Taking the lead

 During these uncertain times, it is good to know that some old truths remain as constant as ever – including that investment companies generally outperform open-ended funds over long-term periods. It has been a little while since I’ve looked at a comparison of the performance of different fund structures, but the latest data tells the same old story.

Figures from the AIC and Morningstar covering a ten-year period to the end of March, and based on the average performance of funds in 16 sectors, show that investment companies did better in no fewer than 14 cases. The margin of victory is only slightly less emphatic over five years, with investment companies outperforming in 11 out of 16 sectors over that period.

What might account for this outperformance? Well, one factor is that investment companies are allowed, unlike open-ended funds, to take on gearing. By borrowing additional funds, investment companies give their returns an extra boost when asset prices are rising. The opposite effect occurs when markets fall, with losses exaggerated too, but since the assets in which most funds invest have tended to rise in value over the longer term, gearing has had a net positive effect.

An interesting footnote to the gearing conversation is that large parts of the UK stock market were more or less flat over five years to 31 March. You might think that would negate the value of gearing, but investment companies still outperformed open-ended funds in the UK. The point here is that investment company managers use their judgement, deploying gearing when they expect markets to rise and pulling back in more turbulent period; the data suggests they’ve been doing a good job in this regard.

Still, other factors are also at play. For example, the closed-ended structure of an investment company also gives managers some competitive edge. They don’t have to worry about significant inflows and outflows of investors’ money – unlike in an open-ended money which expands and contracts in size according to demand and supply. This not only eases the operational burden of running an investment company, but also enables managers to take stakes in more illiquid assets – smaller company shares, say, as well as unquoted investments. Open-ended managers worry about these assets in case outflows from their funds force them to sell quickly; this cuts off a potential source of outperformance.

Finally, there’s one other issue that should not be overlooked – it is that investment companies and open-ended funds are constructs of a fundamentally different nature. An investment company is an independent business, with a stock market listing and a board of directors that has fiduciary duties to shareholders. An open-ended fund is an investment product launched and run by an asset management company.

This distinction is often overlooked, but it has some fundamental implications. The directors of an investment companies have legal responsibilities to ensure their funds are run in the best interests of shareholders – and to intervene where they fear investor detriment. That is simply not the case in an open-ended fund.