Greater freedom, better 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.

The Chancellor’s Budget announcement that investors will, from July onwards, be able to invest up to £15,000 a year via tax-free individual savings accounts (Isas) is undoubtedly good news for savers and investors. Still, if you use your annual Isa allowances to invest in stocks and shares via a collective investment fund – as millions of people do – the higher limit increases the pressure on you to get a difficult decision right.

What are you looking for when you choose an investment fund to give you exposure to a particular stock market or asset class? Well, your first priority is likely to be that the fund you pick gives you the highest possible returns – in other words, that it outperforms other funds investing in these markets and assets. Second, you want to feel you’re getting value for money – that you’re not simply paying a fund manager to replicate the performance generated by the market in which he invests or, even worse, to underperform the market. In either case, you would be better off with a low-cost index tracking fund.

Investment trusts outperform

The data suggests your best chance of achieving those objectives lies with an investment trust rather than an open-ended fund – particularly over the long term.

Winterflood Investment Trusts has just completed its review of the investment trust sector’s performance during the first quarter of the year, enabling it to update its regular snapshots of long-term performance. Over the five years to the end of February, investment trusts outperformed their open-ended equivalents in 16 out of 17 sectors, Winterflood found. Had you used investment trusts to get exposure to any asset class other than North American equities, you would, on average, have been better off with a closed-end fund.

In many cases, the differences were huge. The average UK All Companies investment trust returned 24 per cent a year over that five year period, while the average open-ended fund investing in the same assets could only manage 19 per cent a year. Amongst funds investing in Japanese equities, investment trusts produced returns averaging 18.4 per cent a year, while their open-ended equivalents achieved 8.7 per cent annually.

Just as significantly, in most cases investment trusts managed to significantly outperform the markets in which they were investing. In other words, the higher charges their investors paid for active management compared to passive funds were justified by the end result. Again, North America was the only asset class where this wasn’t the case.

Greater freedom, better structure

Why should investment trusts so consistently outperform over the longer term (the trick is repeated if you look at 10-year statistics)? The answer is that closed-end funds have at least two huge advantages over their open-ended rivals.

First, the investment trust sector has greater freedom about how it invests. In particular, funds are allowed to borrow in order to invest – this gearing amplifies the returns earned during periods of positive performance (and can be dropped if managers are nervous about the prospects for markets).

Second, the structure of investment trusts gives them an edge. The manager of a closed-end fund knows exactly how much money he has to invest and can plan accordingly. Open-ended fund managers, by contrast, must constantly deal with the ebb and flow in the size of the fund as investors add to their holdings or take their money out.

Stacking the odds

All in all, it’s not a fair fight. All other things being equal, an investment trust will tend to outperform its open-ended opponents in rising markets. That’s not to say, of course, that investment trusts will always do better – simply that they hold all the best cards.