Investments trusts in the IT UK All Companies, IT Equity Income and IT Smaller Companies sectors have, on average, outperformed their open-ended peers in the Investment Association universe, according to research by FE Trustnet.
Over the past decade, the investment trusts in the IT UK All Companies sector have outperformed by 28.39 percentage points while equity income trusts have outperformed by 4.24 percentage points.
The widest disparity however is in the smaller companies sectors, where the average small-cap investment trust has beaten its open-ended peer by 32.29 percentage points.
Performance of sectors over 10yrs
Source: FE Analytics
Gavin Haynes, managing director at Whitechurch Securities, said: “There has been a long-running debate as to what is the best approach to gain UK stock market exposure. Is it better to choose open-ended funds – OEICs or unit trusts – or a closed-ended investment trust?
“This data certainly provides a strong endorsement for trusts, but there are a number of factors to take into consideration.”
Indeed, while on the surface this could offer a compelling argument for investment trusts, there are number of factors that must be taken into account, which we will look at below.
Gearing
The first benefit for closed-ended investment companies is their potential to gear, or use leverage, in order to benefit from the sustained bull market that has taken place over the last decade.
Indeed, 10 years ago, the average trust in the IT UK All Companies sector was 10 per cent geared, the IT UK Equity Income was 15 per cent geared while the IT UK Smaller Companies average trust was 18 per cent geared.
It should be noted that these figures have come down since then to 6 per cent, 8 per cent and 6 per cent respectively.
“It is important to remember that the 10-year period highlights the strong decade of performance starting from the depths of the financial crisis,” Haynes said.
“The period which has been dominated by rising markets will have benefited trusts that have employed gearing which will have enhanced returns.”
Essentially, when an investment trust takes on gearing, they are borrowing money to buy more stock.
However, not everyone is a fan of gearing. Ben Conway, senior fund manager at Hawksmoor Fund Managers said he does not believe gearing is a benefit to investors.
He said: “Gearing is certainly not a characteristic of investment trusts we necessarily view as a positive. If the returns from the asset class are attractive enough, why should the manager add an extra layer of risk by gearing up the portfolio?
“And we are particularly alive to this at the current time given prevailing high levels of valuations.
“To repeat, it’s key benefit is the permanent pool of capital that it gives the managers to invest. It is not the ability to gear up.”
Liquidity
Another reason investment trusts have outperformed is their ability to buy more illiquid assets than their open-ended counterparts as they don’t need to worry about inflows and outflows.
Indeed, while Conway is not a fan of gearing, he said the reason he likes investment trusts is because they can own more illiquid assets.
“In that sense, they are very suited to managers who want to be truly active and have a high degree of conviction in their process,” he said.
“Our only exposure to UK equities via investment trusts is currently in the micro-cap space where we believe valuations are either more attractive or the manager is able to fully express their process and give us access to a highly concentrated portfolio of equities.
“We can benefit from the huge amount of work that the manager puts in to selecting these investments.”
This lends itself to investing lower down the market capitalisation spectrum, including mid- and small-caps.
“The closed-ended structure of investment trusts can be used to increase the small- and mid-cap bias of holdings within the fund, relative to their open-ended versions,” he added.
This has been a huge benefit for investment trusts over the last 10 years, Guy Anderson, manager on the Mercantile Trust added.
Over the last decade, the FTSE 250 has outperformed the FTSE 100 in seven of the 10 calendar years to 2018.
Taking the IA and IT UK All Companies sectors as a comparison, when looking at the r-squared – a measure of correlation – to the Numis Smaller Companies ex Investment Trust index (which includes small- and mid-cap stocks) trusts have a much higher correlation over the past three years on a rolling three-year basis.
Rolling 3yr R-squared of sectors over 3yrs
Source: FE Analytics
The Mercantile Trust’s Anderson noted that there are two significant benefits to investing further down the market cap spectrum.
“The first is greater takeover activity – as the big companies wish to get bigger what they are often doing is acquiring smaller companies and many of those are in the mid- and small-cap part of the world,” he said.
“From the turn of the century, on average between 6 and 7 per cent of the mid-cap index has been acquitted each year versus around 2 per cent for the FTSE 100.”
The second, although there is less empirical data behind it, is that there are more likely to be a greater proportion of companies that are earlier in their business life cycle and therefore are exhibiting super-normal growth.
“Obviously people will point to a Fevertree or a Just Eat but we are talking about companies that are tripling and quadrupling their turnover over three years whereas as companies get larger they trend more towards GDP growth [levels],” he noted.
“The trend of smaller companies outperforming has been pretty consistent over time and so those portfolios that are focusing on smaller companies should have significantly better returns.”
Discount/premium
Another factor for investors to be aware of is the widening/tightening of discounts and premiums, which can have a significant impact on investment trusts.
Indeed, the three sectors looked at have all seen their average discounts tighten over the last decade.
In 2008, the average trust in the IT UK All Companies sector had a discount to net asset value (NAV) of 9.62 per cent, the IT UK Equity Income was on a discount of 7.62 per cent while the figure for the IT UK Smaller Companies average trust was 16.05 per cent.
Discount/premium of sectors in 2008 and 2018
Source: Association of Investment Companies (AIC)
It should be noted that these figures have come down since then to 8.03 per cent, 4.9 per cent and 10.24 per cent respectively.
Jason Hollands, managing director of Tilney Group, said: “This has been an unusually long bull-market, turbo-charged by extreme monetary policy in the form of ultra-low interest rates and money printing in the form of quantitative easing.
“One of the many impacts this has had has been to send investors scouring further up the risk spectrum in the search for yield and this has pushed many income-generating investment companies to historically low discounts or even premiums.
“When investors are net buyers of investment trusts, as they have been during this bull run, it leads to narrowing discounts on investment companies which can be an additional boost to returns.”
Sector size
The final impact factor behind these figures is the disparity between the size of the respective sectors. The IT UK All Companies sector has just 15 trusts for example, while the IA UK All Companies sector contains 266 funds including 36 index-trackers, ethical funds and dull benchmark aware funds.
Hollands said: “It is important to recognise that the universe of investment companies in these areas is much smaller than similar open-ended sectors, so conclusions based on ‘average’ returns need to be handled with a degree of care.”
Whitechurch Securities Haynes added: “The number of open ended funds is much greater and I do believe that the UK sectors of open-ended offerings are bloated with many mediocre offerings meaning that it is important to be discerning.”
So, should you buy an investment trust?
Overall, opinions are mixed on whether these figures show that investment trusts have been the better option for investors over the last decade.
Haynes said that he uses both closed-ended and open-ended funds for his UK exposure as there a number of excellent fund managers running open ended funds that do not manage trusts and vice versa.
Informed Choice’s Bamford noted that while he has historically only invested in open-ended structures, as there is wider availability through platforms, he is beginning to look at trusts as well.
“This consideration is becoming less relevant these days, with a wide range of investment trusts now available on the platforms we recommend, so we are increasingly considering investment trusts too,” he said.
Hawksmoor’s Conway said he only uses investment trusts for the more illiquid parts of the market and would never buy a large-cap investment company.
“One of the benefits of investing in open-ended funds is the ability to access your money quickly – given they are daily dealing vehicles. Investing large amounts in even large ITs can sometimes prove problematic,” he noted.
“This makes investing in an investment trust that itself is predominantly invested only in large caps pretty unattractive – unless there was an unusually large discount.”
However, Tilney’s Hollands said investors should avoid being too dogmatic about which structures to use in general.
“I would advocate a more agnostic approach of being open-minded towards both investment companies and funds when searching for the best options in your portfolio and trying to find the most capable managers or teams,” he noted.
“These will often be managing open-ended funds simply because there are vastly more of them, but where a great manager is running a trust and you can pick it up at discount then that can be a good option.”