How investment companies can create a smoother ride through short-term volatility

Advisers quite rightly tell their clients that collective investment vehicles are for the long term – and that they should be prepared to put up with some short-term bumps along the way. But sometimes those bumps will cause considerable discomfort, so if there is a way to provide clients with some cushioning against them, so much the better.

We’ve seen two examples in the past week alone of how investment companies, uniquely in the collective fund world, are able to do exactly that.

Let’s start with the commercial property sector, where investor sentiment has turned more negative in recent months, amid concern that capital returns – if not rents – appear to be slowing. The result has been a sharp increase in the number of investors selling out of commercial property funds.

For open-ended funds, that has now become very difficult. Such funds usually try to match buyers with sellers, maintaining a cash reserve to cope with small imbalances from time to time, but the latter now outnumber the former so significantly that fund managers are faced with the prospect of having to sell holdings in order to pay those who want out. In an illiquid asset class such as property, that can have serious consequences, exposing those investors who remain in the fund to high transaction costs and a loss of value when properties are realised at prices at which the manager wouldn’t otherwise have chosen to sell.

Several funds this week said that sellers would therefore henceforth receive the bid price when selling their unit, rather than the usual offer price – effectively reducing the value of their holdings when cashed in by around 5 per cent. The aim is to protect continuing investors.

Closed-ended investment companies with exposure to the commercial property sector, by contrast, are not caught out by this trap. They may be subject to the same underlying market dynamics, but sellers simply dispose of their shares on the market in the normal way. They may be disappointed by the price they receive – and the fund’s share price may dip accordingly - but there’s no effect on the value of the fund’s assets, and the manager does not have to worry about selling assets to meet realisations. Over time, the share price should move back in line with the net asset value.

In other words, an investment company is capable of smoothing out volatility caused by shifting market sentiment. And there’s a similar benefit to be observed in the second example of how closed-ended funds enjoy a key advantage.

This week, Scottish Mortgage, one of the oldest and most venerable investment companies, told shareholders that the companies in its portfolio hadn’t delivered sufficient dividends to cover the dividend it intended to pay them this year. But this doesn’t mean these shareholders will now see their dividend reduced – rather, the fund proposes to pay it out of its reserve fund, a pool of cash put by in previous years when company dividends were better. The fund also said that if the problem persisted into next year, it would pay dividends out of capital if the reserve fund wasn’t sufficient to cover the shortfall.

Crucially, only investment companies are entitled to operate in this way. Open-ended funds, by contrast, aren’t permitted to build up reserve funds, or to pay income from capital. They are therefore unable to provide the smoothing effect that will be so useful to many investors dependant on their funds for income.

These are powerful examples of the way in which investment companies are able to provide their shareholders with protection from the short-term ups and downs of markets. Investors must, of course, maintain their long-term perspective, but many will be reassured by the comfort on offer over shorter time periods too.