From gearing to access to a wider range of sectors, investment trusts are in many ways superior to the open-ended structure, argues Tony Yarrow.
A closed-ended fund, or investment trust, is a limited company listed on the stockmarket. It has a corporate structure, with an independent board who appoint the fund manager. Its shares are traded on the stockmarket. Someone who wishes to invest, buys shares from an investor who wishes to sell, while someone who wishes to sell can do so only if there is a willing buyer.
This potential illiquidity, together with the investment trust’s more complex structure, may be the reason why the retail funds industry overwhelmingly prefers unit trusts. However, we believe that investment trusts are, in many ways, superior to the open-ended structure, and offer some of our reasons here.
The managers of an open-ended fund are at the mercy of investor demand. They have to invest money as it comes in, perhaps at the top of a market when there is nothing worth investing in. They may have to sell assets at the bottom of a market to raise cash to meet redemptions, at a time when they would rather use the cash to buy cheap shares. Investment trust managers don’t have this problem, as investment flows don’t pass through the fund.
This is a huge advantage in illiquid sectors such as property. Commercial buildings can take months to sell, so managers of open-ended funds need to hold substantial amounts of cash at all times to meet potential redemptions, which acts as a drag on performance.
Even so, the funds need to close to redemptions at times when redemption levels are running high, as in July 2016 following the EU referendum.
Control of fund size
Investment trusts grow either through good performance or by issuing shares, which managers will do only when their trusts are trading above the values of their assets and when they see opportunities in their markets.
Some of the most popular open-ended funds have grown so large as to limit their scope for active management, something that never happens in the investment trust universe, where very few funds grow to more than £1 billion in size.
The REIT structure
The Real Estate Investment Trust vehicle, available to investment trusts in the property sector, allows them to pay income without first deducting tax, an advantage not available to the managers of property unit trusts.
Most investment trusts have the authority to borrow money at the managers’ discretion, subject to prescribed limits.
Some of the managers who we use have consistently used gearing to great effect, borrowing money to buy assets at low prices, and paying down debt at times when asset prices are high.
The judicious use of gearing, unavailable to open-ended fund managers, can significantly improve returns. Most investors in the property space would agree that a modest level of gearing is appropriate and enhances returns.
Gearing is not accessible to investors in the open-ended universe.
Access to esoteric areas
Sectors that aren’t available to open-ended funds, include private equity, infrastructure and renewable energy. The private equity sector has grown rapidly in the past decade at the expense of the quoted sector.
Managers and investors alike prefer a more lightly regulated environment, a relatively lower media profile, and the freedom, where appropriate, to use a higher level of gearing than is currently thought prudent by investors in the quoted markets.
Access to the elite universe
Investment trusts offer access to excellent managers who don’t run open-ended funds. Some examples include Stuart Widdowson at Odyssean trust and Chris Mills of North Atlantic Smaller Companies trust.
The AVI Japan trust is another example. There are plenty of open-ended funds investing in Japan, but none that specifically invest in the corporate restructuring theme, as this closed-ended fund does.
Equity income trusts such as City of London and Temple Bar have built up income reserves over many years. At times of crisis, as during the financial crisis of 2007-09, the trusts will dip into their reserves to maintain dividends at previous levels.
Enhanced corporate structure
The corporate structure of investment trusts allows investors to vote on company proposals and resolutions.
Recent examples included voting against a resolution to demote an investment manager from a trust board. We believed that this resolution was inappropriate when the fund is managed overseas, but has a London-based board, and also because the manager is our main point of contact.
Another example occurred last year, when we voted against a decision to return cash to us in specie, in the form of some very illiquid US-listed stock.
Discounts and premiums
The prices of open-ended funds are made by the fund’s administrators and must reflect the market prices of their assets. Investment trust shares are traded in the open market and reflect supply and demand.
Sometimes, it is possible to buy investment trust shares significantly below their open market prices - when the trust is “at a discount”. Sometimes, at times of high demand, investment trust shares can trade above the market value of their assets - at a premium.
As fund managers, we aim to enhance our investors’ returns by buying investment trusts when they are trading at discounts and selling them at full value (known as “par”) or at premiums. This type of arbitrage is not available to investors in open-ended funds.
The best of both worlds
For investors who would like to benefit from the more nimble, flexible investment trust structure, there are multi-asset strategies that access both open-ended and closed ended vehicles – offering the best of both worlds.
Tony Yarrow manages the TB Wise Multi-Asset Growth fund.