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Coming up trumps

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19 July 2019

David Prosser looks at recent research comparing relative performance of open and closed-ended funds, the latter coming out on top.

A better product at a cheaper price – what’s not to like? New research from the investment platform AJ Bell again shines a light on the relative performance of open-ended funds and investment companies; again, the latter come out on top.

AJ Bell studied the performance of pairs of funds run by the same individual manager with a similar mandate over a 10-year period, in each case studying the returns generated by the manager’s open-ended fund and investment company respectively. Overall, it found the investment company had outperformed in 75 per cent of cases.

This isn’t the first such research to reach this conclusion. Over the years, investment companies have come out ahead in countless studies – including influential work from Cass Business School published last summer suggesting that investment companies outperform by an average of 0.8 percentage points a year.

However, one particularly interesting aspect of AJ Bell’s latest study is its findings on charges, where investment companies also impress. Historically, one reason investment companies did so well is that they had lower fees; but since 2013, when regulators outlawed commission payments, open-ended funds have been able to cut their charges – this was thought to have eroded investment companies’ price advantages and therefore reduced their capacity to outperform.

In fact, this appears not to be the case. Amongst the pairs of funds studied by AJ Bell, the investment company was cheaper in 60 per cent of cases, with an ongoing charges figure that averaged 0.06 percentage points less. Open-ended funds may have reduced their fees, but very often investment companies are still cheaper.

This is no doubt an important part of the explanation for AJ Bell’s findings on performance. A 10-year comparison includes years prior to the retail distribution review, which levelled the playing field on charging, but even after these changes came into effect, the investment companies sector has retained an advantage.

Still, fees aren’t the whole story – there are several instances in AJ Bell’s research where the investment company is more expensive than its open-ended equivalent but has still managed to outperform.

A chunk of this is down to gearing – the fact that investment companies are able to take on borrowing while open-ended funds cannot. Gearing provides an additional performance boost, assuming the fund’s underlying portfolio of assets is rising in value, which helps investment companies pull ahead.

The downside to gearing is that it has the same effect in reverse, exaggerating losses during down periods. AJ Bell’s research confirms that investment companies do, on average, produce more volatile returns than open-ended funds, largely because of gearing. Still, if you believe the fund will rise in value over the longer term, the gearing works in your favour.

Finally, it’s worth making the point that while gearing and fees have quantifiable effects on fund performance, there is another factor in investment companies’ favour that is harder to measure.

The corporate governance of an investment company – the fact it is a listed entity with an independent board of directors who have a legal responsibility to safeguard shareholders’ interests – is often overlooked. But it goes to the heart of the debate about investment vehicles: put simply, investment companies are run on behalf of their investors, while open-ended funds are products launched by asset management firms to generate profit.

The distinction is important. Investment companies don’t always get it right and their directors sometimes make poor decisions. Equally, asset managers running open-ended funds know the secret to selling more of their products is delivering good returns. Still, the bottom line is that not only are investment companies typically cheaper and better performing but also, their managers have someone looking over their shoulders on behalf of investors.

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