F&C's Peter Hewitt looks at what has driven investment trusts' general trend of long-term outperformance.
Past performance is a notoriously unreliable beast, but one thing it does suggest is that over time, closed-ended funds such as investment trusts tend to outperform their open-ended cousins.
Recent research by broker Winterflood showed that over 10 years, closed-ended funds outperformed open-ended funds in seven out of eight major sectors (on a share price basis, taking account of ongoing charges but not the cost of purchase), covering both developed and emerging markets and larger and smaller companies. The only sector in which investment trusts underperformed (over the decade to September 2010) was Japan.
The past 10 years have seen a variety of market conditions, including the slow decline after the dotcom bubble, the ‘Baghdad bounce’ of 2003, the sharp correction as the credit crunch bit in 2008 and the subsequent recovery in 2009. During this time, there will undoubtedly have been periods in which open-ended funds did better. But what drives the general trend of long-term outperformance among investment trusts?
In a rising market, the ability of investment trusts to borrow in order to invest – known as gearing – provides a boost to performance. This is because the trust has a bigger pool of assets with which to benefit from market rises.
Gearing is a two-edged sword, as a geared portfolio will be hit harder when markets fall, but active management of the level of gearing – so borrowings are reduced in anticipation of difficult conditions – can mitigate this. The overall level of gearing across the investment trust universe is fairly modest, with figures from the Association of Investment Companies showing that at 31 October 2010, the average net gearing for conventional (that is, not split-capital) investment companies was 105%.
The introduction of share buyback powers in 1999 helped to put pressure on the steadily widening discounts seen throughout the 1990s.
Discounts arise where the share price of an investment trust is less than the net asset value per share. This arguably allows investors to pick up shares cheaply, although this argument only bears fruit if the discount is narrower when the investor comes to sell their shares than when they bought (although it also has the effect of raising the yield for the investor if the trust produces an income).
By buying back shares – either for cancellation or to be held in treasury and reissued when demand picks up – a trust can mop up oversupply and keep the share price closer to NAV. While the average discount in 1999 was around 15%, today it is nearer 10%, with trusts in more established and/or income focused sectors on much tighter discounts.
Some ‘hot’ sectors such as emerging markets may even see trusts trading at a premium, as is the case with Fidelity China Special Situations, which has planned an issue of further shares in order to meet the demand that has seen the trust’s shares trading well above their NAV.
The uplift to net asset values as the result of buybacks and tender offers has, according to Winterflood, sometimes been the key factor in the relative outperformance of investment trusts.
The closed-ended structure
Unlike an open-ended fund, which creates and cancels shares or units according to investor demand or redemptions, an investment trust broadly has a fixed pool of capital, though supply and demand will affect the share price. This arguably allows the manager to take a longer-term view, and also to invest in less liquid asset classes that may have superior long-term performance potential.
Looking at the experience of property funds when the asset class fell out of favour towards the end of 2007, many open-ended funds were faced with a choice between suspending redemptions or having to sell their most liquid assets to meet the demands of investors wanting their money back. Closed-ended funds moved to wide discounts to net asset value, but those investors who hung in there benefited from the property portfolios still being intact when the asset class began to return to favour.
The closed-ended structure also allows managers to avoid the problems of ‘hot’ money, where open-ended fund managers faced with huge inflows must find more and more new stocks – perhaps of less than optimal quality – to buy in order to put their investors’ money to work. Whereas open-ended funds may find they scale up very quickly and have difficulty employing all the money that is flowing in, the closed-ended structure is self-limiting and, except in rare cases, even very popular trusts have struggled to issue new stock.
Efficiency of the sector
One of the unique features of investment trusts compared with open-ended funds is the presence of an independent board of directors. It is the board’s duty to act in the interest of shareholders, and sometimes the shareholders’ interests are not the same as those of the management company.
If a trust is serially underperforming or if the board simply feels the trust is not being given the attention it deserves, it is within the board’s power to seek a new manager for the trust. The most obvious example of this is the venerable Edinburgh Investment Trust, which moved from Edinburgh Fund Managers/Aberdeen Asset Management to Fidelity and is now managed by Neil Woodford at Invesco Perpetual.
Even the board is not sacrosanct, however, as investment trusts may also be targeted by activist investors or arbitrageurs who may disagree with the strategy being applied and push for alternative methods of value realisation, such as tenders, mergers and so on.
Open-ended funds, on the other hand, often languish in dusty corners, sub-scale and underperforming, as the management company focuses on more saleable propositions.
Launching new trusts is difficult
Connected to the point above – particularly as regards sub-scale funds – is the difficulty of getting a new investment trust off the ground. A glance through the performance tables at the back of Investment Week shows well over a hundred open-ended funds with assets of less than £5m, something that is far less prevalent (although not unknown) in the investment trust sector.
While an open-ended fund might be opened with a modest amount of seed money from just a few IFAs or wealth managers (because the open-ended structure allows the fund to grow to an indefinite degree), investment trust launches below £40m are rare, because the costs involved and the likely illiquidity in the secondary market would render such a small pool of assets unviable.
Because of the difficulty of launching new investment trusts, there will be fewer choices for investors, leading to a greater concentration of assets and – in the case of some of the mainly emerging market focused launches of this year – often shares in these new launches will trade at a premium.
A small word on costs
A further piece of research by Winterflood showed that of the eight sectors where it compared performance of open and closed-ended funds, investment trusts had lower total expense ratios in seven, and in six the difference was greater than 25 basis points. And if less of your investment is disappearing in fees, more of it remains gainfully employed.
In summary, then, while we cannot suggest that past performance is a guide to the future, there are certain features that can give an advantage to investment trusts over time and in certain market conditions. As we move towards implementation of the RDR, perhaps it is time that more investment advisers began to look at what closed-ended funds could do for them and their clients.
Peter Hewitt is manager of the F&C Managed Portfolio trust
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