Share structure

When is a closed-ended fund not closed ended? The answer is when its total number of shares in issue changes – because the fund buys back shares and then cancels them, for example, or because it issues new shares.

One of the key differences between investment companies and funds such as unit trusts is that the latter have an open-ended structure. When investors want to put money into a unit trust, its manager issues more units to meet demand; when investors sell, the manager cancels its units. Investment companies, by contrast, have a fixed number of shares; investors wanting to buy or sell do so by trading on a secondary market – typically the London Stock Exchange.

However, investment companies are not fixed in size for perpetuity. There may be good reasons for the manager to increase or decrease the number of shares available to traders.

Share buybacks tend to get much more attention. Investment companies most often buy back their shares in order to manage the discount at which their share price trades relative to the value of the underlying asset. When demand for the fund’s shares gets out of sync with the value of its portfolio, this discount can widen significantly. Buying in some shares can help restore some equilibrium.

Share issuance, by contrast, is something we hear less about. Partly, that’s because buybacks are more common. But it also reflects the reality that the launch of a new investment company – a primary issue – naturally feels more noteworthy than an existing fund selling a few more shares.

Last year, however, secondary issuance heavily outweighed new investment company launches. The investment company sector as a whole pulled in around £8.4bn of new money from investors during 2020, but only £1bn or so of this cash was raised during IPOs. The rest of the money - £7.5bn in total - came from secondary share sales.

Around half of this money was raised during “tap” issues. These are more informal exercises in which investment companies sell a relatively small number of new shares on the open market – “tapping” them out over time. Many investment companies allow tap issuance up to a certain amount – say 10% of the total value of the fund.

The rest of the cash came from set-piece fund raisings. Some managers prefer C share issues, in which the new shares are managed separately for a period until the money raised is fully invested in the assets held by the existing fund. This puts the costs of the issue entirely on to investors taking part, and also ensures the investment company’s portfolio is not diluted by a large cash holding. Alternatively, managers may simply issue more ordinary shares.

What should existing investors make of these share issues? Well, there are potential disadvantages. These initiatives carry costs, which may drag on the fund’s returns (tap issues are cheaper). Investors may not have an automatic right to participate in the new issue, which may be restricted to large institutions. And there is the potential for a large cash holding to damage performance over the short term.

Equally, however, share issues can be a good way to manage the premiums at which the shares in more popular investment companies sometimes trade at relative to their portfolio values. This can be to investors’ advantage, particularly if they continue to buy into the fund. There may also be economies of scale from operating a larger fund, which may feed through into the fees and charges that investors pay. And larger funds also tend to be attractive to a wider range of investors – including the big platforms that recommend funds to their investor bases – which can support demand.

The price at which new shares are issued is all important. Existing investors will certainly feel disadvantaged if new shares are offered on the cheap, particularly if they are not entitled to buy them. Nevertheless, these secondary issues give investment companies access to important flexibility, which can be to all investors’ benefit.