Investment trusts' low-cost advantage threatened by open-ended fund fee cuts

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Alan Brierley, director of investment companies research at broker Canaccord Genuity, has bolstered investor enthusiasm for investment trusts with his tables on their outperformance of open-ended funds.

In Canaccord's 2016 handbook, for instance, he compared the performance of trusts and open-ended investment companies (Oeics) in 14 of the most popular equity sectors.

He demonstrated that shareholder total returns on trusts in 11 of those sectors, including global and UK equity income, were on average comfortably ahead of the average for Oeics in the same sectors over five years. Returns were ahead for trusts in nine out of the 14 sectors over 10 years as well.

WHY DO TRUSTS OUTPERFORM FUNDS?

To make his research more meaningful, Brierley compared the performance of 33 trusts with 33 similarly oriented Oeics managed by the same teams, and found that all but four of those trusts had outperformed their open-ended sister companies in terms of net asset value (NAV) annualised performance over five years to end November 2015.

Brierley recently updated his research to cover the five years to end September 2016. This time he identified 38 trusts with sister funds and the same manager and investment policy, more than a 50 per cent portfolio overlap, and at least a five-year record.

investment-trusts-versus-open-ended-fund-alternativesHe gave those sister funds the best chance possible by comparing their lowest-cost share classes with the parallel trust's NAV returns, but despite this, 32 had lagged their trust counterparts, two had kept pace and only four had outperformed.

Brierley says a number of factors have contributed to trusts' outperformance.

These include their ability to gear (a double-edged sword, which should work best in a rising market), their ability to a take a long-term, high-conviction view or to hold more illiquid investments (such as smaller companies), their ability to manage money without having to worry about cash flows from new investment or redemptions, and the potential for NAV enhancements from share buybacks and new issuance.

However, an important factor in their superior performance has been trusts' historically lower costs - and this is being seriously undermined by the cut in fees on most Oeics to around 0.75 per cent a year, with even lower levels available on certain platforms.

What is more, competitive costs are likely to be increasingly important if returns on equities over the next 20 years are substantially below the unusually high returns over the last 30 years, as is argued in a recent report by the McKinsey Global Institute.

Demonstrating the increased competitiveness of Oeics, Brierley reckons that fewer than half the investment companies in his latest research have lower ongoing charges than their sister Oeics, even before trust performance fees are taken into account.

However, he also notes that in two thirds of cases the difference is less than 25 basis points, and additionally that a number of trusts with significantly higher charges than their open-ended counterparts have substantially outperformed them.

These include Baillie Gifford's two Japanese trusts (both of which use a lot of gearing), JPM Global Emerging Market Income, Jupiter European Opportunities, and Schroder Japan Growth.

To find out how trust groups have been responding to the low-cost challenge, we contacted two of the largest managers.

JPMORGAN

JPMorgan manages 23 trusts, with total assets of £8 billion. Over the past five years, 10 of JPM's trusts have dropped their performance fees, including Claverhouse, the two emerging market trusts and the two European trusts.

To demonstrate how these changes have affected the cost comparison between its open- and closed-ended funds, JPMorgan compared the total expense ratios (TERs) on the six trusts in its stable which have a parallel open-ended fund with the TERs on those funds' B shares, which are the competitively priced share class offered to retail investors on good platforms.

On this basis the JPM European Growth, JPM Emerging Markets and JPM Japanese trusts currently have lower TERs than the comparative Oeics.

JPM European Smaller Companies has an identical TER to its open-ended counterpart, while JPM Global Emerging Markets Income and JPM Smaller Companies trusts are more expensive than their counterparts.

Comparing the NAV total returns of the six trusts with the performance of the comparable Oeic's B shares (or with the more expensive A shares, where these are the only comparator available over five years), all six of the JPM trusts are ahead over five years, and all except European Growth and Japanese over three years.

Simon Crinage, who heads JPMorgan's investment trust team, comments that even where open- and closed-ended funds bear similar investment mandates, trusts are differentiated by their ability to gear and by their independent boards of directors.

'Investment trust boards exercise independent oversight, hold fund managers to account and look after the interests of shareholders,' he says.

'All of our investment trust boards regularly monitor management and performance fee arrangements.'

HENDERSON GLOBAL INVESTORS

Henderson manages 13 trusts with total assets of over £5 billion. James de Sausmarez, who heads HGI's investment trust team, says falling charges on Oeics have undoubtedly pushed trusts into cutting their charges, and he expects fees to be squeezed further as trusts grow in size.

He gives the example of the cut in charges at Henderson International Income trust when it absorbed Henderson Global trust. However, he defends the performance fees still in place on eight of Henderson's trusts.

'The performance fees on Bankers Trust and City of London trust were dropped in 2013 because their shares are predominantly held by retail investors, and we wanted their charges to be as straightforward as possible,' he says, secure in the knowledge that the tiered management charges on these two massive trusts are now exceptionally competitive at 0.45 to 0.4 and 0.365 to 0.3 per cent respectively.

On the other hand, he claims, HGI's other trusts are followed mainly by professional investors, many of whom recognise the advantage of a 'properly structured performance fee'.

Asked what that means, he explains: 'There should be a low base fee, the performance fee should only be payable if the trust has outperformed its benchmark plus a hurdle after making up for any previous underperformance, and total fees should be subject to a cap of perhaps twice the basic management fee.'

Most of the performance fees on Henderson's trusts comply with most of those strictures, with Henderson Smaller Companies trust, for instance, limiting its basic fee to 0.35 per cent of net assets, only paying a performance fee if it outperforms by more than 1 per cent a year, and reducing the annual cap on total fees to 0.9 per cent in 2014.

Henderson European Focus trust has much higher ongoing charges than its open-ended counterpart when its performance fee is taken into account - but it is hard to complain, given that the trust's ability to gear and invest in smaller companies has helped its NAV returns to outperform those of its sister fund by an average 2.5 per cent a year over five years.

Henderson Far East Income looks on weaker ground, as it has produced slightly lower five-year total returns than the less expensive Henderson Asian Dividend Income fund.

De Sausmarez says the trust's attractions are enhanced by its higher yield, backed by substantial dividend reserves; but he admits its board may push for lower fees at next year's review.

'It would be ideal if the TERs on all our trusts were below 1 per cent, but what you really want is good managers delivering good returns, and price is never the key determinant,' he says.

BEST BETS FOR LOW CHARGES

The simplest advice for those investment trust enthusiasts putting a high priority on low costs is arguably to focus on the largest trusts in the industry.

Excluding the emerging market specialists, which are invariably more expensive, of the 33 equity-oriented trusts with assets of over £500 million, 17 have ongoing charges of less than 0.75 per cent, and only eight in excess of 1 per cent.

The most frugal, with ongoing charges of less than 0.5 per cent, are City of London, Scottish Mortgage, Temple Bar, Henderson Smaller Cos, Mercantile and Woodford Patient Capital.

Other advantages of these big trusts include the fact that they are almost always entrusted to a very experienced manager; they can afford to buy in shares if their discount widens, without worrying about becoming too small; and most of their shares trade on comparatively tight bid/offer spreads.

However, their sheer size can make it hard for them to take meaningful stakes in smaller companies, which is where a lot of the most exciting long-term investments are to be found.


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