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Why investment trusts beat open-ended funds

FUNDS: Investment trusts have been proven to outperform unit trusts. We take a look at the data and see why this is the case.
Why investment trusts beat open-ended funds

Over 10 years to 28 October 2010 - a decade that has seen both sharp rises and falls in stock markets - the investment trust universe has outperformed both the FTSE All-Share and the FTSE World ex-UK indices. But the latest research also shows that investment trusts - the oldest form of collective investment vehicle - have also outperformed their open-ended fund rivals.

An examination of eight Investment Management Association sectors (open-ended funds) and their equivalent investment trust peer groups on a share price total return basis shows that, over a 10-year period, investment trusts have outperformed in seven of the eight sectors. Only Japan has been a serial underperformer, according to the research by Winterflood.

This is an impressive result, particularly as the open-ended performance data does not include the negative impact of upfront sales costs, which can be as high as 5 per cent of the money invested.

However, investors should be wary of over-arching comparisons. Comparing the performance of the average investment trust with the average open-ended fund is essentially worthless, as the composition of the open-ended fund universe is markedly different. For a start, the investment trust universe is much smaller, having total assets of approximately £93.4bn compared with £542.6bn in open-ended funds. Another obvious area of difference is in bond funds, which account for 21 per cent of open-ended funds, according to the Investment Management Association, compared with just 0.6 per cent for investment trusts.

But the trend does give food for thought and it calls for an examination of the underlying structure of the funds and how this influences performance. As Peter Hewitt, the director of global equities at F&C, says: "You can get duff investment trusts and brilliant unit trusts, but investment trusts have a good case on the whole."

With an open-ended fund, units are created and cancelled according to demand, but in an investment trust, the number of shares is more or less fixed and this feature can give the investment trust an advantage.

There are several factors that contribute to investment trust outperformance.

The first is that investment trusts can, and do, borrow money to invest. This 'gearing' helps in rising markets. The investment trust sector is geared 8-10 per cent, according to Mr Hewitt.

The fact that the share price of a trust may be lower or higher than its net asset value (the discount/premium) can also influence performance. Over the past 10 years, discounts have tightened across the whole investment trust sector from 11 per cent to 8 per cent. This is partly the result of tenders, share buy-back programmes (which have led to NAV uplifts), and the introduction of discount control mechanisms. Mr Hewitt says: "In 2008 discounts were very wide and now they are tightening. In 1999 share buy-backs were permitted - this has helped the discounts. The UK Income, UK Growth and Global Growth sectors have the tightest discounts."

However, these same two factors can also weigh on performance in falling markets. Mr Hewitt warns: "There is no doubt that investment trusts are better over the long run, but when there is a severe bear market, as in the second half of 2008 for example, they will do worse."

There are other reasons why investment trusts perform better overall. Proponents argue that the more efficient structure of investment trusts helps them beat their open-ended rivals. Investment trusts have independent boards that can replace the fund manager swiftly if necessary or wind up the fund and return assets to shareholders. And the investment trust sector sees more than its fair share of corporate activity, with a continual rationalisation of funds. Winterflood analysts suspect that the issue of poor performers is addressed more speedily than in the open-ended fund universe and the role of independent boards is crucial in this.

The role of independent boards was highlighted by the case of Pacific Assets Trust, which moved the fund manager mandate from F&C Investments to First State this year. The loss of the investment trust mandate was the second for F&C this year, after Edinburgh Partners assumed management of the Foreign & Colonial Eurotrust, which is now called European Investment Trust, in February.

The most active boardroom has been that overseeing Edinburgh Investment Trust, a fund investing in UK shares. Seven years ago, it threw out Edinburgh Fund Managers in favour of Fidelity. Then in September 2009, unhappy with the job that Fidelity was doing, trust chairman Scott Dobbie turned to Invesco Perpetual - and star fund manager Neil Woodford in particular - to revive the flagging fortunes of the trust. Mr Hewitt says: "It will be very interesting to see what happens if Neil Woodford underperforms for a year or so."

Dividend policy is also where investment trusts have an advantage. For example, BP, a widely-held income stock, suspended its dividends this year. Open-ended funds holding BP suffered a cut in income. However, some investment trusts holding BP were able to use revenue reserves to maintain their own payouts. This option isn't available to unit trusts, as open-ended funds are required to distribute all their income each year.

Investment companies can build up their revenue reserves during the good years to allow them to pay dividends in difficult years, known as 'smoothing dividends'.

"If you are looking for income you will have a higher and more sustainable income from investment trusts," argues Mr Hewitt. However, he notes that this does not apply to all investment trusts, as it takes approximately 10 years for an investment trust to build up reserves.

There are 15 investment companies that have managed to increase their dividends each year for 26 years or longer. Topping this list is City of London (43 years), followed by Alliance Trust, Bankers Investment Trust and Caledonia (all 42 years).

You can see this dividend policy in practice if you compare investment trusts and open-ended funds that are run by the same fund manager.

Neil Woodford is the fund manager at both Invesco High Income fund and Edinburgh Investment Trust. He has managed to increase the dividend on Edinburgh Investment Trust in 2008, 2009 and 2010. However, in 2010 the dividend on Invesco High Income fell by 2.5 per cent.

Temple Bar and Standard Life Equity Income Investment Trust also managed to increase or maintain their dividends in 2009 and 2010, while open-ended funds run by the same managers had large dividend cuts (see table). Given the proportion of long-term returns that come from dividend reinvestment, this can be an important consideration.

Dividend Performance - Open v Closed End

Fund manager 2008 % change2009 % change2010 % change
Neil WoodfordInvesco High Income2.74-2.5
Neil WoodfordEdinburgh Investment Trust5.62.51
Alastair MundyInvestec Managed Distribution10-10.6-23.5
Alastair Mundy Temple Bar62Flat
Karen RobertsonStandard Life Equity High Income 5.4-6.6-15.8
Karen RobertsonStandard Life Equity Income Investment Trust5.35Flat
Source: Lipper. Produced using Hindsight 5 by F&C Asset Management plc.

One reason that Winterflood does not offer for the outperformance of investment trusts is low total expense ratios (TERs). Although a number of investment trusts do have low TERs, particularly Global Generalists or well-established UK Equity Income Growth funds, many do not. This is especially true for more recent launches, which often have performance fees.

That said, many investment trusts remain cheaper than their open-ended rivals. July 2010 research from the Association of Investment Companies (AIC) found that almost a third (30 per cent) of investment companies have charges under 1 per cent (measured by the total expense ratio - the TER). The lowest-cost AIC member was Edinburgh US Tracker Trust, from the North America sector with a TER of 0.38 per cent. Other trusts with TERs under 0.5 per cent are City of London Investment Trust, Independent Investment Trust, HGCapital Trust and Law Debenture Corporation.

Funds of Investment Trusts

Funds of open-ended funds are widely held by investors, particularly those who invest via an independent financial adviser. Richard Saunders, chief executive of the Investment Management Association, says: "Investors continue to show appetite for funds of funds, adding a record £5.1bn so far this year. At the end of September, funds of funds accounted for nearly 10 per cent of total funds under management, also a record high."

With a fund of funds, the fund manager holds a portfolio of other investment funds rather than holding a portfolio of stocks and shares. Investors Chronicle has often criticised fund of funds because management fees are typically higher than those on traditional investment funds - you are effectively paying two sets of fees - and the performance case has not been proven.

However, if you want to go for a fund of funds, why not consider an investment trust that invests in other investment trusts? For all the reasons outlined above, a fund of investment trusts is likely to be a superior product to a fund of open-ended funds.

For example, F&C Managed Portfolio Trust is an investment trust that invests in other investment trusts, and was launched in April 2008. Its structure means investors can opt for income or growth portfolios. In the year to date the net asset value of the income portfolio is up 16.5 per cent and the growth portfolio has risen 14.5 per cent, compared with growth of 9.4 per cent from the FTSE All-Share index (all figures total return, 31 December 2009 to 31 October 2010).

Recent purchases for the income portfolio include the JP Morgan Global Emerging Markets Income investment trust, launched earlier this year, and 3i Infrastructure. The growth portfolio has taken stakes in Polar Capital Technology and Genesis Emerging Markets. Both portfolios have significant stakes in Asian and emerging markets, although in each case the largest geographical weighting is to the UK (45 per cent in the income portfolio and 31 per cent in the growth portfolio).

Investment trusts that invest in other investment trusts are shown below:

British & AmericanBritish & AmericanUK Growth & Income
Capital GearingCG Asset ManagementUK Growth
CayenneCayenneGlobal Growth
F&C Managed Portfolio TrustF&Cna
JPMorgan Elect Managed GrowthJPMorganGlobal Growth
JPMorgan Elect Managed IncomeJPMorganUK Growth & Income
London & St LawrenceLondon & St LawrenceGlobal Growth & Income
Miton Worldwide GrowthMitonGlobal Growth
Strategic Equity CapitalSVG Investment ManagersUK Growth
SVM GlobalSVM Asset ManagementGlobal Growth
World Trust FundLazard FeresGlobal Growth