Investment companies vs. ETFs

It’s hardly big news to point out that investment companies invariably outperform open-ended investment companies and unit trusts – just about every study that has looked at the performance of comparable funds from the two industries has reached this conclusion. But who wins if you compare investment companies to exchange traded funds?

Investment analyst James Carthew of Marten & Co sought to answer exactly this question in a recent research project and published the results on Citywire last week. They make fascinating reading. In truth, this is a take on the age-old debate about passive versus active management. ETFs track particular market indices at very low cost – so the question is whether it’s worth paying the higher charges levied by investment companies that are trying to beat those indices. Are the returns that closed-ended funds generate from the markets in which they invest good enough to overcome the drag of their higher charges relative to ETFs?

Carthew’s analysis set the bar rather high. Instead of looking at ETFs, he simply compared investment company performance to relevant market indices. In other words, he looked at the returns ETFs would have generated from tracking those indices assuming they charged no fees at all.

Carthew looked at 10-year performance and began with investment companies in the AIC’s global growth sector. Here, he concluded that 20 out of 33 funds has beaten the MSCI World Index over the past 10 years (and, by definition, any ETF tracking its performance), assuming you take share price returns. On a net asset value basis, 18 closed-end funds were ahead of the index (the lower figure is explained by the fact that discounts have been falling over the past decade).

Next, Carthew examined the UK All Companies sector, comparing the performance of the 12 companies with a 10-year track record to the returns generated by the FTSE All-Share Index. Here, seven of the investment companies were ahead.

In the Small Cap sector, meanwhile, 10 out of 13 investment companies beat the market, while in the case of UK Equity Income funds, 20 out of 21 closed-ended funds produced superior performance. In Europe, every closed-ended fund was ahead, while elsewhere the sample sizes were a little small, but investment companies mostly outperformed.

These results are not conclusive. For one thing, the record of the closed-ended fund sector is a little less impressive in the global growth category – and even more unconvincing for UK All Companies. Also, this analysis covers just a single period of past performance – a more extensive project covering different periods and periods of different lengths would be worth considering.

Overall, however, investment companies have tended, on average, to beat the markets in which they invest, Carthew’s analysis shows. By extension, that implies they have also tended to outperform ETFs.

“There seems to be a clear pattern here,” Carthew himself argues in Citywire. “On average, investment companies outperform equivalent ETFs over the medium term, despite the fees they charge and despite their shifting premiums and discounts – active management works… and it works best in closed-end funds.”

None of which is to say that this pattern will repeat itself in the future, or that ETFs have no place in an investor’s portfolios. But advisers who have bought into the growing popularity of ETFs in recent times might like to read Carthew’s work in more detail.