Will investment trusts and exchange traded funds find their place in the sun? – 15090

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 accommodat
e 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.

 

 

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