If you want to beat the market, you can’t ignore these funds

published 24 July 2012

It's very unusual to find an open-and-shut case in the world of finance.

Investing is simple in principle, but hard in execution. For every rule, there's an exception. History might rhyme, but it never repeats. And those in the industry are very good at fudging the statistics to argue their case when they want to.

So on those rare occasions when you do find a sure thing (or as close as it gets), you should grab hold of it with both hands.

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I've got one such investment rule to share with you right now. It involves a shamefully under-exposed area of the market that deserves to be a lot more popular than it is

These funds don't deserve to be neglected

When the average investor considers investing in the stock market, they tend to stick their money in a fund. And when they consider which fund to buy, they normally end up going with a unit trust. That's either because it's the first thing they've seen advertised, or because their financial adviser (IFA) has recommended it to them.

But as always with investing, it's a mistake to plunge right in without considering the alternatives. There's another type of fund that has an incredibly strong, consistent track record of beating both unit trusts and the broader market over the long run.

Indeed, on average, reports broker Cannacord Genuity, over the last ten years, funds of this type beat their open-ended rivals by 1.93% a year. More importantly, they also beat their benchmarks the market, in other words by 1.35% a year.

It's an extremely consistent performance too. In 11 of 14 sectors examined by Cannacord, these funds came out on top over ten years. In the North America and UK small cap sectors, they failed to beat their benchmarks, but still beat unit trusts. Only in the North American small cap field did they fail to beat unit trusts.

We're talking about investment trusts.

What are investment trusts?

In short, investment trusts are stock-exchange listed companies whose business is to invest in other companies. They issue shares just like any other company, and investors buy those shares on the stock market.

This means that the share price moves independently of the underlying portfolio value (the net asset value or NAV). So sometimes the share price trades at a premium to NAV (above the value of the portfolio). And sometimes it trades at a discount (meaning that sometimes you can get £1 worth of assets for 90p, for example).

The price of a unit trust, on the other hand, directly reflects the underlying portfolio.

Clearly, the fact that shares in an investment trust can trade both higher and lower than the NAV provides an added element of opportunity and risk. But it doesn't explain why they perform better.

So what's the key to the outperformance?

Partly it's because investment trusts can invest for the longer term. Because the shares are independent of the underlying portfolio, investment trust managers don't have to worry as much about being forced to sell off their holdings at short notice. So they can invest in more illiquid assets.

Investment trusts can also use gearing'. In other words, they can borrow money to juice up their returns if the time is right.

But these features cut both ways. Gearing can be dangerous if you use it at the wrong time. And having money tied up in illiquid investments is only a good idea if they're the right investments.

The secret of investment trusts' success

That takes us to the one area where investment trusts have an unalloyed advantage: they tend to be cheaper than unit trusts. And if costs are lower, performance is going to be higher, all else being equal.

The main reason that costs are lower is that investment trusts don't pay commission to IFAs, whereas unit trusts do. That commission payment comes from the investor's pocket.

However, under the Retail Distribution Review (RDR), commission will be banned from next year. IFAs will also have to make sure they offer all available products to investors. That should make investment trusts a lot more popular. According to the FT, just 0.5% of all money handled by IFAs currently goes into investment trusts.

Of course, as Ian Sayers of the Association of Investment Companies tells the FT, the RDR could be a double-edged sword. With the ban on commissions, unit trusts have scope to become cheaper, because they no longer have to pay IFAs. So the gap between the two will close. In turn, that means the performance gap could close too.

But to put it bluntly, that's not really your problem as an investor. In fact, it's good news. Some of the newer investment trusts have been picking up bad habits from their unit trust cousins. Higher charges, opaque performance fees all the things investors should avoid.

So if competition across the board forces both unit trusts and investment trusts to up their game and drop their costs, it'll be great news for independent investors.

Meanwhile, we think investment trusts should be a significant part of your core portfolio. My colleague Merryn Somerset Webb recently compiled a portfolio of our six favourite investment trusts, along with nearly a dozen suggestions for trusts in different sectors.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.