Investment trusts - the best home for your nest egg

Funds are a popular choice for investors looking to build their fortunes, but they come in two main varieties and one is a much better bet than the other. John Stepek explains.

We often talk about the merits of passive investing here at MoneyWeek. There are good reasons for that. Passive funds, which simply aim to track an underlying market or asset price, are cheap. Active managers, who try to beat the market, are expensive. Every extra fraction of a percentage point you pay in costs is an extra fraction of a percent that you have to make on your investments, just to stand still. So an active manager is only worth shelling out for if they can both beat the market and pay for their own fees in the process. Unfortunately, history shows that most managers find it hard enough even to match the market, let alone earn back their costs. That's the case for passive investing in a nutshell if finding a decent active manager is so hit and miss, then for many investors, it's far better to get cheap access to whatever return the market can deliver at least you know what you're paying for.

However, despite the regular abuse we dish out to the financial industry, not all active managers are duds. Some do a very good job. And if you are willing to put the legwork in to find them, it can pay off in the form of much better returns.

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So how can you increase your odds of success? One big problem with traditional active funds "Oeics" or "unit trusts", also known as "open-ended funds" is that they have a generally poor track record. Plenty of studies show that few fund managers beat the market consistently, if at all. For example, asset manager JPMorgan Cazenove recently looked at the performance of open-ended funds for the ten years to the end of 2016, using data from researcher Morningstar. It looked at funds across ten Investment Association sectors (such as Global Equity Income, Japan, and UK Smaller Companies). Over ten years, only one sector UK Smaller Companies saw more than 50% of active funds beat the market. Over five years, only three of the ten sectors managed it. In other words, in most sectors you'd have had a better chance of picking "heads" or "tails" correctly on a coin toss, than of picking a fund that could beat a passive tracker.

Is there a way to improve those odds? Yes. By choosing an investment trust or closed-ended fund instead of an Oeic. An investment trust is like any other fund, in that a manager is given money by a group of investors to invest on their behalf. He or she tries to beat the market and takes a cut of everyone's money in return. However, unlike open-ended funds, an investment trust is a listed company so you buy shares in the trust on the stock exchange, rather than investing via a fund supermarket or directly. This has some important implications, which we'll get to in a moment.

But first, how did they do compared with the open-ended funds? JPMorgan Cazenove looked at data for investment trusts over the same period and across the same sectors. Over ten years more than half of the trusts in seven of the ten sectors beat their benchmark. Over five years more than half beat the market in nine of the ten sectors. And comparing the two types of fund, closed-ended funds beat open-ended funds in every sector over five years, and in all but two sectors over ten years. In other words, your odds of beating the market would have been pretty decent across most sectors in the last decade, even if you'd just chosen an investment trust at random. And they'd certainly have been a lot better than if you'd picked an open-ended fund.

Why investment trusts are better

So what makes investment trusts a better way to invest? First, there's the closed-ended structure. Like any public company, an investment trust raises money from investors by issuing shares. It invests this money into a portfolio of assets shares, bonds, property, the usual according to the manager's strategy. If a new investor wants to buy in, they buy shares in the trust itself the underlying portfolio is unaffected. That's very different to an open-ended fund. If you want to invest in an Oeic, or take your money out, then the money effectively goes directly into, or comes out of, the portfolio itself. That means that liquidity (the ability to buy or sell an asset quickly and reliably) matters far more for open-ended funds than for investment trusts.

Take last year's commercial property debacle. Amid the panic over how the Brexit vote would affect office prices in London, investors in most open-ended commercial property funds were banned from taking their money out of the funds, as concerns grew over a "run" on said funds. That's because it takes a long time to sell an office building, and if you need to get rid of it in a hurry (to raise funds to return to panicky investors, for example), you're likely to get less than the market value. Real estate investment trusts (Reits), on the other hand, saw their share prices fall sharply, but investors were not locked in, and the underlying portfolio was never at risk of being sold at firesale prices.

You can already see there are several advantages to this structure. Firstly, the lack of pressure to fund redemptions means the manager can take a longer-term view and own assets that are less liquid (things like debt or private equity or exotic stockmarkets, such as Vietnam, say). This in turn means they should be able to reap the rewards of taking the liquidity risk that other investors avoid (for more on this, see page 10). Secondly, a stable pool of capital also means less pressure on a manager to fret about client sentiment on a day-to-day basis "career risk" is still an issue for investment trust managers, but not quite as distracting as it is for open-ended fund managers. This should all free up a decent manager to act on their best ideas with conviction. This is where another benefit of investment trusts comes in the fact that they can borrow money (with the approval of their board of directors) to invest. "Gearing" (as it's known) is a double-edged sword borrowing to invest amplifies both your gains and your losses. However, as JPMorgan Cazenove points out, the fact that closed-ended funds have largely beaten their ungeared open-ended peers even in "down" years for the wider market suggests that managers are largely using gearing successfully, rather than exposing themselves to extra losses.

A free lunch for investors

As well as encouraging longer-term thinking, the investment trust structure frequently offers investors the chance to buy a portfolio of assets for less than it's actually worth. Shares in the investment trust are traded on the stock exchange. As a result, the value of the trust itself moves independently of the value of its underlying portfolio (its net asset value, or NAV). The share price of the trust should, of course, reflect the NAV that's what its value derives from but they rarely match up perfectly. So most of the time a trust trades at a discount (when the share price is lower than the NAV per share) or a premium (when the share price is higher than the NAV). Typically, most trusts trade at a modest discount, but trusts with popular managers, great track records, or those in "hot" sectors, will sometimes trade at a premium.

If a trust trades on a discount of 10% (and many do), you can effectively buy £1-worth of assets for 90p. Now, there's no guarantee the discount will narrow it could widen if sentiment on the sector or trust deteriorates. But it does throw up another good way to hunt down value and potentially juice up your returns, particularly as boards are increasingly under pressure to keep discounts from getting too wide. Broadly speaking, discounts have narrowed in recent years going from an average of around 8%-9% at the start of 2012 to less than 4% for much of 2015. That's partly because financial advisers are now more willing to put clients' money into investment trusts, because they are no longer paid on a commission basis (which favoured open-ended funds) following the Retail Distribution Review (RDR) in 2012. However, discounts did widen in 2016, creating attractive opportunities inspecific sectors, particularly the UK small-caps sector.

Better scrutiny, lower costs

The other big benefit of the investment trust structure is that, like any other listed company, an investment trust has an independent board of directors. The board represents the interests of the shareholders. That should mean more scrutiny of performance and costs, for example. And if the board isn't deemed effective on that front, then it also leaves room for activist investors to come in and force changes if they spot the opportunity to do so. The strategic changes pushed through at Alliance Trust, one of the largest and oldest investment trusts in the UK, by US activist group Elliott, are one high-profile recent example.

Finally, the other point that we always focus on at MoneyWeek costs. Investment trusts have long had a reputation for being cheaper than open-ended funds. This was true prior to the RDR, when open-ended funds had to pay commission to advisers, but costs have evened out since, and we wouldn't assume that using a trust is always cheaper. Keep an eye out for our perennial bugbear, performance fees, in particular. That said, as wealth manager Canaccord Genuity points out, a world where open-ended funds are becoming cheaper and passive funds are ever more popular simply means that investment trusts will be under even more pressure to exploit "the inherent competitive advantages" offered by the closed-end structure.

You just have to make sure that you pick the trusts that are making full use of these advantages. Throughout this issue we've looked at some of the most interesting trusts around and my colleague Merryn Somerset Webb has updated MoneyWeek's model investment trust portfolio. Click here to see theupdate.