David Prosser looks at the structural advantages of closed-ended funds that have contributed to their long-term outperformance.
It used to be a statement of fact that investment companies tend to outperform open-ended funds over longer term periods. But one of the most important single factors in this outperformance has historically been the lower charges levied by investment companies – so now that many open-ended funds are cutting fees in the wake of the retail distribution review (RDR), are they posting returns that match the closed-end sector?
New analysis from the investment trust analyst team at Numis might suggest this is the case. “Over the past five years, most [investment company] equity sectors have performed strongly relative to open-ended funds, helped by narrowing discounts, gearing and a smaller company bias,” it reports. “Over the past 12 months, however, the picture has been mixed.”
To be specific, of the 17 equity-based sectors Numis looked at, average investment company performance was superior in nine over the year to the end of June, while open-ended funds fared better in eight cases. By comparison, investment companies were up in 14 out of 17 cases over five years – and in 15 out of 17 cases over 10 years.
So is this definitive evidence that open-ended fund price cuts have levelled the playing field with investment companies? Well, let’s not be too hasty.
The first point to make is that large numbers of closed-ended funds have also lowered charges since RDR. So the pricing differential has not diminished to the extent that you might expect. Also, these are one-year figures - they’re too short-term to draw definitive conclusions from.
The broader argument, however, is that while the competitive edge on pricing of investment companies may have been eroded by RDR, closed-ended funds retain a number of structural advantages that have also contributed to their long-term outperformance.
Chief amongst these is the ability to take on gearing, as and when fund managers think market conditions are suited to this, an option that isn’t available to open-ended funds. In rising markets, this has the effect of souping up positive returns, and while there is a risk of heightened losses during down periods for asset prices, markets tend to rise over the longer term.
In addition, the closed-ended nature of an investment company leaves managers free to focus all their energies on managing the assets. Open-ended fund managers, by contrast, also have to worry about inflows and outflows of investors’ money – during volatile periods for markets, these can be dramatic and distracting. This may be one reason, by the way, why investment companies have been able to pursue the “smaller company bias” Numis describes – open-ended funds have to be more careful about potentially illiquid holdings.
Another plus-point for the closed-ended sector is the presence of independent boards to scrutinise the actions of fund managers. Investment company directors have a good track record of holding fund managers to account, even replacing managers where performance has not been up to scratch. They’ve also lead the way on discount control mechanisms and policies, negating a perennial bugbear for some financial advisers and investors.
The bottom line is that we will have a better picture of relative performance in a post RDR environment in another three years or so, when comparisons are more meaningful. For now, however, there is good reason to think investment companies have every chance of maintaining their long-term lead over their open-ended counterparts.
Finally, let’s also concede that performance relative to other funds isn’t the only yardstick by which a fund will be judged. Investors and advisers also want evidence of good absolute performance – and to be sure the active management fees they’re paying are justified.
On this front, Numis has good news from the first half of the year. The FTSE Investment Companies Index delivered a total return of 4.6 per cent over the first six months of 2015. By contrast, the UK stock market, as measured by the FTSE All-Share Index, turned in only 3.0 per cent – so did the MSCI World Index. These are short-term numbers, of course, but gratifying nonetheless.