Why investment trusts beat open-ended funds

Two years on and research by the same analyst, Alan Brierley, director, investment companies at Canaccord Genuity, comes up with similar findings.

At sector level, investment trust sectors mostly beat their open-ended fund equivalent sectors (see table below).

Investment companies vs Oeics/unit trusts

Price total returns to 31 December 2012 (unweighted, £ adjusted, base = 100)

Source: Canaccord Genuity & Association of Investment Companies

At individual fund level, out of 21 investment trusts surveyed where there is a similar open-ended fund, 17 outperform the equivalent open-ended fund in net asset value (NAV) terms over five years. The average outperformance of these 21 trusts over their open-ended equivalents is 1.78 per cent on an annualised basis. These funds are often called 'mirror' funds because the investment manager and investment strategy is basically the same but the underlying fund structure is different.

Investment trust outperformance can be attributed to a number of factors.

Investment trusts can also take on debt (gearing), so they have extra money to invest, a tactic that works well in rising markets. If the long-term returns exceed the cost of borrowing, then NAV total returns are enhanced.

Because investment trusts do not have to meet investor redemptions like open-ended funds may have to, their managers can take a long-term view on investments, buying ones that will make superior returns over time but may be hard to buy and sell. This is a very important advantage, according to Mr Brierley. Open-ended fund managers may feel the need to buy investments that can easily be sold in case they need to meet redemptions.

Investment trusts have fewer restrictions on what they can invest in and how much they hold, although having a fairly concentrated portfolio can add to risk.

Investment trusts can also do share buy-backs when they are trading at discounts or share issues when they are trading at premiums, helping to boost NAV returns.

If a fund has a cheaper investment trust equivalent, it could be worth considering a switch as you could access the same manager and similar assets, but with fees eating into less of your returns. You may also be able to benefit from a discount to NAV on the investment trust, so you are effectively buying the assets cheaply. If a discount looks like it is going to tighten soon, then it could be a good time to get in, especially if you intend to hold the investment trust over the long term.

In some cases, the investment trust version of an open-ended fund may not be the best performer, so if you are thinking of changing from an open-ended fund you should research the whole sector the equivalent trust is categorised in to see if there is something better.

Reasons not to switch

You should not favour investment trusts over open-ended funds just on the basis of sector averages: you buy individual funds not averages, and there are open-ended funds which make much better returns than many investment trusts even after charges.

Investment trusts are not always cheaper than their open-ended equivalents so check the ongoing charge against the open-ended fund's total expense ratio (TER). Investment trusts in less mainstream sectors can be fairly expensive, although in these cases, such as private equity, there may be no open-ended equivalents.

If you buy an investment trust at a discount to NAV there is no guarantee the discount will tighten - and it could even widen. Ben Willis, head of research at Whitechurch Securities, says you should check to see if the investment trust has a discount control policy and what the trust's discount history is.

The time you take to disinvest from a fund, receive the proceeds and reinvest could take up to around 10 days, by which time the discount could have narrowed. That said, if it is still wider than its long-term average discount, it could still be worth switching.

If an investment trust is at a high premium, which looks like it does not have further to go, it could be a reason for buying the open-ended version of the fund rather than the trust. If you bought an investment trust at a discount and it has moved to a premium following good performance, it could be a good time to sell out and reinvest in the open-ended version of a fund.

And while taking on debt boosts returns when markets are rising, conversely, it compounds losses when markets are falling, so investing in a geared fund is riskier. Even if a trust is not currently geared, it could take on some debt in the future. Gearing potentially increases the volatility of investment trusts, which may already be more volatile because they are shares traded on markets. Mr Willis argues that investment trusts may not be suitable for lower-risk investors, or investors who do not have the time or wish to do in-depth research.

You also incur trading costs. Investment trusts are shares that are bought and sold on the stock exchange, so they incur broker fees and stamp duty. If using a platform, in some cases buying an open-ended fund can be cheaper if the initial charge is waived and you are buying a low-cost share class or getting a rebate. However, if you do not buy the open-ended fund from a platform, discount broker or adviser, you may have to pay an initial charge.

Also watch out for wide bid/offer spreads on investment trusts - the difference between the buying and selling price. This can widen, in particular with less traded smaller investment trusts in difficult markets.

You should also consider the tax position: if you do not hold your funds inside a wrapper such as an individual savings account (Isa) or self-invested personal pension (Sipp), and have used up your annual capital gains tax (CGT) allowance, currently £10,900, you may incur a charge upon disposal of a fund.

'Bed and breakfasting' - selling a holding and then buying it back the next day to rebase the cost with the aim of saving tax - is no longer permitted. However, 'bed and Isa' - where a fund or shares are sold to the value of the £10,600 limit, then re-purchased in an Isa - is permitted.

Danny Cox, head of financial planning at broker Hargreaves Lansdown, says: "You can keep the same holding or take the opportunity to switch to an investment trust. The bed part will be subject to CGT; however, this is usually below the CGT allowance and therefore not taxed. All future gains in the Isa will be tax-free with no further income tax to pay. If you bed and Sipp you also get tax relief on the amount paid in, subject to annual allowance limits."

Annualised over/under performance by investment trusts versus directly comparable open-ended fund over five years to 31 December 2012

Source: Canccord Genuity & *Morningstar

**Three years to 31 December 2012