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A clear winner

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31 January 2020

David Prosser examines a study from AJ Bell looking at the outperformance of investment companies against their open-ended equivalent funds.

It may be a new year, but some things never seem to change: witness yet another report revealing that investment companies consistently outperform their open-ended equivalents.

The study, from stockbroker AJ Bell, looked at the 10-year record of investment companies versus open-ended funds with the same mandates and run by the same team. It found that over the whole period, investment companies came up trumps 77% of the time.

One clue to the explanation for this outperformance is found in AJ Bell’s research. It points out that 31% of the investment companies studied were cheaper than their open-ended opposite numbers (only 15% of the open-ended funds had lower charges than their counterparts).

AJ Bell also points out that the rising markets of the past decade have favoured investment companies, since they have the option of taking on gearing, which has a multiplier effect on returns.

Some of the performance gaps are remarkable. The study points out that the Baillie Gifford Shin Nippon investment company is up 678% over the past 10 years while its Baillie Gifford Japan Small Companies stablemate has only managed 422%, despite the two funds having nine of their top 10 holdings in common. Henderson Smaller Companies had returned 621% compared to 362% from the Janus Henderson UK Smaller Companies open-ended fund.

Still, if we are putting these disparities largely down to gearing, it’s important to point out that in more challenging market periods, borrowing to invest has the opposite effect on returns, exaggerating losses. Indeed, AJ Bell’s study suggests the performance of investment companies has been notably more volatile over the past 10 years, almost certainly because of the gearing they hold.

What if, however, there’s something more fundamental going on here? What if the investment company structure offers certain advantages in and of itself, which give rise to a tendency to outperform?

On that question, it’s impossible to be definitive. It was interesting to see an update this week from Cass Business School, which in 2018 published research suggesting that even after stripping out factors such as gearing and charges, investment companies have a tendency to outperform. Cass’s latest view is that it doesn’t have sufficient data to be certain about that conclusion – that the universe of investment companies is not large enough, once you try to take all the complications of comparisons out of the picture, to give a decisive verdict.

That will disappoint investment company fans because Cass’s preliminary view two years ago was that the sector had an innate structural advantage. It pointed to the fact that investment company managers had the luxury of running fixed pools of funds, rather than open-ended vehicles that forced them to buy and sell assets as investors entered and exited.

Today, by contrast, Cass says it can’t be sure about this. It’s not backing away from the argument that investment companies outperform, but it doesn’t feel confident it has enough data to explain why this should be so with certainty.

Where does that leave investors? Well, the bottom line is that in rising markets in particular, investment companies stand a good chance of outperforming because of their gearing – and since most investors commit funds on the basis that markets will rise over time, that is in the sector’s favour. Add in the fact that there is also at least some evidence that the structure of investment companies is advantageous and the choice, where there is one, looks pretty clear.

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