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Investment trusts: friend or foe?

First published on FTAdviser: November 27, 2017 by Rory Maguire, Fundhouse

Investment Trusts (ITs) are a lot like open ended funds in that they own a collection of underlying shares, bonds or property or a combination of all three.
They are also efficient from a tax perspective, but there are significant differences too.

ITs are listed on the LSE and this has interesting implications. Positively, they have a board of directors who are expected to oversee it and to act in the shareholder’s (read client’s) best interests.

But being listed means they are also traded via market makers who take their cut in the form of bid offer spreads and brokerage costs each time the IT is bought or sold. There is also the 0.5 per cent stamp duty that is usually applicable each time additional shares in the IT are purchased. Offsetting this, however, is the likelihood that the fees within the IT are probably lower than the fund manager’s fee on an equivalent open-ended fund.

Unlike open ended funds, ITs seldom trade at net asset value (NAV) because of the Mr Market effect and this creates opportunities for investors to buy them at a discount or sell them at a premium.
Perhaps the greatest benefit of an IT is that the number of shares in issue is usually fixed, making them closed ended investment vehicles.

But there are quite severe downside risks created by Mr Market, too. Investors could double down if they sell ITs during a bear market when the discount to NAV widens, because there are more sellers than buyers.

Yet there is a silver lining, perhaps, with the discounts/premia to NAV issue. If we look at studies like those done by Dalbar, buyers of open ended funds are usually irrational, becoming more interested in a fund the better it is doing and are, on average, sellers when the fund has lost value.

Put another way, investors are underperforming the funds they own. But when an IT is trading at a discount, it is often after poor performance and clients may well be tempted to buy it because of the discount status – a sort of incentive to be rational.

There are also other events that happen to ITs because of their listed status, like corporate actions. For example, when raising more capital, ITs often issue shares at a discount to attract new investors. And existing investors are the ones who are funding this discount.

ITs often have fewer investment constraints, too – most notably with respect to liquidity and gearing and these can be significant benefits if exploited by a skilled fund manager. Yet gearing, in particular, has its challenges; borrowing money to invest is not usually sensible. We have also published how we struggle to find good evidence for fund managers being skilled at tactical asset allocation, which is effectively what gearing is.

Perhaps the greatest benefit of an IT is that the number of shares in issue is usually fixed, making them closed ended investment vehicles. This benefits the fund manager and investor, alike. The fund manager gains by having more business certainty because they don’t experience outflows. And investment wise, they do not have to process investor flows each day and they can be genuinely long term investors.

But, most importantly, they can avoid becoming forced sellers of illiquid investments. This is a real benefit over open ended funds – we genuinely fear for corporate bond, small cap or direct property funds if they experience outflows in a down market.

When we weigh up all the pros and cons of ITs, the main con we see is leverage. We suspect advisers would not suggest their clients borrow money to invest and ITs often do just that. And the main pro, we think, is the liquidity benefit, which should protect investors from the damaging effect of selling illiquid investments during a bear market.

Advice wise, we favour both open and closed ended funds, but lean towards open ended funds more often than not. However, ITs are increasingly on the table as we see continued price momentum in illiquid asset classes.

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