9. Equity vehicles

Sunday, 1st July 2012 16:21 - by David Harbage

Over the course of the past two months...

...these blogs have been assessing the merits and shortcomings of various kinds of asset into which long-term savers may choose to invest, from cash to bonds, property to commodities through, most recently, to equity. In this article we seek to consider some of the prime alternative means of investing into stock market listed bonds and equities.

Individual securities can be purchased and traded through a stockbroker (more of that in a later article) but, unless an investor has sufficient monies to acquire a broad spread of bonds and stocks, he or she might want to consider some form of pooled investment in order to minimise stock specific risk and achieve the desired diversification.

The most common forms of collective investment feature open (unit trusts) or closed (investment trusts) ended investment companies. There are a wide range of these traditional products available to private investors, covering various asset classes which range from multi-manager offerings - incorporating various asset classes - through to specialist funds that focus on niche areas of investment (such as technology, private equity or emerging market equity). The prime historic differences surround: firstly, the cash flows that impact open ended vehicles (and not closed ended) and second, valuation - where unit trust prices are calculated once a day and typically perfectly reflect the (previous day's) worth of the underlying portfolio. By contrast, investment trusts are company shares listed on the stock exchange whose price will reflect underlying demand - with net asset worth being an influence, rather than wholly dictating value.

While investment trusts have typically outperformed higher-cost unit trusts (according to Collins Stewart’s latest report on the subject covering the past ten years to end December 2011, closed ended trusts have delivered higher returns in every sector or asset class, except for Japanese equity, than open ended funds), short-term performance may be less reliable as the above mentioned respective methods of pricing these collectives impact.

If an open ended fund becomes unpopular (perhaps because its relative performance has been disappointing or its fund manager has moved to another firm) or otherwise becomes subject to more investors leaving than are introducing new monies - probably most likely when stock markets are falling, and fear abounds - then the fund manager will be forced to liquidate underlying investments in order to meet these calls from the pooled fund. This might prove difficult, especially if the fund invests in illiquid assets, such as the shares of very small companies, and such disposals might jeopardise the prospect of realising fair value. Upon receipt of unexpectedly large sums from investors, a similar dealing issue might arise; accordingly, apparent ‘good news’ may be diluted by an inability to manage a larger pool of money, without compromising the fund manager’s ability to maintain current successful strategies. Such a scenario, leading to an open-ended fund being ‘closed’ to new investors, is not an uncommon occurrence. By contrast, the manager of an investment trust does not have these cash flow distractions.

Another differentiating factor is that, unlike unit trusts, investment trust companies are allowed to borrow (typically to around a gearing level of 10% of total asset worth) and so ratchet up their returns when the underlying securities are performing well; of course, if markets are falling then the trust’s returns are likely to be negative and will be exacerbated by any gearing. Open ended unit trusts are obliged to distribute all of the income they produce but, being a company, an investment trust has discretion to make reserves in the good years and smooth dividend payments to their investors.

Most investment trusts carry out, and advise the market of, a daily valuation of the securities they own – less liabilities, and calculated per share - this is termed, and reported as, the net asset value (NAV) per share. According to sentiment towards the trust, so the shares will be priced on the stock market at a discount (more commonly) or a premium (perhaps driven by exceptionally good performance of the underlying portfolio of investments, and scarcity value) to this NAV. Some investors will scrutinise these discounts, after taking into account current NAV performance and any other influencing factors (such as level of the trust’s borrowing, or gearing), and seek to trade the trust’s shares when the share price reaches the edge of its normal range. Many trusts will also have share re-purchase strategies in place to limit the magnitude of the discount.

Notwithstanding the above comments surrounding their basic structure and performance, the open ended industry is huge (there are more than 3,000 open ended collectives in the UK, worth more than £600 billion), biased towards funds which have the aim of outperforming a particular benchmark, and dwarfs the worth of the closed ended universe (circa 500 investment trusts, valued at £95 billion in total). The demand for unit trusts has been principally driven by advisor recommendations - both independent, and from those employed by banks or building societies - to their clients (typically personal investors), who in turn are influenced by the introductory commissions and ongoing ‘trail’ of commission.

Investment trust companies do not reward introducers in this way and, in part as a consequence, their costs are normally much lower than unit trusts. According to the Collins Stewart report, an investment trust’s annual management fees are typically 0.63% per annum lower than its equivalent open ended fund. Looking forward into 2013, the advising landscape will change dramatically as the Retail Distribution Review (RDR) will impact and require advisors to be more visible in their remuneration (expected to feature fee charging, rather than commission receipt) and advice will encompass more of the available investment market.

Another means of owning equity - as well as other assets - is via exchange traded funds (ETFs) which, like investment trusts, are stock market listed and therefore reflect intra-day worth of their particular asset. ETFs’ inherent costs are typically low (annual management fees range between 0.2% and 0.6% per annum), because they seek to replicate - rather than outperform - an asset, which is usually based on an index of the particular asset type (such as the FTSE100).

Beyond UK equity, ETFs are available for investors to capture a wide range of overseas stock and bond markets, commodities (Exchange Traded Commodities: ETCs) and various strategies - including directional (going 'short', as well as owning or going 'long') and geared (doubling, or more, the asset's price movement) ones. Based in various currencies, both on and offshore, there are a number of producers of ETFs, with one of the world’s biggest fund management houses Blackrock probably being the best known provider, via their series of iShares.

This is a fast growing segment of the asset management industry, especially in North America and Europe, amongst both retail (private client) and institutional investors. Alongside index tracking open ended funds (and a very limited number of closed ended trackers), ETFs represent the standard in passive, lower cost (aided by being exempt from stamp duty in the UK) index-tracking investment vehicles.

Investors who believe that it is possible, and wish to outperform a particular asset class - be it an equity, a commodity or a bond index - will typically look beyond ETFs or ETCs, to other more traditional forms of collective or pooled investment vehicle which features active portfolio management. Perhaps managed by fund managers of global repute, whose well-publicised views matches and attracts the investor, we are regularly and correctly reminded that past performance does not provide any assurance or even indication of future returns.

However, investors do have the ability to capture a higher return via geared strategies (such as an ETF that delivers twice the daily movement in an index or commodity price). While many ETFs are constructed by owning the physical underlying securities (the FTSE100 index constituents, for example), increasing demand for vehicles or instruments which facilitate geared returns requires the use of derivatives to achieve the desired asset or index replication. Where this occurs, the means or resultant instrument is known as ‘synthetic’ and, while it should be capable of producing the same desired outcome (for example index replication) as an ETF owning the physical investments, a synthetically constructed ETF (for example by buying futures or options) can involve higher risk as the underlying derivatives probably carry additional counterparty (by reference to the provider of off-exchange contracts) risk.

Short-term traders increasingly demand investment vehicles or instruments which can provide the opportunity to make greater returns from smaller pools of capital. As a consequence, there has been significant appetite from both professional and keen private investors for contracts for difference (CFDs) and financial spread trading or betting. Investors might be the wrong descriptor to use here, as these educational articles’ view of investment is strictly for the long term - which effectively means the indeterminable foreseeable future, probably of a minimum five if not ten years - rather than adopting a speculative or aggressive trading process to build capital.

Finally, as an example of the three prime types of equity vehicle mentioned in this article, we would highlight the small and medium sized company segment of UK shares - which investors might choose a collective investment in order to buy into the fund manager’s skill or gain diversification. No recommendation is intended by their mention, but one could buy either the open-ended unit trust or the closed-ended investment trust offered by Edinburgh-based fund manager Aberforth Smaller Companies, or the iShare FTSE250 index ETF. Each owns physical securities (Aberforth’s funds will normally comprise 80+ stocks, the ETF the full 250 constituents of the index), the actively managed funds have a preference for undervalued stocks (leading to a higher dividend yield - of 3.8% on the investment trust, which currently has gearing of 8% and whose shares are priced on a 15% discount to net asset worth - as compared to the ETF’s 2.6%), and while both Aberforth funds have relatively low and similar annual management fees (total expense ratio of 0.86% per annum in 2011), this was twice as expensive as the ETF. Performance comparison is inappropriate as they invest, and are benchmarked against, different segments of the non-FTSE100 portion of the UK equity market.

In conclusion, the writer believes that each of the discussed open, closed and ETF vehicles merit further investigation for investors seeking diversification in their equity investment - especially where it would be impractical to acquire enough individual stocks or bonds otherwise (such as for smaller UK companies or overseas markets) - and indeed for other asset types (such as oil or gold).

In the next blog we will take a look at structured (sometimes, and erroneously, termed guaranteed) products and hedge funds which seek to deliver positive, cash-beating returns.


The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.