Funds vs. Investment Trusts

Investors should consider all the tools at their disposal when building up a diversified tax-efficient portfolio. We compare closed and open-end funds

Emma Wall 10 March, 2014 | 10:30AM
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Investing in a composite fund can offer investors exposure to foreign markets and niche sectors that they wouldn’t be able to access on their own.

Stock picking can be rewarding – but it is also time consuming and risky. Asset managers’ size mean they can negotiate better deals, influence companies and meet with executives – all on behalf of the private investor. There are more than 5,000 composite funds available to British investors which invest in stocks and bonds listed globally. Buying just one fund can mean you are invested in an average of 50 assets, offering you instant diversity and reducing volatility.

There are two main decisions investors in funds need to make; where you wish to be invested – emerging markets, global financial companies, commodities, and how – open-end funds, closed-end funds or exchange traded funds.

Open-end Funds

When you buy shares in an open-end fund, you're buying an ownership stake in a range of investments that are managed by a fund manager. The fund manager combines your money with that of other investors and uses the money to buy and sell investments, with the goal of increasing the value of the fund.

The price for a share in an open-end fund is calculated by taking the total value of the securities owned by the fund and dividing that number by the number of fund shares outstanding. Shares outstanding are all the shares authorised, issued and purchased by investors. So if a fund has £1 million in assets, and there are one million shares outstanding, each share would cost £1. This per-share value is called the net asset value (NAV).

These funds are relatively easy to buy and sell. Unlike many other security types, such as individual stocks, ETFs and investment trusts, you don’t need to find a buyer when you wish to sell your fund shares. Investors allowed to trade fund shares within a certain window each business day.

However, this open-end structure can cause liquidity issues. If lots of shareholders wish to redeem their assets at once it can force a fund manager to sell investments at a bad which can have a negative effect on the performance of the fund.

It can also make open-end funds less suitable for certain assets. Tens of thousands of investors lost serious cash during the property crash of 2007 and 2008 popular funds managed by the likes of New Star and Aviva were forced to impose exit restrictions because of liquidity problems. The managers could not sell off their assets quick enough to meet redemptions and so investors’ cash was stuck in the funds for months.

Fund investors have to pay fees and charges to the fund manager and fund company for their work. If the fund manager fails to make more than the total annual charge these fees can have a detrimental effect on performance.

Closed-end Funds

Like open-end funds, closed-end funds, also known as investment trusts, allow investors to pool their money together and have a fund manager make investment decisions on their behalf. Investment trusts also have a board of directors who are tasked with providing another level of oversight for investors.

Fees and on-going charges for investment trusts tend to be lower than open-end funds, which can mean

One of the key advantages of closed-end funds is their fixed pool of assets. Before an investment trust is launched, the manager raises cash which then only grows if the underlying assets grow in value. The number of shares in an investment trusts is set, and these are bought and sold between investors. If you wish to sell your shares, you must find a buyer. This closed-end structure means that an investment trust’s performance is unaffected by asset flows.

However, with open-end funds, you can be assured that the price you pay or receive when you buy into a fund is directly linked to the fund’s net asset value (NAV). Closed-end funds operate differently. With an investment trust, the shares are traded on an exchange and while the market price should reflect the NAV, the price for the shares is ultimately based on the market forces of supply and demand. If demand for an investment trust is high, shares may trade at a premium to their NAV. If demand for an investment trust is low, shares may trade at a discount to their NAV. This investment trust quirk creates an additional level of volatility, but also creates investment opportunities.

Investment trust managers can also use gearing to boost returns, though there is the risk that gearing might cause an outsized loss in the portfolio.

One last drawback for investment trusts: many platforms do not offer these funds. This means that individuals may find that they are difficult to access.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Emma Wall  is former Senior International Editor for Morningstar

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