Investment trusts are sometimes put forward as a superior investment structure since they can provide stronger performances over open ended funds. I am far from sure that this is always the case. This article looks at whether trusts are better than open ended funds by considering the importance of the underlying investment strategy, the impact of costs, how investors can misapprehend the apparent advantages of gearing and stable income generation offered by trusts, and how exposure to illiquid investments can give trusts an advantage over funds.
It is scarcely a profound notion that fund returns are determined by the choice of investment strategy rather than the fund structure, though reading some commentary written about funds and you often wonder. To put this in simpler terms, the fund structure is nothing more than a bucket or container, designed to safeguard the rights and interests of the investor. It makes very little difference to the returns if an investment strategy is applied in an OEIC, SICAV, ETF or investment trust structure. The pricing of investment trusts can cause complications and it is possible to access assets at a discount to NAV but do not forget that if one investor is buying on a discount, another is forced to sell at a discount.
Gearing is sometimes put forward as an advantage for investment trusts as this will enhance returns if equity markets outperform the borrowing costs. However, every private client that I have ever dealt with has had their affairs structured in a manner to reduce equity risks. Invariably this is done through taking long positions in cash and bonds. However, geared trusts must be structurally short either cash or bonds. Geared investment trusts push clients' asset allocation askew and using geared investment trusts makes little sense in clients' balanced portfolios.
Costs are one factor that may impact the returns depending on the fund structure. Investment trusts used to have a cost advantage over open ended funds, but since RDR the playing field has more than levelled. Looking at the All Companies sector both of the AI (using clean share classes on the Zurich platform) and AIC, there is now a slight cost advantage for open ended funds over closed ended funds, 0.89% versus 1.01%. Evidently, investment trusts are no longer universally cheaper although there are some long established trusts that have charges well below the average. One example would be the Temple Bar Investment Trust.
The total charges of the Temple Bar Investment Trust are 0.48%. The open ended Investec UK Special Situations fund is run by the same manager following a very similar investment strategy with charges of 0.85%. However, the Investec UK Special Situations fund is a single priced OEIC which can be bought and sold at NAV. In contrast the bid/offer spread on Temple Bar is 0.66%, stamp duty is levied at 0.5% on purchases and stockbroker commission will also be payable. Therefore, it would take a holding period of at last three years before Temple Bar becomes the cheaper option. The attached chart demonstrates that the overall investor experience has been little different whether investing in the open ended fund, the trust NAV without gearing or the total return from holding the trust itself.
Some trusts have built substantial revenue reserves that have been accumulated over many years. These reserves can be used to bolster income during fallow years and thereby provide investors with a consistent income. We believe that this should be of little interest for most investors. This is purely an artificial accounting device and investors are kidding themselves that this constitutes a 'genuine' income. We see no difference between an investment trust that provides a 2% natural income and a 2% income funded from revenue reserves, and a total return approach where a 4% distribution is made through a combination of income and capital.
Where we think investment trusts have an edge is their ability to hold potentially illiquid instruments. Illiquid assets can be a source of excess returns and this illiquidity premium can be seen as a form of compensation for denying investors access to their capital. Since shares in trusts can be bought and sold, trusts investing in illiquid assets can provide investors a route to exploit this illiquidity premium yet allow investors to retain the ability to exit the investment at any time, albeit not always at NAV. We like this aspect of trusts but the approach is not without issues:
• Discounts can become very wide in trusts following these types of strategies
• By their nature illiquid assets are difficult to value accurately and discounts can persist for extended periods.
• The illiquid nature of the underlying assets can make it difficult to orchestrate a share buy back scheme to manage the discount.
• Illiquid investments are often esoteric in nature and requires specialist knowledge by the adviser to comprehend fully the risks of the specific strategy.
So in conclusion, we believe that the advantages offered by an investment trusts are either overstated or illusory. However, trusts can offer distinct benefits to more sophisticated investors seeking specialist opportunities.
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