Investment Guide: closed- and open-ended investments
But the question on the lips of most investors - certainly beginners - is whether all of these features translate into decent performance.
In other words, do investment companies perform well enough to tempt people used to open- ended funds to try a closed-ended investment structure?
There's no quick answer to this. While unit trusts and open-ended investment companies (OEICs) seem to outperform closed-ended investment companies over the short term, it's a different story over longer time periods.
Of the 15 sectors monitored by the Association of Investment Companies (AIC), investment companies perform better than unit trusts in 11 of them, according to data to the end of March 2015. Over 10 years, investment companies perform better than unit trusts in nine of the 15 sectors.
In some sectors over these time frames, long-term investment company performance really is streets ahead.
In Japan, for example, the average investment company returned £218.9 for every £100 invested over five years, compared to just £138.6 for unit trusts. Similarly, over 10 years the UK Equity Income sector has seen average investment company returns of £273.8 compared to £209 for unit trusts.
Over five years, unit trusts only outperformed investment companies in North America, North America Smaller Companies, Global Emerging Markets, and Property. Over 10 years, unit trusts also outperformed their closed-ended peers in Japanese Smaller Companies and European Smaller Companies.
However, when you look at performance over one year, you get the opposite result, with unit trusts coming out on top in 10 of 15 sectors (although performance is equal in one of the remaining five sectors).
"Investment companies are still generally outperforming over the longer term, as would be expected," says an AIC spokesperson. "This is due to the closed-ended structure, which means that investment companies have a fixed amount of assets, in contrast to unit trusts and OEICs which expand and contract depending on supply and demand.
"Open-ended fund managers have to, therefore, manage fluctuations in the size of the fund due to inflows and outflows of money, and in tough markets can be forced to sell to meet investors' redemptions. Investment company managers however, can take a long-term view of the market and ride out any ups and downs."
That said, the AIC also acknowledges that, over shorter time periods, investment company performance suffers and returns for investors can be extremely volatile in some cases.This is, arguably, why many beginner investors (aside from investment companies being harder to understand than vanilla unit trust funds) shy away from the vehicles.
The current poor short-term performance is, the AIC says, "due to a combination of some discounts widening earlier this year in some sectors, as well as the distortive impact of certain companies in sectors with small numbers of constituents".
It says discount widening impacted the Global Equity Income, UK Equity Income, UK All Companies, North America and Global Emerging sectors and this could have affected returns. The underperformance of the Property sector is due to a more eclectic mix of stocks in the closed-ended sector, and the fact that the data is unweighted.
That may explain the current short- term underperformance but the experts have crunched the numbers over different time periods in recent decades and have usually got the same result: investment companies come out second- best in the short term.
But if short-term performance is more volatile than with open-ended funds, it's also the case that longer-term performance at any point in recent decades has been better than that offered by unit trusts.This is why managers at investment companies worry less about how their vehicles are doing in the short term and position their portfolios for the longer term – a reason why many often bounce back strongly after a downturn.
As we have explored in previous features in this series, investment companies can also borrow money (known as gearing), which also enhances performance over the long term and they have much greater flexibility in terms of the types of assets they can invest in – all reasons why investment companies have outperformed their unit trust peers in so many sectors over five and 10 years.
The statistics seem to indicate that anyone keeping their money in unit trust funds for short-term peace of mind may well miss out on longer- term riches.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
Investors who borrow money they use for investment and use the securities they buy as collateral for the loan are said to be “gearing up” the portfolio (in the US, gearing is referred to as “leveraging”) and widely used by investment trusts. The greater the gearing as a proportion of the overall portfolio, the greater the potential for profit or loss. If markets rise in value, the investor can pay back the loan and retain the profit but if markets fall, the investor may not be able to cover the borrowing and interest costs, and will make a loss. Also used to describe the ratio of a company’s borrowing in relation to its market capitalisation and the gearing ratio measures the extent to which a company is funded by debt. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.