A quick swap for extra value?

Many fund management firms offer two different types of collective investment with exposure to similar assets. In a given area of the market, the same manager will often offer both an open-ended fund and an investment company. And sometimes that creates opportunities.

Analysis just published by Trustnet identifies a number of cases where investors in a manager’s open-ended fund might now be well-advised to move their money into its equivalent investment company. Doing so isn’t changing your investment strategy – you’ll be getting access to a pretty similar portfolio of assets – but it could provide a boost to your returns.

This is because shares in many investment companies currently trade at significant discounts to the value of their underlying portfolios. That’s a function of the structure of an investment company, where you buy shares in the fund, rather than putting your money directly into its assets; sometimes, demand for those shares gets out of balance with the value of the assets, so that the share price doesn’t accurately reflect what the portfolio is worth. The investment company’s shares might trade at a premium, or, at times such as now, when investors are generally nervous, it might slip to a discount.

In practice, that means someone selling out of an open-ended fund and buying into the equivalent investment company is effectively buying the same assets more cheaply. If and when the discount narrows, they’ll get a boost even if the value of the assets hasn’t changed at all.

One example in the Trustnet analysis is Fidelity Special Values, an investment company currently on a 9% discount. Investors in its open-ended sister fund, Fidelity Special Situations, could therefore swap from one to the other. They’ll end up with broadly similar underlying investments, but potentially benefit as the investment company’s discount narrows.

Similarly, Polar Capital Technology Trust currently trades on a 14% discount, which may be attractive to investors in the Polar Capital Global Technology open-ended fund. Templeton Emerging Markets Investment Trust is also on a 14% discount and holds very similar assets to Templeton Global Emerging Markets.

There are plenty more examples of this phenomenon right now because investment company discounts are wide across the market. The bet you’re considering making here is that discounts will narrow. That isn’t guaranteed – and timeframes are hard to predict – but it’s worth reflecting on the fact that discounts are currently unusually large compared to what has been typical over the past 10 to 15 years. And some investment companies are taking specific actions, including buying in their own shares, to drive discounts down. Even if market sentiment takes some time to improve, these initiatives may pay off sooner.

However, even if you’re not convinced about the discount opportunity, there is another reason to consider making these swaps. Quite simply, investment companies have a well-established track record of outperforming comparable open-ended funds over longer-term periods, often by significant sums.

One significant driver of such outperformance is that investment companies are allowed to take on gearing – they can borrow additional sums to invest in their portfolios. This has a multiplier effect on returns – with a positive impact when markets are rising and a negative impact if asset prices fall.

If you’re an investor in any type of collective fund, you presumably expect it to rise in value over time, even if there’s some short-term volatility. In which case, it makes sense to have exposure to the fund that is going to get the best possible performance out of this rising value. More often than not in the same area, that’s the investment company option.