The thinking investor's choice

Plenty of industry players who promote open-ended mutual funds play down the merits of investment trusts. For example, Peter Hargreaves, co-founder of Hargreaves Lansdown, has been quoted in the Financial Times as saying: "I do not think the investment trust industry is capable of being revived. It's run by a lot of fuddy duddies who have no place in the industry."

However, this belies the fact that the performance record of investment trusts is head and shoulders above that of its open-ended rivals, making them increasingly the choice of discerning investors.

Investment trusts aren't as popular as other types of mutual funds such as unit trusts and OEICs, which are heavily marketed to investors and pay commissions to independent financial advisers (IFAs). But that could all change from 2013 when the Financial Services Authority (FSA) bans commissions to IFAs.

First of all, the total return performance of investment trusts is better than that of unit trusts, particularly over longer periods, with the 10-year figure being almost double that of unit trusts and more than double the return on the FTSE All-Share - and that is just the average. The long-term performance of some of the best investment trusts is stunning. Take Finsbury Growth & Income, which delivered double the return of the All-Share (6.2 per cent a year compared with the index's return of 3.1 per cent), its benchmark over the 10 years to December 2010.

Performance, year to 31 July

Secondly, if you look at the different sectors of funds, there is only one sector (UK Small Cap) in which investment trusts fared worse than unit trusts over the past 10 years.

Outperformance record

"If a product performs that well it has to be worth consideration," argues Ian Sayers, director general of the Association of Investment Companies, the organisation that represents the investment trust industry.

How investment trusts compare

There are only about 400 investment trusts, compared with 2,400 unit trusts/OEICs, but the investment trust sector still offers a highly diverse range of investment opportunities covering all global markets and a wide variety of asset classes. As Mr Sayers puts it: "There are certain sectors where we are the only deal in town."

Investment trusts are often referred to as closed-ended rather than open-ended. Closed-ended simply means they have a fixed number of shares (they are 'closed' after the initial share issue). Conversely, open-ended funds including unit trusts and OEICs can continuously create and cancel shares in line with investor demand. The advantage of being closed-ended means the portfolio managers always know how much capital they have to manage and do not need to worry about having to sell high-quality assets simply to meet investor demands for their cash.

But, although they are closed-ended, investment trusts can take steps to increase or reduce the number of shares in circulation, including open offers, tenders and share buy-backs, subject to shareholder approval.

So why has the open-ended funds industry grown at a far faster rate than investment trusts? In the 10 years to December 2009, the funds under management of the open-ended industry grew 90 per cent to £481bn, while investment trust sector assets rose just £2bn to £80bn.

First, there are high barriers to entry as launching a publicly listed company requires scale and resources. Today, investment trusts are only launched where there is high conviction in the investment proposition and a trust's ability to attract capital. This contrasts with the open-ended funds industry where 'me too' fund launches are common if the provider feels the fund can be easily marketed to investors.

Winterflood Securities, the investment trust analysts, point out that new investment trust launches below £40m are now very rare as a trust would be very illiquid in the secondary market and the costs involved would render the fund not viable. The £460m launch of Fidelity China Special Situations in 2010 was the biggest investment trust launch for 16 years, with Fidelity star Anthony Bolton coming out of retirement to take the helm.

More significantly, though, and while it is impossible to quantify, the ability of open-ended funds to pay commission to 'independent' financial advisers (investment trusts don't pay commission) has been a key driver of growth, with only 0.4 per cent of JPMorgan's investment trusts being sold via IFAs.

The professional's choice

A breakdown of the share register of the 21 investment trusts managed by JPMorgan Asset Management shows that the most dominant group of shareholders are the client nominee accounts of private asset managers and specialist institutional investors.

Breakdown of shareholders of investment trusts managed by JPMorgan Asset Management:

■ Independent financial advisers: 0.4 per cent

■ Market makers: 1.5 per cent

■ Private client brokers: 31.3 per cent

■ Platforms: 8.6 per cent

■ Retail investors: 17 per cent

■ Specialist institutions: 26.5 per cent

■ Traditional institutions: 14.7 per cent

In other words, investment trusts are repeatedly the chosen investment vehicle of highly experienced financial professionals, but are not generally held by the mass market audience of clients of independent financial advisers (only 0.4 per cent of JPMorgan's investment trust business).

One of the biggest deterrents to investing in investment trusts for many IFAs will be memories of the 'splits crisis' when a number of split-capital trusts with high gearing and cross-holdings collapsed in value. Most investment trusts are very different investments from these types of vehicles.

IFAs also cite several 'disadvantages' of investment trusts - the ability to gear (borrow money to invest) and trade at a discount or premium to the underlying assets, which viewed in another light can be seen as 'advantages'. Plus, as a company trading on the stock exchange, the shares of an investment trust will generally tend to be more volatile than that of a comparable open-ended fund whose share price simply reflects its underlying portfolio. As the AIC's Mr Sayers puts it: "Investment trusts are a bit more volatile, a bit riskier and more complex. But commission has made a massive distortion in the market. Any argument that IFAs use against them is bogus."

The disadvantages

Let's deal with discounts first. Investment trust shares can trade at a price below or above the value of their investment portfolio (trading at a discount or premium). But many trusts have measures in place to manage discounts. In addition, discounts can be used to the advantage of investors, enabling them to take advantage of investor sentiment to buy assets at a price below their fair value. For example, in March we recommended that investors buy Templeton Emerging Markets investment trust when it was trading at an 8 per cent discount. A good contrarian investment strategy would be to buy shares at a discount and sell them at a premium.

Gearing, on the other hand, is a big contributing factor behind the excellent performance of many investment trusts - they have far greater freedom to borrow money to invest than open-ended funds, which can only borrow up to 10 per cent of assets. Being able to gear into a market recovery is an advantage and can make a significant difference to returns. Of course, there is the risk that the manager makes the wrong call, but the board is required to ensure that the trust is not inappropriately geared. Trusts must state their maximum potential gearing and this will indicate to investors what level of volatility (or risk) they can expect.

The AIC hopes that when the Retail Distribution Review (a new financial advice regime for the UK) comes into effect in 2013, more IFAs will start recommending investment trusts to clients.

Mr Sayers says: "The RDR has the potential to be something quite revolutionary. Other attempts to reform financial advice in the UK failed miserably because they didn't attack the root cause of the problem - that advisers were paid by someone else (the product provider), not directly in the interests of investors. The move to adviser fee charging is a radical reform. IFAs manage billions of pounds of money. Even a small slice, say, 5 per cent of that money, could make a huge difference to the investment trust sector.

"On a five- to 10-year view, there could be a big change in the market. There will be a new breed of adviser who has been through an exam syllabus that includes investment trusts. Plus, the platforms are saying they will bring investment trusts on, so the big structural barriers are being removed."

Cost comparison

Investment trusts have long been promoted as low-cost investments. However, now that investors have access to another type of low-cost listed investment fund - the exchange-traded fund (ETF) - this argument is not so strong. But as ETFs only give pure market exposure, they have a different role to play in portfolios, than an actively managed fund.

Still, the cost argument is not so clear cut. Research by JPMorgan shows that on a simple comparison basis, investment trusts have on average lower total expense ratios (TERs) than unit trusts and OEICs. On a UK-listed investment trust, the average annual TER (the best measure of the total cost to investors), including any performance fee, is 1.29 per cent compared with 1.63 per cent for an open-ended fund, according to data from Lipper.

However, the same research acknowledges that the cost differential between closed and open-ended funds can be largely accounted for by trail commission. Once a nominal 0.5 per cent trail commission is stripped out from an open-ended fund's TER - as it may well be from 2013 - the cost of the two types of fund is broadly the same.

Where investment trusts do benefit investors is in passing on economies of scale. The tendency for many investment trusts to reduce their management charges as they grow, along with other factors such as fixed administration charges, means that TERs often drop significantly the larger an investment trust becomes - and to a much greater degree than on other types of investment fund where board pressure does not exist.

As a company, an investment trust has an independent board of directors. Mr Sayers says: "Independent boards have been maligned but they are important. Their duties are to you, the shareholder. It makes a difference because there are fee negotiations going on. With a unit trust it is what the market can bear."

Alliance Trust, the largest investment trust at £2.7bn, has a TER of 0.63 per cent, less than many passive funds and ETFs, while the open-ended £8.6bn Invesco Perpetual Income fund has a TER of 1.56 per cent, showing no signs of passing on economies of scale to investors.

One-third of investment trusts have TERs of less than 1 per cent, according to the AIC, while almost two-thirds have a TER under 1.5 per cent. In June, the industry body reported that the 20 cheapest investment trusts had delivered an average return of 24 per cent over the past year on fees of less than 0.6 per cent.

The 10 cheapest investment trusts

Mirror funds

Earlier this year, we looked at instances where the same manager ran two different types of fund with the same remit. We found that switching to the investment trust 'mirror' of an open-ended fund could be a good strategy if you want exposure to a particular fund manager, but to access them at lower costs.

It can also lead to better returns. Research by Collins Stewart compared 22 investment trusts with open-ended funds run by the same manager. It found that more than three-quarters of the investment trusts outperformed the open-ended equivalent.

Holders of investment trusts are largely older in profile and more sophisticated and experienced than the average investor. But that doesn't mean that they are not for you if you are a beginner investor. Plenty of large global growth trusts make excellent core holdings (see the table below). And you don't need massive sums to benefit from holding the investment trust sector. Investment trust savings schemes offer a way in for people with small sums to put away on a monthly basis.

The 10 largest investment trusts