Even after the introduction of the Retail Distribution Review (RDR) at the start of the year, our research highlighted that the majority of investors are still put off by the idea of using closed-ended funds.
Many worry about the complexities of the products, but experts say that using investment trusts can boost both an investor’s capital growth and income. With that in mind, we look at the five most important points about closed-ended funds and how they differ from their open-ended rivals.
Discounts and premiums
Investment trusts are listed entities that trade on the stock market, so instead of buying units that you can redeem (as you can with OEICs and unit trusts) you are actually buying shares that trade on an exchange.
This brings us to the first difference, which is that investors can buy a trust on a discount or premium to its net asset value (NAV).
For example, if a trust’s NAV is £100 and you were to buy it on a 10 per cent discount, you would be buying those shares for £90.
That can be a major benefit, because if the sentiment towards the trust’s shares improves, the discount can narrow and boost your returns.
On the downside, if the NAV performs poorly and people want to sell their stake, your losses would be magnified because that discount could widen.
This can seem an alarming prospect, but the boards of investment trusts generally try to keep a lid on the discount volatility in order to protect shareholders.
Some will not allow their trust to move outside a certain range, while others will take a more ad hoc approach.
These are sometimes referred to as discount control mechanisms [DCMs] and are often used by larger, more liquid trusts to make them more attractive to retail investors.
These work by issuing more shares if the trust is trading on wide a premium – which changes the supply/demand dynamic – or they can simply buy back shares and shrink the trust if it is trading on a wide discount.
Robin Keyte, of Keyte Chartered Financial Planners, says discounts are vital to whether he advises his clients on whether to buy an investment trust, as although a narrowing discount is down to market sentiment, it can provide a very welcome boost to returns.
Gearing
Like discount volatility, gearing, or borrowing, is another major difference between open- and closed-ended funds, and just like discount volatility, it can both help and hinder investors.
Investment trust managers can borrow money to invest more, intending to make a greater return on the borrowed funds than the cost of borrowing.
It can also really hurt performance as well, however. There have been many instances in the past where a manager has geared up at the wrong time and so not only have their underlying holdings fallen in value, but they have been left with a huge amount of money to pay back, further eating into returns.
The closed-ended fund’s level of gearing can often be a good barometer for its manager’s attitude to the market: the higher their leverage, the more bullish they usually are. However, it also warns investors how risky a trust can be.
Keyte says this is something investors do need to keep an eye on with investment trusts.
“If a trust is highly geared, it generally makes us nervous,” he said. “We are usually reticent to use them for our normal clients, but if a trust is mildly geared – say 10 per cent – that can give you a nice kick to your return like a wide discount can in a rising market.”
“Ideally however, you want a manager who is closely monitoring their level of gearing in an uncertain market.”
Nevertheless, managers of investment trusts are by no-means forced to use gearing and therefore a number of them do not borrow at all.
Dividend smoothing
Investment trusts can be very useful for income-seeking investors as closed-ended funds are able to smooth their dividends, as Oriel Securities’ Alex Cass explains.
“In order for funds to meet the UCITS [or open-ended] compliance, they have to pay out 100 per cent of their income each year. Investment trusts, on the other hand, only have to pay out 85 per cent,” Cass said.
That means they can build up their revenues in good years so that in future, possibly more difficult years, they can continue to pay out a steady income,” he added.
Dividend smoothing has allowed some investment trusts to consistently increase their dividend over a very long period of time. For instance, the City of London IT, Bankers IT and Alliance Trust have all increased their dividend over each of the past 46 years.
Cass says that in order for trusts like these to do this, they will tend to increase their dividend by a small amount each year, just ahead of inflation for example.
Specialist investments
Due to the closed-ended nature of investment trusts, it can mean they can gain access to more specialist, less liquid areas of the market that are out of reach of their open-ended rivals.
“Investment trust companies can offer attractive access to the more illiquid asset classes,” Winterflood’s Simon Elliott said.
Investors in open-ended funds buy units instead of shares: every time they sell, the managers need to find the money to pay them back, either from the small amount of cash they keep on hand or by selling their holdings.
Therefore, if investors are to pull their money out en masse, managers may be forced to sell their holdings at a knock-down price.
Elliott highlights a number of illiquid asset classes where investment trusts have the upper hand.
“One example is direct property. Although there are open-ended direct property funds, we believe that investment trusts are more suitable vehicles as fund managers do not have to deal with immediate redemptions.”
“It is a similar situation with private equity. The underlying assets tend to be unquoted stakes, often in large companies, that may take several years to realise. It would be impossible to access the asset class through an open-ended structure that offered regular liquidity.”
While Elliott sees direct property and private equity as the two traditional asset classes most suited to the structure of investment trusts, infrastructure trusts are also very popular because of their income generation.
“Infrastructure is an asset class that is well suited to closed-ended funds. Many infrastructure funds invest in PPP contracts, which can last for 25 years. It would be difficult to offer regular redemptions due to the illiquidity of the underlying assets,” he added.
Lower costs?
Keyte says that one of the main draws of investment trusts is they can give investors lower-cost exposure to an asset class.
That is certainly the case in some areas. For instance, Alex Crooke’s Bankers IT has ongoing charges of 0.44 per cent.
With holdings such as Vodafone, GlaxoSmithKline and HSBC, it offers similar exposure to most funds in the IMA UK Equity Income or IMA Global Equity Income sectors.
However, its charges are much lower than for open-ended funds – the ongoing charges figures (OCF) for these tend to be between 1.5 and 1.75 per cent.
There are plenty of other examples across the AIC universe where that is also the case.
However, some trusts (such as funds of course) use performance fees, which can narrow the cost gap between them and their open-ended rivals.
The new change to advice regulation has also made investing in open-ended funds less pricey.
Recently Gavin Haynes, managing director at Whitechurch, told FE Trustnet that the introduction of RDR has started to distort the traditional view that investment trusts are always cheaper than OEICs and unit trusts.
"Before, there was a very strong argument that investment trusts were the cheaper way to get active management, but the removal of adviser commission has levelled the playing field."
"Now you can buy funds on platforms for as little as 1 per cent," Haynes added.
