New comparison, same result

Back in 2012, when regulators implemented the Retail Distribution Review (RDR), some investment analysts thought one result would be a convergence of investment trust and open-ended fund performance.

Prior to the RDR reforms, open-ended funds were allowed to pay sales commissions to intermediaries who recommended them to clients. One effect was that advisers were far more likely to recommend open-ended funds than investment trusts; another was that open-ended funds were saddled with higher charges, to the detriment of returns.

Once RDR banned commissions, open-ended funds were able to cut fees – this provided an opportunity to close the performance gap. There’s no denying this levelling of the playing field has had an impact. Many funds have indeed cut charges; some advisers have also, to their credit (and the benefit of their clients), embraced investment trusts with greater enthusiasm.

Nevertheless, investment trusts retain several structural advantages which explain the outperformance identified in studies such as the one Kepler has just published.

Chief among these is the ability of trusts to take on gearing, something that is off-limits to open-ended funds. The impact of gearing – borrowing additional money to invest – is to boost returns when asset prices are rising. Gearing also exaggerates losses when prices fall, of course, but since share prices have tended to rise over the longer term, investment trusts with gearing have largely benefitted. This has been an important ingredient in many trusts’ outperformance.

Another critical feature of investment trusts is their closed-ended status. Managers invest in a fixed pool of assets with investors buying and selling exposure to it by trading the trust’s shares. By contrast, in an open-ended fund, investors are buying and selling in and out of the pool itself. That means the manager has to run a fund that fluctuates in size.

This can be distracting, particularly during periods of volatility, and can also impinge on investment decision-making. The manager may need to hold on to cash – generating negligible returns – to meet redemption requests. He or she may be reluctant to invest in more illiquid assets, such as smaller company shares, for fear of being unable to sell them quickly if needs be; during periods of stronger performance from such assets, the fund’s returns will then disappoint.

Governance matters are also significant. Investment trust shareholders’ interests are safeguarded by a board of independent directors with a legally binding duty to look out for them. That might translate into actions as radical as sacking a fund manager who is underperforming. Open-ended funds don’t operate this way – they are products manufactured by an asset management firm ultimately focused on its own interests.

None of which guarantees that investment trusts will outperform, but these factors certainly provide closed-ended funds with a fair wind. They explain Kepler’s findings – and those of every other piece of research in this vein.

One final point. Kepler’s note also points to an additional advantage of investment trusts. The closed-ended structure, the analyst points out, will often mean a trust’s shares trade at a discount to the value of the underlying assets. This provides investors with an opportunity to buy in on the cheap, Kepler says.

It’s a slightly more controversial point: discounts have sometimes put people off investment trusts, since they’re perceived as adding complexity. Sceptics point out that discounts may not narrow – and could even widen.

Fair enough, but discounts do allow “investors to benefit from a potential rerating of the shares in addition to the performance of the underlying assets”, Kepler argues. And right now, the analyst adds, there are some attractive looking discounts available on UK-focused investment trusts. It suggests that trusts invested in UK smaller companies could be a particularly happy hunting ground.