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Comparing investment trusts with open-ended vehicles

19 Feb, 2024 | Return|

Open-ended investment vehicles and closed-ended vehicles have distinct structures. Neither structure is better than the other, but depending on the investor, one may be more appropriate when seeking to meet their ultimate objectives.

As Square Mile has now introduced investment trusts, a type of closed-end vehicle, to its Academy of Funds, it is important to understand how the two structures differ. For example, sometimes they can work in a strategy’s favour, whilst some nuances can potentially act as a drag on performance.

Our research process for investment trusts is the same as that applied to open-ended strategies, but with the structure’s additional elements also falling within the scope of our analysis. Here, we investigate those different elements from our research perspective so we can ultimately help advisers and fund selectors make better-informed decisions.

The basics

Before comparing the key differences between investment trusts and their open-ended vehicle peers, it’s a good idea to go over what exactly both are first.

Open-ended strategies: An open-ended vehicle is a collective investment scheme where investors can buy and sell shares or units directly from the fund at the current Net Asset Value (NAV) price. The fund’s managers continuously create and redeem shares to accommodate investor demand. Doing so provides liquidity and flexibility for investors to enter or exit the fund on a regular basis (normally once a day).

Closed-ended vehicles: An investment trust is a type of closed-ended investment vehicle with a fixed number of shares issued through an Initial Public Offering (IPO). Unlike open-ended funds, shares are traded on a stock exchange throughout the day, where their prices can fluctuate independently of the NAV of the strategy's underlying assets, creating discounts and premiums.

Key differences between closed and open-ended vehicles

Throughout Square Mile’s analysis, we appraise how the following eight differences, transpiring from the two structures, affect the running of a strategy and the potential impact on performance.

1. Management

As a publicly traded, limited company, an investment trust has a board of non-executive (independent) directors, which is responsible for governance and oversight of the strategy. They help ensure shareholders’ interests are protected and that the performance is in line with expectations. It, therefore, has the potential to be one of the greatest advantages of the investment trust structure. As such, Square Mile’s analysis takes a deep dive into the board with particular attention on its composition, its independence, its members’ skill set, experience and competence, its diversity, and its alignment with shareholders.

2. Pricing

As investment trust share prices can fluctuate while the stock exchange is open and may trade at a premium or discount to the strategy’s NAV, advisers and fund selectors must assess whether this benefits their client’s investment strategy over using an open-ended vehicle which will be priced based solely on its historic underlying NAV. From Square Mile’s point of view, analysts must also appraise the board’s efficacy when implementing price control measures which limit the volatility of the discount or premium.

3. Gearing

The investment trust structure allows for the potential deployment of gearing unlike their open-ended equivalents. Gearing can amplify both investment gains and losses and the income derived from the investments. More broadly, gearing is likely to increase the volatility of returns depending upon the magnitude of its use and the prevailing market conditions. The use of gearing and its impact upon returns and the additional risk that investors are potentially exposed to is considered within Square Mile’s expected outcome and our understanding for the trajectory of potential returns.

4. Investment Liquidity

Liquidity requirements for the underlying assets set open-ended and closed-ended strategies apart. Open-ended strategies may have to have enough cash set aside to meet redemption demands of its investors, rather than selling underlying assets which can potentially cause a cash drag on performance - an important factor to analyse as part of Square Mile’s investment process. In contrast, closed-ended strategies can invest in longer-term and potentially more illiquid assets because they do not need to accommodate investor redemptions on demand as open-ended strategies do, so they do not always have the same level of cash drag on performance.

5. Dealing

Open-ended strategies allow investors to purchase or redeem shares directly with the fund manager, usually on a daily basis. As a result, investors do not take on as much liquidity risk as with closed-ended strategies which cannot create or cancel shares on demand. Instead, as shares are bought and sold on a stock exchange there must be a buyer if an investor wants to exit their investment trust position. The result can cause the aforementioned variation in share price, relative to the strategy’s NAV.

6. Time horizon

Arguably, the structural differences between an investment trust and open-ended strategies mean investment trusts are better suited to holding illiquid and private assets. As a result, they can invest with a longer-term time horizon, which our analysts take into consideration when appraising a strategy’s ability to meet its targets. Generally speaking, investment trusts are able to invest with fewer liquidity constraints of their open-ended counterparts. It means fund managers within an investment trust can buy or sell only when they feel the time is right. They can also invest in a broader range of assets to take advantage of the fund manager’s best ideas.

7. Dividend

The treatment of income varies in open-ended and closed-ended vehicles. In open-ended strategies, 100% of the income generated by the strategy's underlying assets must be distributed to investors during each accounting period. In contrast, closed-ended strategies can retain up to 15% of income in each accounting period to smooth distributions by supplementing dividend payments from the revenue reserve when required. As a result, investment trusts are often associated with predictable, growing income, which is essential for Square Mile to evaluate on a strategy-by-strategy basis.

8. ESG

The growing use of Environmental, Social and Governance (ESG) factors in the investment process is of interest to a variety of investors and may enhance returns and, more importantly, to understand and manage risk. Square Mile analyses ESG integration at two levels, regardless of the vehicle type, for every strategy researched. At an asset manager level, how a business integrates ESG across its investment processes is assessed. How ESG is used by the individual manager(s) of a strategy is assessed too. Additionally, for the investment trust structure, the governance of the board is closely monitored.

The above distinctions between the two types of vehicles may materially affect their risk-reward profiles and, as such, are essential to understand so that advisers and fund selectors can pick the vehicle which most closely aligns with their client’s financial objectives and circumstances. By including these factors within Square Mile’s ongoing analysis, it is possible for our analysts to determine a level of conviction in a strategy’s ability to meet its stated objective and if it merits a rating - whether it’s a closed-end or an open-ended vehicle. In doing so, we provide exposure to a broader spectrum of investment opportunities so that advisers and fund selectors can make better informed decisions over suitable investment options on behalf of their clients.

Take a look at Square Mile’s rated Investment Trusts.


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