its directors have a legal responsibility to prioritise the best interests of the company’s shareholders. In other words, the fund must be run in the interests of investors.

The practical implications are numerous. For example, an investment company that is underperforming has the option of firing its investment manager and replacing it with a new firm that the directors expect to do better. Also, an investment company must give its investors a say in the operation of the company, through annual general meetings and shareholder votes, for instance. The directors themselves may even be ousted if they lose the confidence of shareholders who subsequently refuse to re-elect them.

Shareholders flex their muscles

These are not simply theoretical possibilities. A small but significant number of investment companies have changed their fund manager over recent years. Others have been wound up after shareholders voted to have their money returned to them rather than reinvested.

Corporate actions continue too. This week, Electra, the private equity fund, received an approach from one of its largest shareholders – he is asking for a seat on the investment company’s board and the mandate to conduct a strategic review of the fund, though his requests have so far been rejected by the independent non-executive directors of the company.

The point is not to debate the rights and wrongs of the situation at Electra, but merely to observe that this situation would never arise at an open-ended fund. Electra has a shareholder who thinks the company should move in a different direction and he has a right to pursue that goal – and to try to persuade other shareholders to support him.

Investment companies must listen to their owners

The bottom line is that the directors of investment companies are there to serve the interests of the owners of the business. This is not a guarantee that closed-ended funds will necessarily deliver better returns than their open-ended equivalents, or even perform better in other ways – on charges and communications, say. But it does mean that closed-ended fund investors are not battling the conflicts of interest sometimes seen elsewhere in the financial services sectors, where product providers may not always put customers’ interests above their own. For many investors, that will be hugely reassuring.