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An Open and Shut Case

Updated: May 17, 2022

Closed-ended funds – investment trusts – are wonderful structures. So, too, are open-ended funds – OEICs, short for open-ended investment companies. What is the difference and what sort of underlying investments are each of them best suited to?

"Asking your investment platform might be a good place to start"

What follows is based on my previous experience as a chief investment officer at a multi-asset investment firm – the term ‘multi-asset’ meaning the firm’s funds invested in equities, bonds and other investment types rather than just equities or bonds.

Indeed, this perspective is particularly relevant given that investment type, specifically investment liquidity, almost single-handedly determines which of the two structures is better suited.

An OEIC must be able to sell quickly its underlying investments when it receives redemptions, ie underlying investments must be liquid. Poor liquidity in underlying investments is what got Neil Woodford into trouble and why open-ended direct property funds should be prohibited.

An investment trust – though there are exceptions I will come to – has a fixed number of shares, unlike an OEIC, whose number of units goes up and down, so it can afford to hold illiquid investments. Generally, when you sell/buy shares in a trust, you sell to/buy from another investor; there are no flows in or out of the trust.

In short, OEICs are suited more to liquid investments such as bonds and listed equities, while trusts are better for unlisted (illiquid) investments such as private companies, direct property, infrastructure, aircraft, ships, trains and royalties.

These latter investments are generally called ‘real assets’, meaning they are inflation sensitive, as opposed to ‘financial assets’, such as equities and bonds which are more interest rate-sensitive. If you think there is going to be rising/high inflation in the next few years, you should probably skew your portfolio more to real assets and thus to investment trusts.

Of course, there are investment trusts holding mainly liquid equities that have performed fabulously over the years. I would not advise against owning such funds if there is no open-ended alternative. An open-ended fund that holds illiquid investments, on the other hand, should in my view be strictly avoided.

A quick note on passive multi-asset OEICs. Because they are open-ended and managed against composite indices, they tend not hold real assets investment trusts. Due to their smaller size, the trusts are not on the whole constituents of broad equity indices, which are part of passive funds’ composite indices.

If you are looking for a one-stop, or ‘multi-asset’, solution and are worried about rising inflation, you may want to consider an active fund, closed- or open-ended, that has a decent exposure to these real assets investment trusts.

I shall not dwell too much on the technical differences between trusts and OEICs, though the picture is not as simple as it used to be. While in the past all investment trusts were closed-ended, meaning the number of units – shares – was fixed, many trusts now have a discount control mechanism (DCM).

With a DCM, a trust can issue or buy back shares to address an imbalance in supply and demand between buyers and sellers. In the absence of a DCM this imbalance would result in swings in the trust’s share price in relation to the value of its underlying investments, the so-called ‘discount to NAV’ (net asset value).

A trust can only have a DCM if its underlying investments are sufficiently liquid, so many don’t, including those investing in real assets.

Some investors still prefer trusts without a DCM, as there is the potential to make money from discount swings. For example, all else being equal, a change in the discount from 20% to 10% translates to a return of +12.5% – note also that a negative discount is the same as a premium.

Although discount swings do indeed present opportunities to make money, they are now generally regarded by investors as undesirable, and trusts with DCMs have become more popular in recent years.

Sadly, because there are different forms of DCM mechanisms, there is no easy way to find out which trusts have them. Asking your investment platform might be a good place to start.

Trusts that have some form of DCM can be considered quasi open-ended. While in the past funds were either open- or closed-ended, there is now more of a spectrum. That aside, the more important distinction relates to the liquidity of underlying holdings.

Published in What Investment

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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