Most financial industry insiders don't invest in the things you do. The majority of ordinary investors put their money as instructed by their independent financial advisers (IFAs), their pension managers and the press into unit trusts or open-ended funds (OEICs). The financial cognoscenti go instead for a different kind of fund: investment trusts. They do so for two simple reasons.
First, investment trusts tend to cost less than unit trusts. Second, they tend to perform better. An investment trust is a listed company whose business is to make investments in financial assets. That usually means shares in other listed companies, but investment trusts also invest in assets as diverse as private equity, infrastructure, property and hedge funds. As with any other listed company, an investment trust has a board. That board appoints a manager to run the firm's investments.
A key feature of an investment trust is that, as a listed company, its shares can be bought or sold at any point during the day at its market price. This price could be more or less than the portfolio's net asset value (NAV). If it is more, the trust is said to trade at a premium. If less, it is trading at a discount.
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This is very different to an open-ended fund, where units are bought and sold at prices related directly to the value of the underlying assets. This feature of investment trusts offers both risk (you don't know what price people will pay for your shares even if you know the NAV) and opportunity (you can buy underlying assets at a discount to NAV and profit from changes in the discount).
Do the numbers stack up?
Of course, the most important thing when choosing a fund is to buy the one that will make you the most (or lose you the least) money. Right now, the answer looks like investment trusts.
Annualised investment trust performance
relative to open-ended equivalent over ten years
Broker Winterflood recently looked at the performance of investment trusts against their open-ended peers over the last ten years. The results are pretty clear. In some areas, such as fixed income, there are many fewer investment trusts than open-ended funds, so no meaningful historic comparison can be made. However, the chart above shows that, whether you look at NAV or just at share prices, investment trusts produced better price returns in all sectors analysed (Japan is the exception).
The share-price performance is partly due to the fact that discounts have tightened over the period. But that isn't the whole story: investment trusts have also produced better NAV returns ie, underlying portfolio performance than equivalent open-ended funds. Highly regarded broker Collins Stewart looked at the sector over the ten years to the end of December 2010 (see chart below). Over that time, only the UK small-cap sector underperformed in NAV terms relative to open-ended funds (to be fair, they didn't cover Japan).
Ten-year NAV total returns,
investment companies vs oeics/unit trusts
So overall, there seems to be good reason to view past investment trust performance favourably, particularly as the level of outperformance (over 3% a year versus open- ended funds for the Asia Pacific ex-Japan region, for example) has been quite meaningful. So why are investment trusts prone to beat their open-ended rivals? And why might you invest in them now?
Access to specialist assets
Closed-ended funds can give you the chance to invest in assets you might not otherwise be able to own (though you have to be careful here, as owners of funds investing in Bulgarian property will know). It may be that the assets are too expensive for you to invest in via normal means (as with private equity), or too complicated to access (infrastructure projects). Listed funds solve one of the key problems for many alternative assets (including hedge funds), in that you can buy or sell the shares in the same way as any other share, and you don't have to wait for lengthy lock-up or redemption periods to come up.
Access to managers
You can invest with top managers or firms you may not normally be able to access their open-ended funds may have high minimums, or be closed to new investors. Or, as with RIT Investment Trust (LSE: RCP), which is effectively the personal investment vehicle of Lord Rothschild, there may just be no equivalent available.
Managers can think long term
Another advantage of the closed-ended structure is that the manager doesn't have to worry about meeting redemptions (as with open-ended funds). As a result, he or she can worry less about liquidity, and focus instead on making the best investments for the long term. This should help returns if you have a good manager.
Lower total expense ratios (TER)
Low costs are often cited as an advantage of investment trusts. Generally, the older the trust, the lower the fees many vehicles launched over the last decade to invest in more exotic asset classes (eg, hedge funds, private equity) actually have quite high fees. Nonetheless, there are bargains to be had. Work by Financial Express in 2010 showed average TERs for the Asia ex-Japan, global growth and global emerging market sectors of 1.17% compared to 1.68% for the equivalent open-ended funds. The investment trust sectors had also beaten their open-ended peers over the three years studied.
One reason for lower costs is that investment trusts pay no trail fees to independent financial advisers (typically up to 0.5% a year for open-ended funds), with rare exceptions. So they're rarely favoured by traditional commission-led IFAs. But with the Retail Distribution Review (which is changing the way financial advice is paid for from the end of next year) due to restrict IFA bias to commission-paying products, investment trusts may get more popular.
Corporate governance
Investment trust boards have been criticised for having too close ties to the fund's manager and for being a bit sleepy. But in the last decade the make-up of boards and way they operate has changed a lot, and most do a good job of representing shareholder interests. The position is arguably better for the underlying shareholders than with open-ended funds. Active boards can sack underperforming managers, for example. When did one of your underperforming open-ended funds ever change the management firm for a better one?
Discounts and special situations
A discount is not necessarily good for existing shareholders, but it can provide opportunities. If you buy at a discount, effectively you are buying a pound of assets for less than a pound. In special situations for example where a liquidation may be forced by shareholders on an underperforming trust a discount can present money-making opportunities.
Ease of trading
As investment trusts are listed, you can buy or sell in the same way as a normal share, rather than being confined to once-daily dealing or worse. Of course, as with shares you get what people in the market will pay or pay what people will offer, which could be too much or too little.
That said, there are special risks with investment trusts. The first is liquidity. While it is always nice to be able to buy and sell as you wish, smaller investment trusts may not be liquid enough. This can also mean some trusts are very volatile: one buyer or seller can move the price substantially. Next is leverage: investment trusts can borrow money to enhance returns, where open-ended funds generally cannot. This can work in good times, but also magnifies losses in bad times. Finally, fees and costs are generally rising. More recent issues tend to ape the unit trust sector with higher management fees. For every trusty old bargain, there is a trust where the manager wants to get the board to agree a generous performance fee.
Also, the financial food chain doesn't make much money out of investment trusts. With lower fees, no commissions to IFAs and most holders being very long term (so there is little churn of shares), neither brokers, fund managers nor IFAs are keen on the structure. Demand for plain vanilla, equity investment trusts has also been eroded by exchange-traded funds (ETFs), which offer low costs and convenient dealing without the risk of selling at a discount to NAV (though arguably your assets are more transparent, and hence a bit safer than in many ETFs).
However, these are problems for the industry rather than you as an investor. It is precisely because they are not much favoured by large financial institutions that the nimble private investor can find good opportunities. So what do you buy? The Murray International investment trust is one option; my other current favourites are below.
Sandy Cross's best buys
1. Personal Assets Trust (LSE: PNL)
Global growth sector: 1.5% premium.
The fund has a good record of protecting and growing capital long term, and active discount control keeps the share price near NAV more shares are issued if the trust moves to a premium.
2. Aberdeen New Dawn (LSE: ABD)
Asia Pacific ex-Japan: 8.1% discount.
Good record of outperformance in the long-term growth markets of Asia and with Aberdeen's value bias.
3. Advance Frontier Markets (LSE: AFMF)
Emerging markets: 8.1% discount.
Smaller, individually risky frontier' markets should offer long-term growth and have in the past shown less correlation to mainstream markets.
4. Standard Life Property Income Trust (LSE: SLI)
UK direct property: 6.1% discount.
UK commercial property is not for everyone, but the diverse portfolio and a yield of just under 8% are attractive.
5. Ecofin Water & Power Opportunities Ltd (LSE: ECWO)
Utilities, 30.5% discount.
Invests in global utilities and yields 4.2%. The level of gearing and capital structure add risk, but it looks cheap.
Sandy Cross holds shares in these and other investment trusts
This article was originally published in MoneyWeek magazine issue number 563 on 11 November 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.
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