Wise up to investment trusts

Secondly, Mr Woodford was reportedly fed up of the administration and paperwork associated with being the manager of the UK's biggest open-ended fund (see the FTAlphaville report).

These factors highlight a couple of advantages that investment trusts have over open-ended funds such as unit trusts and open-ended investment companies (Oeics). Most importantly, the closed-ended structure of investment trusts means the managers don’t have to bother about buying and selling shares to meet inflows and outflows of funds from investors.

In addition to this, investment trusts are not as highly regulated as open-ended funds. This may be a downside for some, but regulation can be stifling - there are all sorts of rules about what unit trusts can invest in, and how they operate their investments. Unlike unit trusts and Oeics, investment trusts do not fall under the direct regulatory scope of the Financial Conduct Authority (FCA). Instead, because they are listed companies, they are governed by the rules contained in the Companies Act 2006 and the UKLA Listing Rules. However, the person appointed as fund manager to the trust must be authorised by the FCA.

Proponents of investment trusts can cite several other advantages. Unlike open-ended funds, investment trusts can borrow money and invest the proceeds. This borrowing, known as financial gearing, can increase returns to investors in a rising market (and vice versa in falling markets). A gearing factor of 100 means the trust has no gearing. A gearing factor of 120 on a trust with equity of £100m means that it has £20m of debt (bank borrowings).

While Mr Woodford posted excellent performance with his open-ended funds, turning an investment of £1,000 in his High Income Fund into £23,000 over 25 years, there is plenty of research to show that performance of investment trusts is on average often better than their open-ended rivals. Most recently, a report published by analysts at Winterflood Investment Trusts concluded that over the 12 months to the end of August, investment trusts outperformed their open-ended equivalents in 11 out of 15 sectors. The largest outperformance by investment trusts came in the European Smaller Companies sector, where they beat their open-ended rivals by 23.3 per cent. There was also very strong outperformance from investment trusts investing in Japan (+22.5 per cent).

What's more, the largest underperformance of investment trusts against open-ended funds came in the Global Growth & Income sub-sector (-4 per cent).

Performance of investment trusts vs. open-ended funds to 31 Aug 2013

Mirror funds

It is interesting to see where the same manager manages both an open-ended fund and an investment trust with a similar investment mandate - called mirror funds - as this often shows the investment trust to advantage. Sticking with the example of Neil Woodford, who has managed the £1.1bn Edinburgh Investment Trust since September 2008, let’s see how his investment trust mirrors the performance of his open-ended funds.

In every calendar year since Mr Woodford took over the investment trust, its share price total return has beaten the FTSE All-Share index but also the returns from his open-ended funds. The trust has 18 per cent gearing, and over the past three years its gearing has ranged from 17 per cent to 26 per cent.

Mirror funds compared: annual total returns (%)

Discount issues

Detractors of investment trusts point to the fact that they can trade at a premium or a discount to their underlying net asset value (NAV), an extra complication which adds to the risk of investing in an investment trust.

Mr Woodford's investment trust has traded at an average premium of 4.14 per cent for the past 12 months. This means that if you wanted to buy it you would have to pay 4.14 per cent more than the underlying NAV of the investments it holds. However, on the news that Mr Woodford was leaving Invesco Perpetual, the premium has dropped to 0.15 per cent because investors worry that he might also give up the management of his investment trust.

On average, discounts on investment trusts have narrowed this year, with the sector average discount (excluding private equity, hedge funds and direct property funds) ending September 2013 at 5.2 per cent, compared with 6.9 per cent at the end of June, according to Winterflood.

At Investors Chronicle, we think that discounts and premiums should not be a deterrent to investors thinking about closed-ended funds. In fact, the discount and premium can throw up great opportunities for investors. You can often get a modest discount in a great investment trust if you’re prepared to wait, watch and strike when the markets are bearish.

Performance of investment trusts vs unit trusts

Top 100 Funds - discount opportunities

Investors Chronicle has whittled down the 396 investment companies to select 61 for our Top 100 Funds (see table below). These trusts will sometimes trade on a hefty premium to their underlying NAV. If this is the case, it may be best to keep them on your watchlist and delay your purchase until they are selling at a discount. On Friday 18 October, 30 Top 100 Fund investment trusts were trading at a discount. Notable discounts include Henderson Smaller Companies Trust (-13 per cent), British Empire Securities & General (-12 per cent), Fidelity European Values (-7 per cent), Advance Developing Markets Fund (-9 per cent), JPMorgan Chinese (-13 per cent), BlackRock Emerging Europe (-10 per cent), City Natural Resources High Yield (-12 per cent), TR Property (-9 per cent), International Biotechnology Trust (-11 per cent) and Impax Environmental Markets (-10 per cent). The three private equity trusts in the selection (Standard Life European Private Equity, Pantheon International Participations and Graphite Enterprise) are also trading at very wide discounts to their underlying NAVs.

We've always maintained that investment trusts are good vehicles for investors. But how do they shape up in a changing funds industry? Regulatory reforms launched in January gave independent financial advisers more reason to recommend investment trusts, potentially levelling the playing field with open-ended funds such as unit trusts. The Retail Distribution Review (RDR) means independent financial advisers (IFAs) are no longer heavily incentivised with commissions to put clients into unit trusts and oeics over investment trusts. Some of the larger investment trusts are best-placed to benefit from this change, which could lead to discounts closing and better liquidity for investors - ie, more frequent trading could lead to bid-offer spreads narrowing.

There is some evidence of this happening. For example, in September, fund data provider Morningstar reported strong footfall on its investment trust pages over the summer, stating: "Investors appear to have used the seasonally-quiet summer months of 2013 as an opportunity to continue their hunt for, and research of, investment trusts."

10 cheapest long-only equity investment trusts

Transparency

Investment trusts still need to improve transparency, particularly through the disclosure of full portfolio holdings on a regular basis. The Association of Investment Companies (AIC) encouraged its member boards to be more transparent with their 'Disclosure of Portfolio holdings Post RDR' report in November 2012.

Since then, there has been a change in disclosure policy at a number of large funds. Looking specifically at trusts whose market capitalisations exceed £1bn:

■ Alliance Trust (ATST) - market value of £2.46bn - from non-disclosure of full holdings to monthly;

■ Foreign & Colonial (FRCL) - £2.12bn - from quarterly to monthly;

■ Templeton Emerging Markets (TEM) - £1.9bn - from annual to quarterly;

■ Mercantile (MRC) - £1.45bn - from semi-annual to quarterly;

■ Witan (WTAN) - £1.21bn - from quarterly to monthly.

These trusts alone comprise some £9bn of assets and they all have wide shareholder registers - that represents a significant increase in the number of investors who are better informed about their fund holdings, not forgetting potential new investors who can drill right down on a full and frequent basis to ensure the funds match their investing requirements.

Jackie Beard, director of closed-end fund research at Morningstar UK, reported in May 2013 that: "The transparency of holdings at investment trusts has improved markedly in the past 12 months. There is still room for more improvement but it's encouraging to see so many funds now willing to divulge their holdings on a full and frequent basis. Those trusts that are disclosing more frequently are becoming increasingly of interest to investors, notably the self-directed investor. Disclosure alone isn’t the only solution to the discount dilemma, but informed investors should have a better investing experience over the long term."

10 largest investment companies

Investment trusts in numbers

Costs

Reducing costs is an important goal for many investors because annual fees for investment management compound over the years, eating large sums out of your investment returns over time.

Investment trusts have a long history of being cheap. Low charges - under 1 per cent a year for investment management - are particularly abundant in the global growth sector. Trusts such as Henderson Smaller Companies and Scottish Mortgage offer distinctive and truly active management for a fraction of the fee charged by some open-ended funds.

Of course, you still have to pay the stockbroking fee on top of this (unlike unit trusts and Oeics), which is an extra concern for investment trust investors with small sums. However, if you invest via investment trust savings schemes, you can cut this out (see 'How to buy investment trusts').

Not all investment trusts are super cheap, though. And the 'investment trusts are cheaper on average' argument is not as strong as it once was.

The implementation of the RDR in January 2013 has had a significant impact on reducing fees in the open-ended world, with many providers introducing commission-free share classes for clients of IFAs, who now have to pay fees for advice.

Performance fees are also common in the investment trust world - usually charging a percentage of any outperformance over the trust's benchmark index. Nevertheless, many investment trusts have removed their performance fees over the years. British Empire Securities is the latest investment trust to abandon its performance fee. According to the AIC, this is the 10th trust so far to do this in 2013. But in 2012, only three dropped performance fees.

Investment trusts selected for IC Top 100 Funds 2013