Investment companies show their colours

It isn’t always obvious why it is important that investment companies are structured in a different way to other types of collective investment funds. In the end, all such funds offer professionally managed exposure to a diversified portfolio of assets and aim to deliver attractive returns for investors. However, in recent weeks, the unique nature of investment companies has stood out – arguably, for better and for worse.

On the positive side, last month we saw the ranks of the Association of Investment Companies’ “dividend heroes” swell to 20, with Henderson Smaller Companies joining the list. These are funds that have increased their dividend payouts to investors each and every year for at least 20 years; indeed, almost half the heroes now have a track record of increases that goes back 50 years.

Only investment companies can pull off this trick. Unlike other types of collective fund, they are allowed to hold back some of the income they earn in their portfolios each year, with the money allotted to a dividend reserve fund. This buffer can then be used to support dividends to investors in years when portfolio income is not so plentiful. This is how some funds keep increasing dividends year after year, whatever is happening in the market.

Less happily, investment companies have also been attracting lots of comment about rising discounts. Shares in the average investment company investing in equities are now trading at a discount of close to 15% of the value of the underlying assets. These are some of the widest discounts we have seen since the dark days of the global financial crisis in 2008 and 2009.

Again, discounts are unique to the investment companies sector. They reflect the fact that investors buy and sell shares in investment companies, rather than investing directly in their assets. Sometimes, demand for a fund’s shares gets out of sync with the value of the assets – in which case, the investment company moves to a discount (or a premium).

Where does this leave investors? Are you attracted to the promise of a consistent income stream, or turned off by the uncertainties of discount volatility?

There isn’t a right answer here. But it’s just worth reflecting on one other feature of the investment companies sector – the fact that over longer periods, it has consistently outperformed other types of fund.

That outperformance reflects other elements of the unique nature of an investment company. For example, investment companies, unlike other funds, are allowed to take on gearing – to borrow additional money to invest. This increases returns when markets are rising, but damages performance in a falling market; so if you expect markets to rise over the longer term, gearing is a good thing.

Another important point is that an investment company is a stock market-listed business – and as with other such companies, that gives shareholders important rights. Not least, there must be an independent board of directors with a legal duty to prioritise the interests of investors. This important distinction is often overlooked but often proves very valuable.

The bottom line is that investment companies come with a different set of characteristics to other funds. There will be times when that throws up certain concerns, particularly when it comes to discounts. But for many investors, the advantages of the investment company structure outweigh this anxiety.

Indeed, it’s worth reflecting on what a discount really means. For new investors, or those topping up their holdings, this is a chance to buy exposure to assets on the cheap. If you’re convinced about the long-term prospects for those assets – or you’re keen to tap into consistent dividend income – a widening discount can be an opportunity rather than a problem.