Fees: Investment companies vs open-ended funds

For many years, there was no debate about the cost advantages of investment companies. As they were actively prevented from paying commissions to financial advisers, and since almost all open-ended funds did, closed-ended funds were almost always cheaper. Since the retail distribution review reforms levelled the playing field, however, by outlawing the payment of commissions by any funds, the waters have got muddier.

In the past week alone, financial advisers may have seen three separate pieces of research exploring the relative costs of open-ended funds and investment companies. And the arguments are certainly more finely balanced than they used to be. There is no doubt open-ended fund managers have relished the opportunity to compete more effectively on price. But equally, many investment companies have responded, reducing their own charges; many have got rid of performance-related charges altogether.

Research conducted by Quoted Data, published in Money Observer magazine, comes down firmly on the side of investment companies. It looked at instances of fund management companies that run both an investment company and an open-ended fund with a similar portfolio and investment mandate – of which there are quite a number – and concluded that investment companies had lower ongoing charges in almost all cases.

However, analysis conducted by Square Mile and published in Fund Strategy, was much less clear cut. In the UK All Companies sector, for example, it found that open-ended funds were now, on average at least, cheaper than their investment company counterparts, though it also pointed out that there were some very low-charging closed-ended funds in the research.

Square Mile also argued that the comparison of ongoing charges could be misleading, since investment companies may be more expensive to compare upfront – it suggested it would take three years of holding the latter to catch up.

Finally, Citywire looked at the performance of investment companies against passively-managed exchange traded funds. This isn’t a straightforward comparison of costs, but provides further evidence, given that proponents of ETFs point to their very low charges. In Citywire’s analysis, based on five-year performance figures, investment companies outperformed in the UK, Europe, Japan, smaller companies and equity income, but were behind in the US, emerging and global markets. 

What are financial advisers to make of these seemingly conflicting research findings? Well, the first point to make is that cost isn’t everything. While we rightly focus on charges given the impact they have on performance, they’re far from being the only consideration – a cheap fund won’t necessarily outperform a more expensive one.

Nevertheless, lower charges have been a big part of the explanation for why investment companies have tended to outperform open-ended companies over longer-term periods. The fact they may take on gearing has been another factor – and this remains off-limits to open-ended funds.

Overall, investment companies appear to retain their edge on cost, particularly for clients who intend to hold their funds for longer periods (which is what one would hope in the case of equity-focused investments) – and particularly where the same manager offers a choice between the two fund structures. However, the contest is definitely getting closer and it shouldn’t be assumed that a closed-ended fund will always be cheaper.