Widely cited study showing investment trust superiority abandoned

Due to a lack of data, a popular study showing that closed-ended investment trusts provide better performance has been shelved. 

Funds and Investment Trusts January 23, 2020 by Tom Bailey

A popular study showing that closed-ended investment trusts provide better performance than open-ended investment funds has been shelved, owing to issues with data.

The initial study was released by two academics from the respected Cass Business School in 2018, showing that trusts average around 0.8% greater returns (using NAV) than their open-ended equivalents.

The ability of investment trusts to provide superior performance to their open-ended equivalents is something many have long believed, with the investment trust structure said to have certain benefits.

The study seemed to confirm this belief. While 0.8% per year outperformance may appear modest, compounded over several years it would start to add up for investors.

To ensure the comparison was fair, the researchers attempted to control for several factors such as the sectoral composition of the trust industry, the typical risk profile of investment trusts, the ability of trusts to buy shares back at a discount and their ability to amplify returns through gearing.

Initially, however, the better performance was believed to come principally from trusts having a fixed pool of capital. Unlike open-ended funds, investment trusts do not have to buy at market peaks to meet investor demand or sell in market drawdowns to cover redemptions.

Professor Andrew Clare, one of the Cass Business School researchers, commented at the time: “We were quite surprised to find such a difference. Our results suggest that the structure of an investment trust, where the manager does not have to contend with constant inflows and outflows, may have led to better or more efficient investment decisions.”

A final version of the study, however, has now been abandoned owing to a lack of comparable data.

To ensure a fair comparison, the researchers had to remove closed-ended trusts that were not wholly invested in publicly listed equities. This left them with a sample of just 134, in contrast to the thousands of open-ended funds available to compare.

The problem with this, says Dr Simon Hayley, a senior lecturer in finance and one of the researchers involved in the project, was that with such a limited dataset, they could not control for all the factors needed in order to separate genuine outperformance from other factors. And as their research progressed, the number of factors affecting the results increased.

Hayley says: “The further you get into the process, the more you find stuff to correct for. You find all these other factors to control for. We cannot distinguish the different reasons for performance. There’s so much more that might be going on.”

One example Hayley gives is the greater likelihood of closed-ended trusts being invested in mid-cap stocks, compared with open-ended funds.

He says: “One key factor is that mid-cap outperformed massively. Could that explain everything going on? The average closed-ended fund holds slightly smaller stocks. Perhaps they were in the right place at the right time. It would be unfair to say that is outperformance [of the closed-ended structure].”

The researchers concluded that there are too few closed-ended funds that can be fairly compared to open-ended funds, given the large number of variables that could be skewing results. “We decided we really don’t have enough data,” says Hayley.

In a press release, the researchers noted: “We have useful data on [only] a relatively modest number of (very diverse) closed-ended funds, and this turned out not to be enough to give reliable answers. This is frustrating, but good science requires an acceptance of the limits of what can be established with the available data.”

Does this mean that the closed-ended structure is not, after all, superior to the open-ended structure?

Jonathan Davis, in his Investment Trusts Handbook 2020, notes: “[The cessation of the study] doesn’t invalidate the belief that investment trusts tend to outperform open-ended funds with similar mandates… but nor does it provide the clinching evidence that would have given the belief a stamp of academic endorsement.”

Other data also purport to show that investment trusts can often provide better performance. For example, data recently released by AJ Bell shows that over the past 10 years, three out of four investment trusts beat the open-ended versions run by the same manager.

However, unlike the Cass Business School study, AJ Bell did not control for factors such as gearing or the ability to buyback shares at a discount.

Indeed, Laura Suter, personal finance analyst at AJ Bell, notes: “A big factor in some trusts’ outperformance is their ability to use gearing or borrowing.”

Nor are the many other potential variables noted by the Cass Business School study accounted for, meaning that outperformance could be the result of other features of investment trusts, rather than just the closed-ended structure itself.

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