Comparing the costs: open and closed ended funds

What to make of new research from Tilney BestInvest on the relative costs of open-ended funds and investment companies? The wealth manager’s study is the first in living memory to suggest that the former are cheaper than the latter – appearing to turn conventional wisdom about the cost of collective funds on its head.

To be fair, the comparison is pretty finely balanced. Tilney BestInvest looked at 47 paired investment companies and open-ended funds – that is pairs of funds run by the same management team with a similar investment mandate. It found the open-ended funds to be cheaper in 25 cases – 53 per cent of the time – while the closed-ended funds cost less in the remaining 22 pairs.

Still, this is a surprising finding since it has been received wisdom for years that investment companies are by and large less costly. That reflected the fact they’ve never been able to make commission payments to advisers; but now open-ended funds aren’t allowed to pay commissions either, they’ve been able to bring their prices down aggressively on so-called clean share classes.

In fact, what we’ve seen over the past couple of years has been something of a price war. Closed-ended funds have been cutting charges too, reducing annual management fees and often getting rid of performance-related fees altogether. Tilney BestInvest’s analysis suggest some investment companies haven’t been able or willing to match the price cutting of their open-ended counterparts, but investors are paying lower charges across the board.

The big question is what this means for performance – it is, after all, returns that investors care about most at the end of the time.

Here, Tilney BestInvest’s research reveals a game of two halves. On a three-year basis, 60.5 per cent of the open-ended funds outperformed their closed-ended pairs, the study shows; but over five years, 63.9 per cent of the investment companies were ahead.

There are likely to be a number of explanations for the longer term outperformance of investment companies. One contributory factor is that closed-ended funds have the option of taking on gearing, which soups up returns in a rising market, but this strategy is not available to open-ended funds. Investment company managers also benefit from the structural advantage of having only a fixed number of shares in issue; by contrast, open-ended funds produce ebbs and flows in investor demand that managers must deal with on an ongoing basis.

It's also worth pointing out that investors who want access to certain types of asset class either can’t get it in the open-ended sector or would be better off getting their exposure via an investment company. Illiquid assets such as private equity, infrastructure, debt and venture capital are obvious examples. Similarly, investment companies have more flexibility when it comes to making income payments to investors, since they may keep some income back in good years for dividends in order to fund pay-outs in leaner times.

Despite these structural advantages, however, there’s no doubt that the falling cost of open-ended funds is a challenge to investment companies to raise their game. All other things being equal, it makes it tougher for an investment company to match the performance of its open-ended opposite number, particularly over shorter periods. For this reason, you can expect to see more boards asking managers about fee levels in the months and years ahead – and in the end, investors stand to benefit.