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A league of their own

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19 June 2020

David Prosser looks at new research from interactive investor which shows investment companies outperforming funds and at lower costs.

In these turbulent times, it is soothing to see that at least some things remain unchanged. Last week saw the publication of another of those performance comparisons between investment companies and open-ended funds that analysts so enjoy – and as ever, it was investment companies that came out on top.

Interactive Investor looked at the performance of both types of fund in 10 comparable sectors, focusing on the average annualised return achieved over the 10 years to 31 May. For anyone who has seen such a project before, the results won’t come as much of a surprise – in eight out of 10 sectors that Interactive Investor reviewed, the typical investment company outperformed its open-ended fund rival, often by a margin of several percentage points a year.

There are good reasons for this, of course. Interactive Investor singles out the effect of gearing – the fact that investment companies can take on borrowing to boost returns in a rising market – as particularly significant. But there are other factors at play too, ranging from the structural advantages enjoyed by investment companies to their superior governance arrangements.

There was a time when we routinely added price competitiveness to the list of attributes that enable investment companies to power ahead. In this regard, Interactive Investor’s research is interesting. In recent years, open-ended funds have sought to compete much more aggressively on price, empowered to do so by the fact that changing regulation prevents them from paying sales commissions to intermediaries, which has reduced their costs. Given this shift, the assumption that investment companies charge smaller fees has felt less safe – but in fact, Interactive Investor’s research suggests the industry is still cheaper, on average, in seven out of the 10 sectors reviewed. To take just one example, the average open-ended fund in the UK All Companies sector has an ongoing charge of 0.85%; its investment company counterpart charges only 0.73%.

It’s worth pointing out that Interactive Investor’s research suggests that investment companies’ superiority accrues over an extended period. When it looked at five-year performance, honours were even with open-ended funds and investment companies each doing better in five out of 10 sectors. And on a one-year basis, open-ended funds were actually ahead in eight out of 10 sectors.

Should that concern us? Well, not really. There is the very obvious point that stock market investment is a long-term pursuit. Advisers and their clients who do not feel comfortable investing for five years or longer almost certainly shouldn’t be in equities in the first place. But there is also a more subtle point here: the advantages of investment companies are also the very reason they have underperformed over the past year, a period in which markets as a whole have suffered setbacks. Their gearing, for example, amplifies losses just as it supercharges gains.

What we’re really saying here is that investment companies may be more volatile than their open-ended rivals. And that is what studies tend to show. For some advisers that may be concerning – volatility, after all, is one important measure of investment risk.

However, there are other types of risk too. Long-term underperformance in relative terms is also a risk in its own right – and probably one that investors are likely to focus on. Many will be very happy to put up with increased volatility in pursuit of longer-term advantage.