FE Analytics: Closed-ended vs open-ended funds

Financial advisers who keep a close eye on the debate about the respective merits of open-ended and closed-ended funds will be used to seeing performance comparisons that flatter the latter; over the medium to long term, the average investment company in most sectors has generated a higher return than the average open-ended fund. Data published this week by FE Analytics may therefore have come as something of a surprise, revealing as it did that open-ended funds have paid more income over the past five years.

To be precise, FE Analytics looked at the income distributions made by equity income funds over the five calendar years to 2015. It found investment companies had paid more than open-ended funds in two out of those five years, while the latter had paid more in the other three. Over the whole five years, an investor who, on 1 January 2011, put £10,000 in the average equity income open-ended fund would have received total income of £2,419, while their opposite number in the closed-ended sector would have received £2,385.

That seems counter-intuitive. The investment company industry is renowned for its ability to generate good levels of income for investors, with many funds in the sector raising dividends year after year – in some cases over several decades. Do financial advisers now need to rethink their appreciation of the sector for income?

The short answer is no – and all the more so, if their clients are depending on income continuing to flow from their investments. The crucial advantage of an investment company in this context is its ability to continue making attractive dividend payments in different market conditions – including during times when dividends generally are falling.

They can do this because unlike other collective vehicles, investment companies have the ability to retain some income in good years for dividend pay-outs in order to finance payments to their investors in leaner times. When dividends are rising, they keep some of the money back in a reserve fund on which to draw if dividends start falling.

For many investors, this will prove incredibly valuable. Increasing numbers of people are turning to stock market investments for income on which to live – including many pension investors – and the last thing they need is for this income to suddenly take a dive as the market environment changes. The smoothing ability of an investment company makes this prospect much less likely.

Still, what about those FE Analytics figures? Well, it’s worth remembering that over the past couple of years in particular, we’ve seen strongly rising dividend pay-outs from many of the UK companies that equity income funds hold in their portfolios. Indeed, 2015 was a record year. Investment companies will have been holding some of this bumper harvest back for leaner times, while open-ended funds will have been passing on their increased income to investors in full. That will be a large part of the explanation for the relatively small gap open-ended funds have opened up.

It’s worth reflecting too on what the immediate future holds. This year looks certain to spell the end of higher dividends, at least for now. Plunging commodity prices have forced energy and natural resources companies to slash their dividends. We’ve also seen dividend cuts in the retailing and banking sectors, as well as a high-profile reduction from Rolls-Royce. As a result, income fund managers are going to find it increasingly difficult to fund higher pay-outs to investors – and the smoothing effect delivered by investment companies will come into its own.