All about alpha

New research from Cass Business School shows investment companies outperform comparable unit trusts by 0.8% a year.

What motivates investors and advisers as they decide how to invest in a particular asset class or sector? “The choice between unit trusts and investment trusts depends on a range of factors such as the investor’s need for liquidity, their time horizon and the trading costs involved,” remarks a new study published by Cass Business School, before observing - with some understatement - that “the performance of the respective vehicles can also be important”.

Afterthought or not, it was relative performance that Cass’s researchers set out to investigate – and their findings make interesting reading. The performance of funds managed within an investment company was, on average, 0.8% per annum higher than the returns achieved by a comparable unit trust, the study concluded.

Similar studies in the past, typically undertaken by investment professionals rather than academics, have reached the same conclusions. But the difference with the Cass analysis is that its researchers have attempted to discount as many distortions as possible.

They focused on the alpha generated by funds – the performance over and above the returns that could be accounted for simply by aggregate market performance. And they stripped out factors such as the sectoral composition of the investment company industry, the risk profile of investment companies, their use of leverage and the question of share buybacks.

In other words, this is intended to be as pure a comparison as is possible of the respective ability of unit trusts and investment companies to deliver added value for their investors. It comes from an unbiased source – and the researchers were supported by CFA UK, the organisation that represents qualified investment professionals.

Annoyingly, Cass’s study doesn’t offer an explanation for the 0.8% performance differential. The researchers, who expressed surprise at the scale of investment companies’ lead, have now promised to investigate further.

In the meantime, can we hazard a guess about what might be going on here? Well, there are at least two obvious advantages that investment companies have over unit trusts that might be at play.

The first is the structural difference between open-ended and closed-ended funds. The manager of an investment company does not have to contend with the distraction of flows of capital in and out of the fund as investor demand ebbs and flows; this also means they can maintain a higher exposure to the fund’s chosen asset class, with no need to maintain a cash buffer to pay departing investors.

Advantage number two is governance. The independent board of an investment company has a legally-binding responsibility to hold the manager to account – and ultimately to take action if performance disappoints. There is no such mechanism in an open-ended fund, which is a product created by a fund manager rather than an independent vehicle owned by its investors (and run for their benefit).

It will be fascinating to see whether Cass’s researchers pinpoint these two factors in the next stage of their study – and, in particular, whether they can attribute value to performance drivers that are often considered nebulous or even debatable.

In the meantime, however, the message from this study appears to be crystal clear. Investment companies outperform – so if you’re one of those investors for whom performance matters (most of us, that is), take that into account as you choose funds.