Buy these managed funds while you still can

The biggest argument in fund management is between those who believe that it is possible (and consistently so) for an individual manager to outperform the stock market, and those who do not.

The evidence is all on the side of the passive approach. Study after study has shown that the average fund manager underperforms the stock market and that the fees he charges to do so pretty much guarantee the ongoing poverty of his clients.

That should make it clear that the average investor should bypass active funds and stick to tracker funds or a variety of cheap exchange traded funds (ETFs). But if this is all so obvious, why are there still well over 2,000 actively-managed unit trusts for sale in the UK? And why do we buy them?

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It is partly about ignorance of course marketing material for most funds tends not to mention the high odds of failure. But it is also about hope: the returns from the main indices seem so paltry (let's not forget that even after this summer's mega rally, the average investor has only broken even over the last decade), that we can't give up the idea that it is possible, with a little sense, to do better.

So, we keep buying the funds and we keep paying the fees.

The good news is that there is a cheaper way to keep the dream alive: the investment trust sector.

Recent research from Money Observer shows that, over the last 30 years, investment trusts have significantly outperformed unit trusts. For example, of the 51 investment trusts that have a track record going back 30 years, 68% beat the index. Of the 82 unit trusts with similar records, a mere 28% did the same.

So what's the secret? It is partly the 'closed ended' structure. Investment trust managers can't be forced to sell out of positions by investors looking to redeem shares in the same way that unit trust managers can, so they are more able to look to the long term.

It is partly down to the gearing (unlike unit trusts, investment trusts can borrow money to invest). Gearing boosts returns in rising markets and, as the market generally does rise over the long-term, it clearly contributes to out-performance.

Then there is the board of directors. Investment trusts are listed companies and, as such, have boards. These boards, charged with looking after the interests of shareholders, can and do shift between managers as they see fit.

Finally, there are fees. According to Lipper, the average investment trust has a total expense ratio (TER) of around 1.4% and a third have TERs under 1%. Contrast that with unit trust charges, which average well over 1.5% and which have risen steadily over the past decade.

Overall, all this makes me a great fan of investment trusts. Current favourites? The Schroder Japan Growth Fund, which is trading at a discount of around 14% to its net asset value (NAV) making it a bargain if you think (as I do) that the Japanese market is underrated.

I'm also interested in Alliance Trust, which has just completed a buyback of its own shares. The trust has underperformed the market this year, thanks to its low-risk approach to investing (no bad thing) and is currently trading on a 17% discount to its NAV. It also has a 41-year record of consecutive dividend increases. I suspect there is a value opportunity there.

However, there is a problem looming for this cheap and flexible asset class: the Alternative Investment Fund Managers Directive. This legislation, currently under discussion in Europe, is to regulate all investment companies in the same way, be they massive hedge funds moving markets on a daily basis or small trusts innocently investing in dividend-paying blue chips for their retiree investors.

If the directive goes through, the investment trust sector as we know it is pretty much done for. It will prevent trusts from issuing new shares and make it hard for them to market the ones they already have in issue (irritating, given the investing public's preference for unit trusts).

It will, says Annabel Brodie-Smith of the Association of Investment Companies, undermine the role of the board a shame, as it is arguably the board that keeps fees down and performance up. It will put limits on leverage. And it will force funds to offer immediate redemptions of their shares on request.

That might sound nice in that it would end the problem of discounts if everyone has the right to get the net asset value of their shares out at any time, why would the shares ever trade at a discount?

But it would take away the main thing that makes the sector special the fact that you can't redeem at NAV and that your manager is therefore able to look much more to the long term than most.

The AIFM isn't with us yet and it may well not pass as it is. But it is still a threat.

Investment trusts: they're cheap, they're easy to buy and they easily outperform most other funds in rising markets. Buy them while you still can.

This article was first published in the Financial Times