Investment trusts show their true colours

David Prosser compares the performance of investment trusts with their open-ended counterparts.

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Don’t believe everything you read in the media. For all the recent negative headlines about the struggles of investment trusts, the hard facts continue to tell a familiar story: in a straight contest with other types of collective funds, they very often come out on top in the end.

A new study from Wealth Club makes this very clear, reaching the same conclusions as research conducted in the past by multiple analysts. Wealth Club looked at 80 pairs of investment trusts and open-ended funds – that is pairs managed by the same managers and with similar mandates – and concluded that in three quarters of cases, investment trusts outperformed over the longer term.

Moreover, the outperformance was significant. The average investment trust in the study delivered a return that was 5.3% higher than its corresponding open-ended fund over the past 10 years. In some cases, the excess return was huge – the research found five pairs of funds where the investment trust outperformed its sister fund by more than 40%.

Now, there is a caveat here. Wealth Club looked at net asset value performance, rather than focusing on investment trust share prices. That made for a purer comparison with open-ended funds. However, where shares in investment trusts have slipped to wider discounts to the value of their underlying assets, investors may not have seen the full value of this performance. Still, at the very least, the data tells you which fund structure is more likely to generate higher returns.

There’s nothing particularly magical about these performance gaps. Investment trusts simply benefit from a number of structural advantages that ensure, all other things being equal, that they will outperform.

"There’s nothing particularly magical about these performance gaps. Investment trusts simply benefit from a number of structural advantages that ensure, all other things being equal, that they will outperform."

David Prosser

David Prosser

Most obviously, investment trusts, unlike their open-ended equivalents, are allowed to take on gearing – that is, they can borrow additional sums to invest. This gives their performance a boost when markets are rising – as they tend to over the longer term.

Also, investment trusts don’t have to worry about liquidity issues. Managers of open-ended funds must be ready to meet requests for redemptions from investors wanting to withdraw their money. This may even force them to sell assets. This can prove disruptive, particularly in asset classes such as real estate and infrastructure, where the underlying asset is illiquid. Investment trusts, on the other hand, don’t face this problem, since investors wanting in or out of the fund simply buy or sell its shares on the stock market.

A third advantage for investment trusts, highlighted by Wealth Club, is that the funds can buy back their own shares. This proves useful when funds start to trade at an excessive discount, with buybacks providing an additional source of demand for the stock and helping the trust back towards a more realistic valuation. Indeed, buybacks have been running at record discounts over the past year or so, as investment trust boards have sought to overcome some of the issues facing the sector.

Do these benefits mean that every investment trust will always outperform? Of course not. Funds often find the going tough during more volatile periods for markets, when discounts can widen rapidly. That has been the experience of recent times. There are also question marks over the future of some smaller investment trusts, because institutional investors such as wealth managers and fund platforms appear reluctant to invest in them.

Still, investment trusts have repeatedly shown their willingness to battle for potential investors. For example, for many years, the sector was able to point to its lower fees, only for regulatory changes to make it easier for open-ended funds to compete on charges. In recent times, that stiffer competition has seen many investment trusts cut their fees to even lower levels.

All of which is to say that rumours of the demise of the investment trust sector continue to look premature. Wealth Club’s data tells its own story – and the long-term record of investment trusts will continue to attract support for the foreseeable future.