Investment trusts: first class investments

Let's take a closer look at the evidence in favour of investment trusts. The Association of Investment Companies is the trade body for closed-ended investment companies, which includes investment trusts, offshore investment companies and venture capital trusts (VCTs). It commissioned research from Canaccord Genuity comparing the performance of the open and closed-ended fund sectors. Canaccord found that investment companies outperformed open-ended funds in 12 out of 15 sectors over 10 years, 14 out of 15 sectors over five years and 11 out of 15 sectors over one year.

The table below shows the results - sectors in which investment trusts beat open-ended funds are highlighted in red.

Why this outperformance? Simon Elliott is head of research at Winterflood Securities. He points to four key factors: discounts, gearing, fund structure and costs.

1. DISCOUNTS

Investment trusts can trade at a discount or premium to their underlying net asset value, which makes them an attractive target for bargain-hunting investors. But in 2014 the bargains are thinner on the ground because discounts have tightened over the last 10 years across the investment company sector. Alan Brierley, head of research at Canaccord Genuity, says: "The sector has enjoyed a broadly based re-rating since global financial markets embarked on the recovery phase in March 2009 and this has compounded some outstanding returns." The weighted average discount has narrowed from a low of 20.4 per cent in December 2008 to 3.6 per cent in September 2014. Some investment company sectors, for example infrastructure, trade at such high premiums that analysts say investors should be trimming their exposure.

2. GEARING

Investment companies can use gearing - borrowing money to invest - to enhance returns and in positive market conditions this has been a benefit. It does raise the risk of the trust though and can contribute to lower returns if the investment trust manager uses gearing in a falling market.

3. CLOSED-END STRUCTURE

Investment trusts are closed ended in structure - they have a fixed number of shares in issue, so for every buyer there must be a seller. The company does not expand or contract in size depending on fund inflows and outflows, as is the case in the open-ended sector.

This can be a structural advantage for investment trusts because it means that fund managers can take a long-term view without the worry of having to sell good stock to meet redemptions (as happens in open-ended funds). This closed-ended structure can be particularly useful in illiquid assets such as commercial property.

The managers of closed-ended funds say they are better able to make long-term decisions. They don't have to deal with inflows and outflows from the fund, as investors move their money - often at the wrong time in the market cycle. Therefore, they don't have to hold cash to meet redemptions and can be fully invested, potentially leading to better longer-term performance. Mr Elliott says: "A certain manager I have in mind will always hold a certain amount of cash in his open-ended portfolio. There will always be 5-7 per cent sitting in liquidity in case he has to meet redemptions. Conversely, the investment trust that he manages is always fully invested and in an area - it happens to be an emerging markets fund - in which that is a significant advantage over the long term."

The Canaccord Genuity research looks at share price return rather than the net asset value (NAV) return. Because investment trusts are traded on the stock exchange, changes to their share price are a result of investor demand. Changes to the NAV, however, are the result of manager performance, just as with an Oeic.

To further demonstrate the competitive advantages of investment companies over open-ended funds investors can look at the net asset value returns of investment companies where there is an open-ended fund with similar investment objectives and portfolios, and the same manager or management team. Mr Brierley looked at the five-year NAV total returns to 31 December 2013 of 20 investment companies alongside their mirror open-ended funds. He found that the investment companies outperformed the open-ended structure in every case, with a simple average outperformance of an annualised 3.1 per cent.

Annualised out/underperformance by investment company vs directly comparable Oeic/Unit trust (5 years to 31 December 2013, %)

Source: Canaccord Genuity, based on company data. Note: *3-years to 31 December 2013

4. COST

Traditionally investment companies have been able to operate on a lower cost basis than open-ended funds because they didn't have to earmark a portion of their fees as commission to financial advisers. But this advantage has now disappeared.

The AIC says that the main criticism its data faces is that the historic performance figures don't reflect the new 'clean' share classes and lower costs that open-ended funds have offered since the Retail Distribution Review. The RDR is the name for a new set of rules that has been enforced in the UK from the beginning of 2013 aimed at introducing more transparency and fairness in the investment industry. As a result of the RDR, the average open-ended fund now charges investors 0.75 per cent in annual management charges, but the commission charge to the fund manager that used to bump the average annual fee up to 1.5 per cent has been removed. Instead, investors now have to pay platform costs on top of fund charges, which in many cases puts investment trusts on a level playing field with open-ended funds.

Below are the 10 cheapest investment trusts, as measured by their AIC ongoing charge - a measure, expressed as a percentage of NAV, of the regular, recurring costs of running an investment company, including the fund manager's fee.

Investment companies with lowest charges

Source: AIC. Notes: *0.58 with performance fee

Although the charges on these investment companies and many others undercut the average 0.75 per cent fee for an open-ended fund, some parts of the investment trust industry don't look as competitive. The Property Direct sector, in particular, has some eye-wateringly high charges.

Investment companies with highest charges

Source: AIC

Notes: *8.97 with performance fee, ** 6.77 with performance fee, ***5.83 with performance fee

However, investment trusts have independent boards of directors which are acutely aware that costs need to come down in order to remain competitive. Many boards have been sitting down with managers and pushing for lower fees. For example, we have seen a trend for investment trusts to drop their performance related fees in favour of a single charge. Mr Elliott says: "Twenty per cent of the investment trust universe since the start of 2013 has seen a change to its management fee arrangements."

In many cases fee changes have occurred at larger retail-focused companies that want to compete for business with open-ended funds, for example City of London, Edinburgh Investment Trust and Fidelity China Special Situations.

However, the AIC argues that the amount of outperformance can't be explained just by historic cost advantages. Canaccord Genuity found that £100 invested in the Global investment company sector would have turned into £272 over 10 years. The same investment in the IMA Global sector would have turned into £208. Put another way, investment companies have outperformed by about 3 per cent a year for 10 years. That's significantly more than a few basis points in charges.

Will the good performance continue? Some commentators say that investment trust discounts have had a general one-off narrowing over recent years, which is unlikely to be repeated anytime soon and may have made the comparison more favourable to investment trusts. They also argue more investors - both institutional and retail - have been attracted to investment trusts post RDR as a result of the growing recognition of the longer-term performance record, which may have contributed to lower discounts. A report from the AIC showed a 66 per cent increase in adviser and wealth manager investment company platform purchases in the first nine months of 2013.

Mr Brierley believes it is too early to be talking about a new valuation paradigm. He says: "Markets have gone up almost in a straight line for five and a half years and it begs some obvious questions. Gearing will be a drag on performance on the downside and discounts could widen if we enter a more challenging period."

Top 100 Funds on biggest discounts to NAV

Source: Investors Chronicle based on Morningstar data as at 17 October 2014

Top 100 Funds on biggest premiums to NAV

Source: Investors Chronicle based on Morningstar data as at 17 October 2014

WIN £5,000 TO INVEST IN AN INVESTMENT COMPANY

Investment trusts: Striking the right balance at Foreign & Colonial

Investment trusts: Best global investment trusts

Investment trusts: The professional picks 2014

Investment trusts: IC reader favourites

Investment trusts: Around the world in eight investment trusts

Investment trusts: How to buy investment trusts