Are closed-ended funds as difficult to understand as they seem?
Earlier this month, research from the Lang Cat and the Association of Investment Companies saw 57 per cent of advisers are discouraged from recommending investment trusts because of their lack of knowledge.
In light of this, Money Marketing is heading back to basics and looking at how advisers can use investment companies within a client’s portfolio. Keep an eye out for further guides on closed-ended funds in future issues.
Here, we speak to three industry experts to give their views on where to start with ITs.
What are the biggest risks when using ITs? For example, gearing, liquidity, etcetera.
Ian Sayers, chief executive of the AIC: Much of the research that advisers do when looking at open-ended funds is the same for ITs but they need to specifically consider the level of gearing, whether a trust trades at a discount or premium and liquidity. It’s worth remembering that, while these features may contribute to risk, they can also be factors that contribute to the strong long-term performance record of ITs.
Jason Hollands, managing director, business development and communications, Tilney: Gearing is a double-edged sword. Used effectively, it can enhance returns by enabling managers to buy up extra stock when opportunities arise, but excessive gearing does increase the risk profile and in extreme market conditions could be problematic if banking covenants are at risk of being breached. That said, gearing is used far more sparingly these days. Big moves in discounts and premiums are also a factor to consider, but these tend to be short-lived in nature and can present tactical buying opportunities.
Are there any particular asset classes that are better suited to an investment trust than another vehicle? For example, private equity or hedge funds.
Gavin Haynes, managing director, Whitechurch: The closed-ended structure means that they are more suitable for gaining exposure to illiquid assets than in open-ended funds. An example is investing in companies that are unquoted through private equity trusts.
Hollands: The closed-end investment company structure is particularly suited to illiquid underlying asset classes such as physical property, private equity, venture capital, hedge funds, operational infrastructure projects and speciality finance. But the structure also has advantages when investing in markets prone to bouts of volatility and aggressive capital flows such as emerging markets and frontier markets.
Sayers: Unlike open-ended managers, trusts do not have to worry about inflows and outflows of money at the top and bottom of the market. The suitability of ITs for property was demonstrated after the Brexit vote and during the financial crisis, when the commercial property sector plummeted and many of the open-ended property funds were closed or semi-closed as managers struggled to keep up with redemptions.
How can liquidity issues be managed?
Hollands: Most boards these days have a discount control mechanism in place to enable them to put a floor on discounts, but liquidity can still be problematic for very small trusts, especially those with cornerstone strategic shareholders that are lightly traded. For most individual investors this may not be a problem, but it is certainly something an adviser needs to be aware of when recommending a small trust across their client bank as it may be difficult to exit the aggregate position if their view on the trust changes at some future point in time.
Is there a type of investor best suited to using ITs or are they a one-size-fits-all vehicle?
Haynes: I think ITs are suitable for all investors. There are a wide range of plain vanilla well-established trusts that are ideal for beginners looking for first-time stock market exposure. They are cost-effective and have a simple structure. However, the wide variety of trusts means that there are also a large number of more specialist and esoteric areas that you can gain exposure to through ITs that are more suited to sophisticated and institutional investors.
Sayers: With the pension freedoms, many advisers are considering ITs for a portion of their clients’ portfolios when they are saving, or in retirement due to a trusts’ strong performance, long-term record and dividend advantages. They are used for long-term saving objectives like saving for a child, a house or the future.
Hollands: I believe the right approach is to be agnostic. There are relatively few genuinely-talented fund managers out there, so in searching for them it is right to use the widest universe of structures possible. The historic cost differences between trusts and open-ended funds have now moderated to a significant degree, with the shift to clean share classes on funds. So the decision to use a fund or investment company for a particular component of a portfolio really comes down to the specific circumstances; who has the best track record, the most competitive costs and if the trust is trading at a discount or premium.
What time period do you think should be the minimum holding time for a closed-ended fund?
Hollands: This ultimately comes down to the particular asset class and strategy of the investment company being considered. In this respect there is no difference between choosing an open-ended fund or investment company. For a core, developed market equity trust, the time horizon needs to be at least five years.
Sayers: ITs are primarily intended as long-term investments, therefore you should be prepared to hold them for at least five years, but preferably 10 years or more.
Haynes: While it really depends upon the underlying assets held within the trust, given that most ITs are invested in shares, it is reasonable to say that five years is a reasonable minimum holding period for ITs.
Investment trust jargon explained:
Closed-ended: A closed-ended investment company has a fixed number of shares in issue at any one time. These are traded backwards and forwards on the stock market, which has no impact on the underlying portfolio.
Convertibles: Shares or securities which can be converted into ordinary shares at some time in the future.
Discount: The amount, expressed as a percentage, by which the share price is less than the net asset value per share.
Gearing: Ways in which investment companies can magnify income and capital returns, but which can magnify losses. At its simplest, gearing means borrowing money to buy more assets in the hope the company makes enough profit to pay back the debt and interest and leave some extra for shareholders. However, if the investment portfolio doesn’t perform well, gearing can increase losses. The more an investment company gears, the higher the risk. Investment companies can usually borrow at lower rates of interest than you’d get as an individual. They also have flexible ways to borrow – for example, they may get an ordinary bank loan or, for split capital investment companies, issue different classes of share. Not all investment companies use gearing, and most use relatively low levels.
Premiums: The amount, expressed as a percentage, by which the share price is more than the net asset value per share.