Proof that investment trusts turbocharge investor returns

Mirror funds: we examine research pitting the performance of funds against those investment trusts managed by the same fund manager or management team.

The cat is finally out of the bag. Increasing numbers of investors are warming to the virtues the investment trust sector has to offer. Formerly regarded as the City’s best-kept secret, investment trusts have enjoyed an unprecedented level of investor demand in recent years, with the sector’s assets jumping by £100 billion over the past six and a half years to pass the £200 billion milestone for the first time at the end of July.

Financial advisers have also been taking more of an interest, with figures from the Association of Investment Companies showing a fivefold increase since 2012, when new regulations banned advisers from pocketing commission on the open-ended funds they recommended, helping to level the advisory playing field for funds and trusts. In addition, the increased visibility of trusts on retail-focused investment platforms has helped stoke demand.

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Structural advantages

As Trust regularly highlights, investment trusts have certain structural advantages that set them apart from open-ended funds. Such features, when used effectively, give investment trusts an opportunity to gain an edge on open-ended funds, particularly during good times when markets are largely buoyant.

Research by investment platform AJ Bell hammers home the point. The firm crunched the 10-year performance data for fund managers who run both an open-ended fund and an investment trust using a similar strategy. In total AJ Bell identified 40 such ‘mirror’ portfolios, although as we explain below, some investment trusts have changed strategy and manager over the 10-year period.

All in all, though, the research is overwhelmingly positive for investment trusts, showing that the vehicle has successfully gained an edge over its open-ended fund cousins.

First, when it comes to performance, three-quarters of investment trusts outperformed their open-ended fund equivalent over the 10-year period examined, up to 21 June 2019. Not only do trusts tend to supercharge returns, but they are also on the whole cheaper, with 60% of trusts having a lower ongoing charges figure than their open-ended mirror fund. On average the 40 open-ended funds cost 0.97%, while investment trust charges stood at 0.91%. (See below for a brief run through on how investment trusts have won back their fee advantage in recent years.)

Developed market funds and trusts: how mirror portfolios compare

Click here to see larger version of table

Developed market funds and trusts: how mirror portfolios compare 600

Notes: Data is on a total return basis. All figures asides from discount analysis to 21 June 2019. Discount analysis carried out on 16 September 2019. Source: AIC/AJ Bell/FE Analytics

Trust in long-term closed-ended benefits

James Carthew, founder and head of investment company research at Marten & Co, says the data underlines the fact that those who are prepared to invest for the long term – five years at a bare minimum – should always select the investment trust version over the open-ended fund. He adds that he would even overlook a small premium in some instances (see box for our analysis of investment trust discounts and premiums for the 40 pair portfolios).

“The structural advantages come down to gearing (borrowing to invest) – although in most cases the proportion of gearing is actually not that large .

Other benefits include the lack of cash drag, as you don’t have to keep cash in reserve to fund unexpected redemptions; and the ability not to worry so much about the liquidity of your portfolio – investment trust managers have greater freedom to hold smaller small companies, for instance, so they can look-through temporary dips in profitability,” says Carthew.

In some cases, the performance difference is stark. The table lists developed market funds and trusts run by the same fund manager, showing that investment trust outperformance is particularly prevalent in investment trusts that have bias to or invest exclu- sively in smaller companies.

Examples include Henderson Smaller Companies IT outperforming Janus Henderson UK Smaller Companies by 162%. Both are managed by Neil Hermon.

In a similar ilk, JPMorgan Smaller Companies IT has outperformed the open-ended JPM UK Smaller Companies by 95.4%, Standard Life UK Smaller Companies IT has outperformed the open-ended Standard Life Investments UK Smaller Companies by 83.4%, while Fidelity Special Values IT has delivered excess returns of 80.7% versus its open-ended equivalent fund Fidelity Special Situations. The investment trust structure allows fund managers to invest in more illiquid names, meaning there’s greater freedom to invest in even the smallest of smaller companies.

But the developed market invest- ment trust with the most noteworthy level of outperformance is Jupiter European Opportunities IT, which over the 10-year period in question outperformed Jupiter European by a staggering 203.9%.Therefore, it comes as no surprise that the investment trust’s board has opted to retain the services of manager Alexander Darwall to continue running the portfolio at his new fund firm – Devon Equity Management.

In terms of the investment trust laggards in the table, three of the five developed market trust mirror versions underperformed their open-ended counterparts and carried a higher fee.

In two cases performance was close, meaning that higher fees came into play: BMO Multi-Manager Investment Trust underperformed BMO Managed Portfolio Growth by 8.6% and Jupiter UK Growth IT lagged the open-ended Jupiter UK Growth by 7.2%. In the case of Baillie Gifford Global Discovery versus Edinburgh Worldwide IT, the 64.5% out-performance of the open-ended fund was too substantial to be influenced by the higher charges of the investment trust.

In the second table, the majority of Japan, Asia and emerging market-focused mirror portfolios saw the investment trusts – Aberdeen Japan, Aberdeen Standard Asia FocusAberdeen New DawnBaillie Gifford Japan, Baillie Gifford Shin Nippon and JPMorgan Japanese – gain the upper hand over the open-ended fund version.

But for a couple of the more specialist strategies it was the open-ended fund that came up trumps: Aberdeen Global Indian equity edging out Aberdeen New India by 14.7%, and BGF Latin America– outperforming BlackRock Latin America – by 14.4%.

Bear in mind, though, that with some of the 40 pair examples the investment trusts hasn’t been following the same strategy for the full 10 years. According to Carthew those that should arguably be discounted are: Aberdeen JapanEdinburgh WorldwidePacific Horizon and Jupiter UK Growth.

Some pairs have more overlap than others

Also take into consideration that some of these mirror portfolios have more overlap in terms of their holdings than others. Laura Suter, personal finance analyst at AJ Bell, says: “One of the more famous dual managers is Nick Train, who runs both the £7.1 billion Lindsell Train UK Equity fund and the £1.8 billion Finsbury Growth & Income trust. The fees on the funds are almost identical (as are the top 10 holdings), but the trust’s performance has outstripped the fund, returning 498.6% over 10 years compared to 432.8% for the fund. However, over time the trust has been slightly more volatile, likely due to the gearing that the trust has, which is currently low at 1.2%.”

Darius McDermott, managing director of FundCalibre, further stresses the importance of “looking under the bonnet”. He adds: “Although the process for these pairs may be the same, the portfolios can be different. Jupiter European Opportunities trust, for example, includes UK investments and is more concentrated in fewer stocks than the fund. Also, it can, and does, take bigger stakes in individual holdings – its largest holding is often over 10%, which is not possible in the fund. So it is higher up the risk scale. Likewise, the Baillie Gifford Japan trust is more concentrated than the open-ended Baillie Gifford Japanese fund and also invests in more mid- and small-sized companies.”

Overall the trade-off is that investment trusts are generally riskier than their open-ended equivalents, typically displaying higher levels of volatility. This is broadly down to two things:
the ability to gear, and discount moves. Against this, if discount moves are positive for investors, this helps boost share price total returns.

Asia, emerging market and specialist funds and trusts: head to head

Click here to see larger version of table

Asia, emerging market and specialist funds and trusts: head to head 600

Notes: Data is on a total return basis. All figures asides from discount analysis to 21 June 2019. Discount analysis carried out on 16 September 2019. Source: AIC/AJ Bell/FE Analytics

Shifting gearing

Suter adds: “Investors don’t get this extra performance for free and they have to be prepared for a bumpier ride. When investment trusts are doing well, the ability to gear can supersize returns, but when their investments are falling, these losses could be amplified.”

Nonetheless, in the case of Troy Income & Growth IT, which has never used gearing in the 10 years since Francis Brooke took over the portfolio, the trust has still managed to beat the open-ended fund mirror version Troy Trojan Income more than comfortably, by 87.4%.The majority of other income-focused investment trusts produced superior performance compared to the open-ended mirror fund, the only three exceptions being Aberdeen Standard Equity Income IT and Henderson Far East Income IT and IP Select Global Equity Income.

In addition, dividend growth consistency is another big tick in the box for investment trusts. Research earlier this year by Fundexpert found that just two open-ended UK equity income funds have grown their dividends every year over the past decade: BlackRock UK Income and Troy Trojan Income.

But as revealed in the September issue of Money Observer, the stellar run in growing the Troy Trojan Income fund’s dividend is quite likely to come to an end in 2019, as Brooke has moved the fund into a more defensive gear. Troy Income & Growth Trust has revenue reserves equal to 0.73 years to draw on, so it has greater freedom to pay a rising level of income.

A final thought, as we head into a potentially trickier period for equity markets: does the lower volatility of open-ended funds strengthen their appeal? According to McDermott, investment trusts with a high level of gearing could be caught out if markets become more volatile. “During trickier times – or falling markets – you would expect the open-ended fund version to do better in the short term, as the reverse is true: they cannot gear.”

Plenty of tools in the trust armoury

That said, for a long-term investor, such short-term fluctuations do not matter in the great scheme of things, and when it comes to investment trusts the fund manager has plenty of tools in the armoury to draw on to deliver performance above and beyond an open-ended fund, which frankly are more limited in terms of their structure.

It should not therefore come as a surprise that on the whole, based on conversations Money Observer has had over the years, managers who run both an open-ended fund and an investment trust prefer to run the latter – with the fixed pool of assets providing managers with the freedom to focus on stock-picking without the distracting noise created by investor withdrawals.

Investment trusts win back fee advantage

One of the often-cited advantages has been that investment trusts, on the whole, are cheaper than open-ended funds. This is no longer necessarily the case, due to rules introduced nearly seven years ago which banned commission payments for financial advice and resulted in a proliferation of commission-free ‘clean’ share classes for open-ended funds. Some fund managers took the opportunity to reduce their charges, which is why some open-ended funds now have lower charges than those of similar investment trusts.

As Winterflood, the investment trust broker, notes: “The advantage of lower fees that the investment trust sector had historically benefited from was significantly eroded.”

In response, over the past couple of years investment trust boards have put pressure on fund management groups to reduce fees. In 2017, 36 investment trust companies made changes to their management fee arrangements. A further 43 made tweaks last year. The majority of trusts that have made changes have moved to a tiered fee structure, under which the charges paid by investors decline progressively as the trust becomes bigger, passing on economies of scale.

Winterflood noted in its 2019 annual report that the “wholesale review of management fees over the last few years has undoubtedly been positive for shareholders and has ensured that investment trusts remain highlight competitive.”

It added: “Fund management groups may take a different view, but at least the fee cuts have been accompanied by a growth in assets.”

Investment trust discount opportunities in short supply

Traffic-light system

Red: as a general rule avoid buying investment trusts on premiums of 5% plus

Yellow: small premium of less than 5% generally still worth paying, particularly in the case of investment trusts that pay dividends

Green: investment trust bargain occurs when an investment trust is trading at a notably wider discount than its 12-month average discount figure. Consider what the catalyst will be for the discount to narrow.

The past decade has been a good environment for investors to make money in equity markets, pretty much wherever they have chosen to invest. But, as a result, bargains are now much harder to find, and in the case of investment trusts discount opportunities have been drying up.

On moneyobserver.com, for a couple of years now we have been drawing attention to investment trust bargain opportunities, comparing current trust discounts with their 12-month average discount figure. The reason we stick to this ‘rule’ is because some trusts consistently sit in a tight discount range, meaning it is not a ‘true’ bargain and the discount is merely ‘normal’.

Most of the 40 pair trusts are on a discount, but in mid-September only 11 were trading on a wider discount than the 12-month average. Two standout bargains at the time of writing were Pacific Horizon and Aberdeen Standard Equity Income.

Pacific Horizon is trading on a discount of 7.6% versus a 12-month average discount figure of 0.6%. Its short-term performance trails the AIC Asia Pacific sector; over the past six months the trust has lost 6.3% versus 1.7%, which is one reason why the discount has widened. Another reason is investor sentiment, which has taken a knock over the past 18 months or so as the US-China trade war rumbles on.

In the case of Aberdeen Standard Equity Income it is a similar story, in that performance has been disappointing. Over three and five years, the trust lags the AIC UK equity income sector average, but it has even more notable over the past year, losing 14.8% against 3.6%. In addition, the UK market is currently ‘unloved’ by both domestic and international investors, who are on the whole adopting a wait and see stance to the never-ending Brexit saga.

Investors who have stayed on the UK sidelines this year have missed out: the FTSE 100 index has returned 11.4% up to 7 October, including dividends. This represents a decent result for investors who focus on fundamentals – and on that front UK shares are cheap compared to history. In mid-September Aberdeen Standard Equity Income was trading on a discount of 7.4% versus its 12-month average discount figure of 2.5%. Manager Thomas Moore is well-respected by fund analysts, but time will tell whether performance can be turned around.

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