Charles Stanley’s Stephen Peters considers the pros and cons of selecting two very different investment styles and their potential performance
Closed-ended funds are said to be ‘better’ than open-ended funds for a variety of reasons. They include:
- Lower fees;
- Better performance;
- Better management;
- Fees more aligned with shareholder interest;
- Semi-permanent capital structure allows more illiquid strategies to be used.
These claims are usually countered by criticisms investment trusts are illiquid, higher-risk vehicles with a limited choice of funds and several major sectors and asset classes with little to no coverage. In contrast, there are a large number of open-ended funds in most sectors, and units can be bought or sold with relative ease.
We analysed data relating to the first two points (table one), as well as looking at the provision of income. We looked at seven equity sectors – country, regional and global. Due to the absence of a sector of a closed-ended US equities sector of meaningful size, that market was excluded. We focused on sector ‘average’ performance, weighted by the market capitalisation or quantity of assets of each of the funds. While this methodology has obvious disadvantages, as peer group benchmarks are only a representative guide of the performance of the underlying trusts within them, which we fully accept, it is relatively easy to understand.
Fees
There are a variety of fees that can be charged by both open-ended and closed-ended funds. These range from the obvious, such as annual management charges, to the more opaque, such as auditors or directors fees, custodial charges etc. Therefore a simple comparison of the Total Expense Ratio (TER) is the best way of comparing the two fund types.
Of the seven sectors shown in table two, investment trusts and companies are cheaper in six. The biggest difference is in the UK Income and Growth, Global Growth and Global Emerging Market sectors, with the closed-ended Global Emerging Market sector showing a TER of half of that offered by open-ended funds.
Size
A very valid criticism of closed-ended funds is they are often illiquid and hard to deal in. It can take days to buy a position that can be bought with ease within an open-ended fund. Table two compares fund size across the two investment universes.
We do not claim that size of market capitalisation equates directly to an ability to deal in the size you want, but the data stacks up well for Global Growth and Global Emerging Markets within the closed-ended fund market. Both are substantially larger than their closed-ended counterparts. It is worth noting here that the Templeton Emerging Markets Investment Trust has around £1.7bn of total sector assets, almost three times the average size of the other trusts in its peer group, which has a major influence on the data.
Yield
For clients interested in yield, closed-ended funds have some notable advantages over their open-ended counterparts. This is clearly shown in table four.
Here, closed-ended funds achieve a clean sweep. For yield purposes, the best option in all cases is to buy a closed-ended fund. Due to the structure of the closed-ended fund and its ability to use its revenue reserve to assist in paying a smoothed dividend over time, investment trusts remain a better option for those wanting regional equity exposure with a higher yield.
Volatility
Due to the geared nature of many closed-ended funds, it would be expected the performance of closed-ended funds is more volatile than their open-ended equivalents, as illustrated in table four.
As might be expected, investment trusts do show a more volatile return stream, especially when compared to their open-ended equivalents in the UK and Japan. This, we believe, is a function of the gearing inherent in many trusts. In many cases, the share price volatility is higher for investment trusts, demonstrating the effect of the movement in discounts on closed-end fund prices.
Performance
It is clear investment trusts offer many advantages over their open-ended fund competitors, although for many, factors relating to liquidity and discounts will prevent them from buying a closed-ended fund. However, is performance from the closed-ended fund sector better than open-ended equivalents?
We analysed the performance of the same sectors as used in table five over the short, medium and long term. For the closed-ended fund world, we looked at performance at both the NAV and the share price level.
We fully appreciate that simply comparing sector returns can be misleading, and risks misrepresenting individual sectors and asset classes. We also appreciate the role of shorter-term trading strategies such as selling trusts when at a premium and buying a similar open-ended fund is not discussed. However, investment trusts are ideal vehicles for very long-term investors with either a willingness to take risk, in our opinion, or those that have a bias towards requiring income – something the analysis produced in the tables supports.
Strengths
The strengths of investment trusts are best shown within the Global, European and Global Emerging Markets, and UK Small-Cap sectors. In all these cases, closed-ended funds have shown significantly better relative performance than their open-ended cousins over a 10-year period. However, it can be shown that gearing has a positive and negative effect on returns, just by looking at closed-ended Japanese performance.
There are currently only five Japanese investment trusts, and so the available universe is quite limited to investors compared to the open-ended sector. The volatility produced by closed-ended Japanese equity managers is far higher than that of open-ended peers, suggesting that risk-adjusted returns are extremely poor. Within UK equities, returns are better in the investment trust sector, although being geared within 2009 has improved returns greatly. UK Growth is a varied closed-ended fund sector, helped markedly in the last year with its large mid- and small-cap bias. It must be said the case for investment trusts in general was much less positive when we ran this analysis in the middle of 2009.
Which is better?
There will be fans of open- and closed-ended fund sectors, and both have extremely valid reasons for their views. The answer to the question ‘which is better?’ will be different for different investors, but we hope this article provides some food for thought.
Stephen Peters, investment trust analyst, Charles Stanley
