Mind the performance gap between Oeics and investment trusts

Last year advisers and wealth managers purchased almost £1bn of investment companies on adviser platforms.  This is a five-fold increase on purchases pre the Retail Distribution Review (RDR) in 2012 so the message about the benefits of investment companies is getting out there.  However, there’s still a lot more work to do as advisers and wealth managers purchase tens of billions of open-ended funds every year.

This is despite the average investment company outperforming the average open-ended fund consistently over the long term. So why are investment companies which are celebrating their 150^th anniversary this year, so appropriate for long-term investing?

Well the closed-ended structure of investment companies allows managers to take a long-term view of their portfolio and ride out market volatility, whereas open-ended funds have to manage inflows and outflows of cash, inevitably often at the top and bottom of the market cycle. This closed-ended structure also makes investment companies particularly suitable for less liquid investments like smaller companies and illiquid assets such as property, infrastructure and unquoted companies.

Many of the investment companies investing in illiquid assets have the ability to generate attractive yields. This is a message which is getting through to wealth managers and advisers, with four of the six most popular sectors last year being in alternative assets including Property Direct – UK, Debt, Property Specialist and Infrastructure.

The advantages of the closed-ended structure were highlighted after the Brexit vote in 2016 when many open-ended property funds closed to trading when sentiment in property plummeted. Of course, investment companies’ share prices in the Property Direct-UK sector fell but investors could continue to buy and sell and by the end of 2016 investment companies had bounced back and were trading on premiums again. It’s worth bearing in mind that even in good times open-ended funds in the property sector need to keep up to 20% in cash to meet redemptions so there is less money invested.

Investment companies also have structural income advantages which contribute to their long-term performance. Open-ended funds have to distribute all their income whereas investment companies can retain up to 15% each year and hold this in the revenue reserve.  When times get tough, for example in the financial crisis when banks cut their dividends or when BP suspended its dividend after their oil spill, investment companies can draw on the revenue reserves to boost their dividends.

This ability to smooth dividends explains why investment companies have such strong records of dividend increases with 21 investment companies, the dividend heroes, increasing their dividend every year for more than 20 years. Three companies – City of London, Bankers and Alliance Trust have increased their dividend every year for 51 years.

City of London is in the UK Equity Income sector which was the third most popular sector for advisers and wealth managers in 2017 and in total 10 of the dividend heroes come from this sector. Bankers and Alliance Trust are from the Global sector which was the most popular sector last year for wealth managers and advisers and nine dividend heroes are from this sector.

Another key contributor to investment companies’ long-term performance is gearing. This boosts performance over the long term as prices rise but it can be a drag on performance if asset values fall. The average level of gearing is currently around 8%. Not all companies gear and it varies between sectors and individual companies.

Independent boards of directors are another benefit, looking after shareholders’ interests and providing an additional layer of scrutiny over the management group. Over a third of investment companies have reduced their fees since 2012 demonstrating the value of boards.

There are many structural reasons which explain why investment companies are particularly suitable for long-term investment.  With pension freedom meaning investors potentially staying invested for much longer and perhaps taking an income in retirement from those investments, it may well be time to consider investment companies.

£100 lump sum share price total return performance over 30, 20 and 10 years

Source: Morningstar