Will investment trusts and exchange traded funds find their place in the sun?

24th January 2013

Investors may find their advisers increasingly recommending investment trusts and exchange traded funds in addition to the more traditional mutual funds. 

The reason is that fund managers and pension providers are now banned from paying commission on all products levelling the playing field between the different product types. In addition IFAs are now required to demonstrate they have searched all relevant markets before making their recommendations. Investment journalist Cherry Reynard considers the merits and pitfalls of all three types of investment vehicle below.

In the bad old days – a few weeks ago – when many advisers were forced to rely on commission to pay their fees, products such as exchange traded funds (ETFs) and investment trusts were at a natural disadvantage. Their charging structures did not, in general, facilitate commission. That meant, for the most part, it was only advisers who charged hourly fees or a percentage fee from funds under management who tended to recommend the products.

But the Retail Distribution Review (RDR), which came into effect on 1 January, should in theory have changed all that, creating a level playing field for different products on cost. With costs taken out of the equation, which structures stack up better for investors?

Investment trusts

Investment trusts have historically been the choice of stockbrokers and private client managers, or they have been bought direct by experienced direct investors. In other words, they have been the insider's choice. They have traditionally had a cost advantage with many charging fees at just a fraction of their unit trust equivalents. As this Telegraph piece points out, in some instances investors could get the same manager in an investment trust structure for around one per cent less in charges per year.

As costs are unbundled as part of the RDR and investors finally see what they are paying, unit trusts may start to look expensive and the cost advantage of investment trusts will become clear. However, there is also the possibility that once the commission costs are stripped out of unit trusts and OEICs, their fees will come down too and investment trusts may not look as advantageous.

However, even if their fee advantage erodes there is, in many cases, a performance advantageto investment trusts. In this piece for investment trade site Fundweb veteran investment commentator Brian Tora, principal at the Tora Partnership,finds that most investment trusts outperform unit trusts in most sectors with a couple of notable exceptions among sectors such as European Smaller Companies.

Investment trusts have the advantage of being able to use gearing, which contributes to performance in rising markets, as discussed on ratings and fund analyst Morningstar on its website. They also bring advantages for income seekers. They can reserve income and therefore pay out a more consistent income to investors.

Of course liquidity can run both ways. On the one hand, investment trusts are not 'forced sellers' in declining markets. Unit trusts and OEICs have to sell holdings to meet redemptions, which investment trusts managers don't have to do. This means that they are a good way to manage more illiquid asset classes for example commercial property, and it also means that there are some types of asset – timber, for example – that are only available through investment trusts. That said, investment trusts have liquidity problems of their own. There is often very limited trading in the shares, particularly in smaller trusts, and bid/offer spreads can be wide.

The discount/premium issue may be an advantage or a disadvantage. If a company is trading at a discount, investors can pick up assets cheaply and benefit from a rise in the price of the assets plus a narrowing of the discount in more buoyant markets. Nevertheless, the opposite can be very painful.

Investments trusts have undoubtedly been overlooked and offer the best way to access certain asset classes and certain managers. They may be due their time in the sun though as always it is important investors understand what they are investing in.

Exchange-traded funds

The use of ETFs has exploded in recent years, with billions pouring into the sector. Again, they have been relatively little used by commission-based advisers, because their fee structure did not accommodate commission, but they may be another area, alongside investment trusts, that will see growth in the post-RDR era.

ETFs are cheap and, as Alistair Cunningham, director of Wingate Financial Planning points out, "in anuncertain world, if you can guarantee low costs, it is one way to get closer to your goals. All things considered, costs count." Robert Forbes, a financial planner at Plutus Wealth, says: "We tend to use passive funds unless there is a strong reason to use an active fund." Conventional wisdom suggests there are markets in which active managers can find anomalies – such as emerging markets – and others – such as the US – which are so efficient that a passive approach is arguably the best option. ETFs are increasingly diverse. Not only are they available for a huge variety of different markets, some groups now offer 'smart beta' strategies. This is designed to circumvent the problem that conventional 'tracker' funds, that track a market weighted index, tend to have a bias tolarger companies and therefore to certain sectors such as oil companies and pharmaceuticals in the UK. They will have followed BP through its well documented travails for example. These 'smart beta' strategies may be based on income, or other risk metrics – MSCI recently launched a series of indices prioritising 'quality' metrics reported here on website ETF Strategy.

There are complexities around ETFs, notably in the use of underlying derivatives and there is associated counterparty risk i.e. it may rely on the financial strength of the financial firm offering the derivative contract.  Morningstar explains the key differences between synthetic replication (using derivatives) and physical replication here.  In general synthetic replication tends to be more accurate and can be cheaper, but physical replication has fewer 'hidden' risks.

Unit trusts/Open ended investment companies

For many, unit trusts and Oeics will continue to make up the lion's share of their portfolios. Costs are likely to come down as the commission era ends and they may be able to claw back some of their performance disadvantage over investment trusts as a result. There is more choice in the unit trust and OEIC market, and many managers are simply not accessible in any other way. This is particularly true for fixed income investments, many of which are not available in an investment trust format. Also, many would suggest that they are a more straightforward product than either investment trusts or ETFs. There will be no gearing, so they tend to be less volatile. The chances are that many investors will already have held several unit trusts in their portfolios and are comfortable with the structure and how to buy and sell. Liquidity remains their key disadvantage. While this is not generally a problem in popular funds, trading in larger companies, it can be a problem in less liquid areas of the market, such as smaller companies or niche emerging markets. It undoubtedly contributed to the difficulties experienced by many commercial property funds in 2007/2008 as they couldn't sell property fast enough to meet redemptions.

Ultimately, investors should be flexible on the structure of investment they use. The Retail Distribution Review should remove some of the artificial advantages for unit trusts and OEICs and force them to compete on their own merits. It means that investors can decide the area in which they want to invest and pick the right fund, regardless of its structure.

 

 

32 thoughts on “Will investment trusts and exchange traded funds find their place in the sun?”

  1. Anonymous says:

    Interesting. They will never unwind QE. They will never raise rates of their own volition. Why have we not had any real growth since 1997? Because the UK is not a going concern. Politicians have made it even less sustainable by using short-term fixes which encourage bad behaviour. A positive feedback loop.

    I’d just forget it if I were you. The UK is going down. Never felt more sure. What will the black swan be? No idea – I just know there will be one.

    ps how much of the 375bn GBP do they have left to spend on suppressing gilt yields?

    1. DaveS says:

      Why the £375bn limit ? They have proven they can get away with the lie – markets don’t care because money ends up in the markets,

      Any sign of “market stress” from rising gilt yields and they will swoop to the rescue with another “temporary injection of liquidity”.

      Its so easy, I don’t know why Zimbabwe messed it up with its own QE.

      1. Anonymous says:

        I’d be really interested to know from Shaun how much of this they have left to spend. I have seen regularly in the past few weeks people on forums stating that the last QE is over and not suppressing gilts. From what Shaun says purchases are ongoing but for how long?

    2. Paul C says:

      Hi there, I subscribe to your conclusive assessment however you have to give them credit for maintaining the staus quo thus far. Rich have gotten richer, Co-op bankers are getting paid more, there are extra layers of politicians in Wales and Scotland. The only down-sides are that wage slaves are a little more enslaved and that there is a burgeoning under-class borrowing rfom Wonga to enjoy their tablet-based online gambling habits. Black swan, what black swan?

      1. Anonymous says:

        The extra layers of politicians might make some sense if they decentralised and reduced British taxation to cover common items like defense. (Think US federal govt) Watch for screams from Wales & NI when they realise their tax must pay their own politicians salaries, policing, school & welfare bills etc.

      2. Anonymous says:

        It’s amazing. I think they can keep it going for some time. The problem will be if the US starts growing. Basically the BoE has been hiding under the skirts of the Fed.

        What black swan – that’s the point, you don’t see it until it’s too late. It won’t need to be anything big, the UK is tottering, punch drunk. A well placed kick in the nuts from a kid will see it fold double.

        1. Jim M. says:

          All this talk of black swans reminds me of another character from Shaun’s Film of the Day, Snatch

          Bricktop: “Do you know what Nemesis means?”

          i would have thought it impossible to kick oneself in the nuts. In the light of the BoE’s actions over the last 7/8 years I may have to reconsider my position on this!

          1. Anonymous says:

            Hi Jim

            I was quoting that line only yesterday to another apparent fan of the film who quoted it in unison with me……

  2. anteos says:

    Hi shaun

    Great article. And well done for standing up against the usual ill informed MSM.

    I’ve been amazed that people have taken this. Apart from saveoursavers, no-one has batted an eyelid. They prefer to blame the bankers, energy companies et al. Its really our own government robbing us blind, and then redistributing it via spending.

    And none of the parties have an answer for this. It will eventually go wrong, its only a matter of time. Who will they blame this time?

    1. Anonymous says:

      Hi Anteos and thank you

      The one thing that we can be sure of is that our political class will not be blaming themselves!

      1. Anonymous says:

        ….and we can also be certain they will be well-insulated from any hardships…….pass me the AK

  3. forbin says:

    Hello Shaun,

    I think they want to unwind the QE , the effect on savers is depressing the consumer market , and we can see that despite all the talk SME are still being punished.

    They have gone for what seems the least worst option thinking this Bank bailout will be like all the others , a few years everything will bounce back , sell off with a profit.

    I have said before that this time is different , the problem too large the debt too big and growth is illusionary if not out right fantasy

    And HMG can roll over the debt for a long time , our HMG is around a lot longer than a human, the trick being – can we afford the interest ?

    Thats the sticking point , and current deficit of 115billion per year – you can’t keep borrowing like that forever

    interesting times indeed

    Forbin

    1. Anonymous says:

      Hi Forbin

      It is one of the ironies of these times that the real issues are often avoided and our public finances are one of them. We seem to be sleepwalking to persistent high deficits whilst everyone talks of austerity.

      Back at the time of the autumn statement I thought that with the economy growing at a reasonable lick we would see the beginnings of a solid improvement but so far it has not happened. Something does not add up here.

  4. GusBmth says:

    Hi Shaun

    Thanks for another great article.

    From the comments at the meeting, I can only surmise that the ‘strategy’ to unwind the £375bn of QE is to allow it to run down as bonds reach maturity, as and when the Bank considers the market conditions are right – which they clearly don’t believe is the case yet.

    If the Bank started to enact such a strategy mid this year, how long would it take to unwind the £375bn? In terms of the maturity dates of the bonds the Bank holds, are there some notable peaks ahead in terms of the amount of debt to be refinanced?

    My guess is that QE will in fact be (at least) a long term and probably permanent feature of monetary policy – with the stock of govt. debt the Bank holds being run down at times, held constant at others and increased when the next crisis (inevitably) hits. I think that the accounting used at present is very favourable and highly questionable; it assumes a ‘free lunch’ is available, which in time will have to be paid for, most probably when the country can least afford it.

    As an aside, I noticed that the BoE inflation survey was released a few days ago to its usual lack of fanfare. The headline rate fell from 4.4% to 3.5%, which is very encouraging, but still way above official estimates of inflation. Interestingly, people would prefer a rise in interest rates to a rise in the rate of inflation by a margin of 58% to 14%. Perhaps the Bank could take that into account before trying to talk down the pound yet again (and pushing inflation up).

    1. Anonymous says:

      Hi GusBmth

      If they adopt your strategy then there would be a relatively quick beginning as £12.7 billion of QE matures on the 7th of September. The lumpiest amount would be £23.2 billion in March 2022 but the effort would go on as far as 2068 although only £84 million then (so far).

      I saw the inflation survey too and had a wry smile at this answer.

      “40% of respondents expected rates to rise over the next 12 months, up from 34% in November.”

      So much for the famed Forward Guidance….

  5. dutch says:

    http://www.theguardian.com/business/2014/mar/02/interest-rates-five-years-rock-bottom

    ‘But it is a peculiarity of the financial crisis that the lower interest
    rates have fallen, the more we have saved. In the dying days of the boom
    in early 2008, UK households were saving just 0.2% of their total
    income every month. But as the banks toppled and worries about job
    losses mounted, the savings ratio leapt to 8% within a year. It’s a sign
    of renewed confidence that the figure is now falling again.’

    Shamelessly nicked off HPC

  6. Anonymous says:

    Hello, Shaun. I noticed that Financial Times liked your tweet about a fourth DG post being created at the BoE so much they included it in their Live Blog of the MPC members testimony before the Treasury Select Committee. When will they offer you your own column on their pages?

    At the TSC hearing Governor Carney had only kind words for five years of QE and a 0.5% bank rate at the BoE. He had no qualms that the CPI inflation rate from March 2009 forward has averaged just above 3.0%, i.e. it has not even respected the upper bound of the central bank’s target range.

    Conservative MP Brooks Newmark accused Governor Carney of bait-and-switch tactics in his introduction of forward guidance. Unfortunately, Mr. Newmark didn’t follow up on his brilliant insight. Arguably the most important part of the forward guidance framework was to establish a knockout if the inflation forecast 18-to-24 months out was 2½% or higher. Introduced in August, this was retained in February when the unemployment rate knockout was dismissed. Governor Carney,
    tried to sell forward guidance to Britain based on his blarney about the unemployment rate and hoped that no-one would pay much attention to his furtive hiking of the target inflation rate.

    Governor Carney never tires of talking about how he brought in time-contingent forward guidance at the Bank of Canada, promising not to raise the bank rate until after the second quarter of 2010 unless inflation turned ugly. In fact, he raised the overnight rate from 0.25% to 0.5% in June 2010, just weeks short of the time threshold. At that time the most recent published Bank of Canada forecasts on CPI inflation showed 1.9% inflation for 2011Q3, 2.0% for 2011Q4 to 2012Q4. If there had been a 2.5% knockout, Governor Carney wouldn’t have raised the overnight rate then.

    Yesterday Martin Wolf argued in the FT that the euro area would be better off with 2% inflation than the current 0.8% inflation, “If average inflation reached 3 per cent (roughly the level that the Bundesbank achieved in Germany over the period from 1980 to 1995), it would be still better.”

    The constant thread between Governor Carney’s forward guidance in August and his fuzzy guidance in February is this implicit 2½% target rate. Britons who don’t approve of the change really should push back, because there are people like Mr. Wolf around who would cheer for pushing the target rate higher still. As you say in your column: to infinity and beyond. Andrew Baldwin

    1. Anonymous says:

      Hi Andrew

      The FT could certainly do with some alternative viewpoints and arguments in my opinion. As to Canada I did note this from CIBC on Mark Carney’s track record there with a smile.

      “arguing his policies led to an over-valued Canadian dollar and plant closures, and left an economy “struggling to wean itself off homebuilding.”

      A boom based on house building evokes all sort of images of a one club golfer with what is happening in the UK.

      Here is the link to the full article.

      http://blogs.wsj.com/canadarealtime/2014/03/12/canadian-economist-takes-swipe-at-mark-carneys-policies/

      1. Anonymous says:

        Shaun, thank you so much for the link. I am familiar with Mr. Shenfeld’s work but hadn’t seen this article. In one way, at least, Governor Poloz seems to have taken a different path from his predecessor. Now the interest rate announcements from the Bank of Canada don’t specify whether the next change will be up or down. No one would accuse Governor Poloz of trying to talk up the loonie.as Mr Shenfeld accuses Governor Carney of doing. Andrew Baldwin

  7. Rods says:

    Hi Shaun,

    An excellent blog as always.

    I’m never expected anything else after they announced they were handing the interest to the government. If they were bought at x + y and matured at x will they be publishing the profits and losses?

    We have seen over the last few years in several Euro countries, the problem with can kicking in that when the can catches up with you again you can easily be in an even worse financial situation. With falling birth rates, a pyramid welfare system, aging demographics and the most expensive costs to governments in our lifetimes are normally after we have retired and head towards the end of our lives, what can possibly go wrong?

    Will there also be the workforce to support the welfare system? The first industrial revolution enabled machinery and limited automation to improve productivity. Since the 1980s when the second industrial revolution started, a cognitive revolution, with the advent of cheap microcomputers, advancing AI and robotics, we are doing away with many low skilled jobs. US wage v skill charts from the 1980s show that the largest workforce sector, the unskilled and semi-skilled their wages are dropping in real terms and the only winners are those will higher education or a degree. This trend will not only continue but will move up skill levels as AI and robotics improves. An example is that driverless vehicles are on the horizon and will become the norm in the next 5 to 10 years, so all professional drivers are made redundant. The challenge is going to be what will replace these jobs? Working is a very important human function for physical and mental health. This also partly explains the widening gap between the top 5% and 95% and also 99% and the 1%.

    1. forbin says:

      Hi Rods

      replacement was supposed to be by Growth .

      All those jobs would be replaced by services – exactly how we’re supposed to afford those services was never explained – all the guff about the “market will provide” just covering up the politocos back sides because they didn’t know either.

      The latest AI will be soon capable of Doctors . lawyers, Judges and politicians……. ( not so sure we can teach the robots the last one )

      Who will be the consumer?

      We can already see that the middle classes are having their wealth taken away (even if it was an illusion according to some)

      The rich will only buy so much – we’ll end up like Brazil or India

      Forbin

      1. Anonymous says:

        Hi Forbin

        You are right about the politicians bit. After all how can they obey the 3 laws of robotics and be a politician?!

        1. Patrick, London says:

          Hang on – They are trying to manipulate and control every aspect of our lives… sounds to me as though they’re following the logical outcome of the 3 laws to the letter. :)

    2. Anonymous says:

      Hi Rods

      This hits home to me “driverless vehicles are on the horizon and will become the norm in the next 5 to 10 years, so all professional drivers are made redundant.” for the simple reason that my brother works as a driving instructor.

    3. Anonymous says:

      No professional drivers in 5 to 10 years – you might find it’s like the claim – fusion power will be ready in 40 years. But each 10 years later, it’s always another 40 years ….

      Given the satnav cockups that ocassionally get reported, I’m sceptical of driverless cars getting 100% accuracy. Increasing electronics in cars has led to complexity & repair difficulty. Either a robot or a human operated machine will need to perform breakdown recovery ….

      What happens if a recovery or repair robot has an inevitable logic fault in it’s software ?

  8. Eric says:

    Hi Shaun, Great stuff; thanks.
    It does seem all the king’s horses and all the king’s men can’t put humpty ….
    which is a bit of a scandal in view of the personal fortunes being made by the king’s men.

    1. Anonymous says:

      Hi Eric

      Too busy profiting personally to have the time to put Humpty back together?

  9. Anonymous says:

    Thanks, interesting. So they are rolling over gilts originally purchased with QE cash only with a longer period to maturation. Is that right, or is this “fresh” QE money expanding their stock? If the former why didn’t they buy a longer term gilt to begin with? They did QE in 2009, 2010 and 2011.

  10. digger says:

    Thanks for that Shaun,

    Roughly £50n bn p.a since 2010

    That pretty impressive.

  11. Patrick, London says:

    Hey Shaun,

    Is there a year by year comparison of the number of repossessions that have taken place in this crash and the last?

    I saw a figure somewhere recently that referenced approx 70k repossessions in a single year of the last recession, and maybe >50k for a year since the beginning of this recession.

    After 6 years of near ZIRP, and massive artificial life support, the prevention of some 20,000 repossessions in a year seems disappointing…

    Given that this recession has lasted much longer, how are the figures looking overall.

    Apologies if i’ve misquoted or misunderstood what I saw…

    Patrick

  12. Noo 2 Economics says:

    The MPC would leave it to the Debt Management Office to decide what maturities to buy trying to ensure an even spread of different durations over the coming years.

    They don’t bother with the implementation, just the big ideas – this is why everything is in a mess. I’ve always said implementation is all.

  13. Anonymous says:

    Ok I get the DMO do the detail, my ignorance was more around how long QE stays in the system.

    Say they purchase 375bn of gilts, when these expire they just always let them drop off the face of the earth without repaying and that’s it? So say the avg date to maturation is 10 years. They “spend” 375bn on govt debt now and in 10 years time the govt doesn’t have to pay it back so they increased the money supply by never withdrawing the stimulus which has been (deficit) spent by the govt and then resides “in the system”, and is never “destroyed” by matching off the payment.

    But unless the govt reigns in it’s deficit it’s going to have to QE again. And again. Or they somehow get to the point where they can pay mkt rates on gilts. Doubt that will happen…

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