Join our community of smart investors

IT geek: investment trusts are not always best

There are times when other types of fund are better
May 24, 2018

If you read this column you are probably a fan of investment trusts, in which case you're not going to like what you read next. But like it or not, there are instances when an investment trust is not the best option, and stubbornly holding one instead of whatever is better will probably be detrimental to your investment returns.

Fund managers sometimes run both a closed-ended investment trust and an open-ended version. If the open-ended fund has a meaningfully lower charge, and the total cost of purchasing and holding the open-ended fund on the investment platform you use is still less than buying the investment trust, you are better off accessing that manager via the lower-charging open-ended fund. I can't generalise about total costs because investment platforms charge differently to each other, so check carefully to see how your platform charges affect the overall cost. See Platforms vs share schemes: the best way to buy an investment trust for more on this. So for the purposes of this commentary I will just look at charges at fund level.

For example, Baillie Gifford Japanese (GB0006011133) run by Matthew Brett has an ongoing charge of 0.63 per cent against 0.78 per cent for Baillie Gifford Japan Trust (BGFD).

Janus Henderson European Focus (GB00B54J0L85) run by John Bennet has an ongoing charge of 0.85 per cent against 0.87 per cent for Henderson European Focus Trust (HEFT). This is not a great difference, but Henderson European Focus can charge a performance fee, and when this is triggered the difference can be substantial. It did not trigger its performance fee for its financial years to 30 September 2017 or 30 September 2016, but if its performance gets better it will kick in again.

Jupiter European Opportunities Trust (JEO) run by Alexander Darwall also seems to have a reasonable ongoing charge of 0.99 per cent relative to Jupiter European Fund's (GB00B5STJW84) 1.03 per cent. But when Jupiter European Opportunities' performance fee is triggered the charge can be a lot higher. When we dropped this investment trust from the IC Top 100 Funds in 2016 in favour of Jupiter European, it had an ongoing charge plus performance fee of 3.92 per cent against the open-ended fund's ongoing charge of 1.03 per cent. And in Jupiter European Opportunities' last annual report its board staunchly defended the performance fee so it doesn't look as though it will be scrapped any time soon.

Always check whether an investment trust has a performance fee. Even if it is not currently levying it, an unactivated performance fee is a dormant threat to your returns because if performance improves, sooner or later your charges will rise.

You might argue that an investment trust can use gearing (take on debt) to enhance returns, so it's worth paying more. Gearing may not enhance performance, but charges most definitely detract from returns. If a manager gets their selection wrong or markets are falling a trust with gearing will experience bigger losses than a similar fund without. "Gearing can enhance returns in rising markets, but is an additional source of risk," warns Jason Hollands, managing director at Tilney Group. "Be very wary of highly geared vehicles."

Also, it is not mandatory for investment trusts to be geared – a number of them at times don't have any. So check this, and don't invest in the more expensive investment trust version of a fund in the hope that gearing will get it higher returns than its open-ended equivalent, when it doesn't have any.

If an investment trust does have gearing look at what it is paying for its debt. Even if its managers get their calls right and markets go up, if a trust is servicing expensive debt the costs will eat into returns, so it might not do better than ungeared funds investing in the same area.

If an investment trust is trading at a high premium to net asset value (NAV) it often doesn't make sense to buy it. Even if it seems like a very reliable or solid proposition a number of things could make its share price and premium to NAV come down. "This is particularly the case in the current market environment with yield-based investments," says Mr Hollands. "If you assume that over time you will get mean reversion the trust's rating should move down to nearer NAV." See IT geek in the issue of 27 April for more on this

When you are looking for alternative options, if there is an open-ended fund run by the same manager, via the same strategy, for a reasonable cost also making strong returns, this could be a particularly good substitute.

For example, we include Lindsell Train Global Equity Fund (IE00BJSPMJ28) with an ongoing charge of 0.55 per cent in our IC Top 100 Funds, rather than Lindsell Train Investment Trust (LTI), which trades on an excessive premium to NAV of around 42 per cent. It also had an excessive ongoing charge plus performance fee of 3.6 per cent at the end of its last financial year.

Baillie Gifford Shin Nippon (BGS) has an ongoing charge of 0.89 per cent and is on a premium to NAV of about 7 per cent due to its good performance, which is likely to continue, says Mick Gilligan, head of research at broker Killik & Co. But open-ended Baillie Gifford Japanese Smaller Companies (GB0006014921) is run by the same managers – Praveen Kumar and Felicia Hjertman – and has very similar holdings. It also has a lower ongoing charge of 0.63 per cent.

Investment trusts don't provide adequate access to some types of assets such as bonds, physical commodities and US equities, something I will look at in more detail in a future column.

And investment trusts may not be suitable if you do not like to see the value of your investments moving around on the back of sentiment. In this case, you might prefer an unlisted fund that while far from risk-free has a unit price that reflects the value of its underlying assets. And you wouldn't have to worry about wild swings to premiums or discounts to NAV.

In the right circumstances investment trusts that fit the bill – specifically your individual requirements – can be great. But they aren't always the right option, so it would be unwise to hold an investment trust when there's something better.